Today, Oppenheimer downgraded the stock of Business Development Company newbie OFS Capital. We thought it would be useful to provide some context around the story. The fly in the ointment is what is happening-or not-about the Company’s intention to convert the investment in it’s SBIC investment into a wholly-owned subsidiary.

We read the IQ Conference Call (best as we can-transcriptions make some of the language goofy). Certainly, management had to admit on the call that there was considerable uncertainty about converting their separately owned SBIC into a subsidiary, and getting heir hands on that large amount of cheap capital. Otherwise, the Company’s remaining cash and unused Revolver capacity won’t be sufficient to cover their current dividend. Here’s the basic language in the Earnings Report:

“Simultaneously, we continue to work towards converting our Tamarix Capital Partners L.P. (Tamarix LP) investment into a drop-down small business investment company fund (SBIC) within OFS Capital. We are working to obtain the necessary investor and regulatory approvals. “

Here is what the CEO Bob Pittson said early in the Conference Call about the process of getting the SBIC into the Company:

View the full OFS chart at Wikinvest

“… I want to update everyone on our progress and converting the SBIC fund into a drop-down subsidiary. I personally had conversations with a large number of third-party investors in the fund. Based on these discussions, we will soon be sending out a proposal to acquire all their commitments on which $4.5 million is currently funded. We are also finalizing a drop-down documentation, which will be submitted to the SBA for their approval. While we are generally pleased with our progress, there are number of variables that could impact consummation of the drop-down and we cannot provide guidance as to the timing or ultimate outcome. The company [ph] required unanimous consent, there are by my count about 20 potential stakeholders including SBA, who’s non-approval could materially alter the drop-down process or derail the process in its entirety”.

Later on, following an analyst’s question the CEO made it clear that if SBIC and shareholder approvals from the 20 “stakeholders” are not received, the strategy of OFS will be to invest $25mn in the SBIC anyway (as a minority investor). If approvals are received, the goal is to invest $75mn to maximize the SBIC leverage.

“We currently have a firm commitment to invest. I think we’re roughly at $19 million to $20 million in commitment for the fund, but there is overarching commitment depending on the diversification of investors in the fund, that commitment can move up to $25 million, if we don’t become a drop-down. In case of becoming a drop-down, our plan is to and our discussions with the SBA involves committing $75 million in capital to that to maximize the benefits and roll the fund to $225 million.”

The CEO spelled out later why the economics of the planned SBIC subsidiary are so critical to the Company’s future:

“(At the time of the roadshow in October 2012) we were looking at the SBIC fund generating a rate of return fully utilizing the leverage and looking at today’s interest rates where they’re above 20% rate of return on that investment and the senior loan fund itself, is kind of below teens maybe 12% depending on how much leverage, we can put into that.

The strategy works, concert with one another getting that exemptive relief essentially creates the ability to create a little more leverage in the BDC with very low cost long-term capital. So really does drive our profitability. …Our interest rates haven’t moved much, maybe there’s been a little competition and compression in maybe risk premium side. I’d still hold to mid teens kind of rate of return off of this business model, net of management, based management fees.”

The CEO went on to explain that the projected risk-adjusted return at the SBIC should be very good, especially as OFS intends to provide uni-tranche financing in the SBIC rather than pure mezzanine debt. That means a portion of the assets will be higher up in the capital structure and losses should be lower than in a pure mezzanine vehicle.

All of that is in the future, and at a time when loan spreads are under pressure, so the uncertainty about getting the SBIC subsidiary approvals is weighing on the stock price. Not helping is that management admits the time being spent on getting the SBIC approved has kept OFS from booking much in new uni-tranche deals.

The good news here is that the existing portfolio of 58 senior loans is performing well, with only one non-performing loans on nearly a quarter billion of assets. However, management did mention that pricing pressure in the market, has caused the syndicates in which OFS is invested to lower rates on 15% of the portfolio in recent weeks. There is no reason to believe that this won’t continue, and only makes more important the ability to invest bi-laterally at higher rates through the SBIC.

There’s too much uncertainty here for Oppenheimer, which downgraded the stock. The price has been stumbling, down $2 off the IPO price and could go lower until the uncertainty about the Company’s likely business model is resolved.

The post Uncertainty about SBIC Subsidiary Impacting OFS Capital appeared first on BDC Reporter.

First, the Company appears to be proceeding with management’s  stated intention to broaden the portfolio from energy-only loans and investments to more traditional targets for buy-out groups and their financiers.  As we’d expect, NGPC is providing the debt capital in association with a Private Equity group: Wingate Partners.  We would be worried if NGPC was making so-called “sponsor-less” loans, as they’ve done in the past in the energy space. When you start a new type of lending it’s always a good idea to have a PE partner with capital at risk, both to serve as a way to validate one’s own credit underwriting and to mitigate the risk by having equity capital beneath NGPC in the capital structure of Nekoosa Coated Products.   Without knowing any details about either the buying company or the target,  and without any details on the capital structure and cash flow of the businesses involved, we are pleased to see the transaction is an “add-on acquisition” with a reputable and experienced sponsor.  Still, it’s way too early to say if NGPC is going to be successful in it’s attempt to become a mainstream BDC rather than an “energy play”.  It takes years to see how new loans will perform, but a journey of a thousand miles starts with a single step, and the Company is on it’s way.

View the full NGPC chart at Wikinvest

Second, the deployment of the new loan may be critically important to NGPC’s earnings in the months ahead, given the uncertainty about a couple of the Company’s current energy loans. We’ve written about NGPC’s troubled loans quite recently (see the April 22 link here to our article “NGP Capital: Trouble Ahead ?”).  A $17.5mn loan at 15% will make a material difference to the Company’s total income in the second quarter.  There may be a fee involved as well. New loans such as that being made to Nekoosa may be the difference between maintaining or cutting the current dividend should matters at  troubled borrowers GMX Resources and ATP Oil & Gas go the wrong way.  The market remains very worried about NGPC’s immediate prospects. The stock is trading below $6.50 a share, a huge discount to Net Asset Value. The current price level is at a YTD low. Indeed, NGPC has not traded at these levels in a year, suggesting the uncertainty about it’s troubled energy investments outstrips any positive from the economics of the new loan.

Anyway, here is the NGPC press release from this morning:

“PRESS RELEASE TEXT (May 6, 2013): NGP Capital Resources Company today announced the closing of its third non-energy middle market portfolio investment. On April 22, 2013, the Company closed a $17.5 million Second Lien Term Loan to fund a portion of the acquisition of IGI Corp. (“IGI”) by Nekoosa Coated Products (“Nekoosa”), a portfolio company of Wingate Partners, a Dallas-based private equity group. The Second Lien Term Loan earns interest payable in cash at an annual rate of 13% plus paid-in-kind interest of 2% per annum and matures in October 2018.

The Nekoosa business, originally started in 1961 as a division of 3M Company, is a leading manufacturer of carbonless sheets and an expanding line of specialty products used by digital and offset printers in the commercial printing industry. IGI is the parent company of RTape Corp., a leading manufacturer of application tape and a wide range of other products for the sign, screen print and digital printing markets, and CET Films Corp., a manufacturer of custom extruded films for a range of niche graphic arts and ancillary markets.

Jason Reed, Principal at Wingate Partners, said, “NGPC really delivered for Wingate and Nekoosa on this transaction. We had an accelerated schedule to close the IGI acquisition and NGPC met our timetable, moving rapidly from initial term sheet to a commitment through due diligence and closing. They delivered on every promise, and we really enjoyed working with them. We look forward to working with NGPC on Nekoosa and in the future on other Wingate deals.”

Steve Gardner, the Company’s President and CEO stated, “We are very pleased to participate in this transaction and expand our relationship with Wingate Partners. The combination of IGI and Nekoosa is an attractive opportunity given the similarities in manufacturing processes and strong relationships with their respective channel partners, and we look forward to their continued expansion and success. This investment increases our total year-to-date new investment activity to $72 million, and middle market non-energy investments now make up approximately 18% of our investment portfolio.”

The post NGP Capital’s New Loan Announcement Dissected appeared first on BDC Reporter.

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We reviewed the filing for hints and here’s what we found:

BORROWER GMX RESOURCES HAS FILED FOR BANKRUPTCY

1. The Company’s investment in GMX Resources is going sour. Here’s the run-down from the filing, which brings developments almost up to date:

“On September 19, 2012, GMX Resources, Inc., or GMX, consummated an exchange offer for its outstanding 5% Senior Convertible Notes due 2013, or the 2013 Notes, pursuant to which holders tendering the 2013 Notes received new Senior Secured Second-Priority Notes due 2018, or the 2018 Notes, and shares of GMX common stock. We tendered our 2013 Notes in the exchange offer, and consequently received 2018 Notes with a face value of $12.7 million and 3,646,368 shares of GMX common stock. We sold 671,270 shares of GMX common stock in 2012. Effective January 3, 2013, GMX executed a 1-for-13 reverse stock split; consequently, our 2,975,098 shares were converted into 228,853 post-split shares, which we sold in March 2013 for an average price of $3.28 per share, or $0.8 million, resulting in a realized short-term capital loss of $1.6 million, or $0.07 per common share. Interest on the 2018 Notes accrues at a rate of 9% per annum and is payable quarterly (commencing March 4, 2013) at GMX’s option, in cash or, with respect to interest paid prior to September 19, 2014, either in the form of cash, GMX common stock, or a combination thereof. The number of shares of GMX stock, if any, to be issued in lieu of cash interest is calculated by assigning a value per share equal to the product of (a) 0.75 and (b) the 10-day volume weighted average price ending the business day prior to the interest payment date.

On March 4, 2013, GMX announced that it failed to make its interest payment on the 2018 Notes, which was due on March 4, 2013. Under the indenture, this failure to pay does not constitute an event of default unless it continues for thirty days; however, it does constitute an event of default under another GMX debt security, which could potentially trigger cross-default features and acceleration of substantially all of GMX’s indebtedness. GMX has announced that it has engaged a financial advisor to assist GMX in its ongoing exploration of financing alternatives, including a potential restructuring of GMX’s balance sheet in light of its current liquidity and cash needs. GMX has announced that if it is not able to successfully implement a consensual alternative for restructuring its balance sheet, or in order for GMX to implement a financial alternative, GMX may voluntarily seek protection under the U.S. Bankruptcy Code. As of December 31, 2012, we recorded a 100% reserve, totaling $0.4 million, or $0.02 per share, on our interest receivable from GMX as of such date.

On April 1, 2013, subsequent to the date we filed our Annual Report on Form 10-K, GMX filed for protection under Chapter 11 of the U.S. Bankruptcy Code. At December 31, 2012, the fair value of the GMX Notes was $7.4 million”.

If NGPC ends up writing off the full face value of the $12.7mn in Notes that’s quite a hit for a small company with only 14 investments. We calculate the potential loss on the debt, using the info in the filing, at $0.25 per share on Net Asset Value, and a potential 5% drop in Investment Income over 2012′s level, and an even greater hit to Net Investment Income.

ATP OIL AND GAS ROYALTY INVESTMENT UP IN THE AIR

2. There is a great deal of uncertainty whether  NGP Capital Resources big, risky bet on ATP Oil & Gas is going to pay off. Here’s the language from the filing:

” In 2011 and 2012, we purchased from ATP Oil & Gas Corporation, or ATP, limited-term ORRIs in certain offshore oil and gas producing properties operated by ATP in the Gulf of Mexico, including $25.0 million advanced on July 3, 2012. Under this arrangement, we own the right to portions (ranging from 5.0% to 10.8%) of the monthly production proceeds from the various oil and gas properties subject to the ORRI in ATP’s Gomez and Telemark properties. The terms of the ORRI provide that it will terminate after we receive payments that equal our investments in the ORRI plus a time-value factor that is calculated at a rate of 13.2% per annum. On August 17, 2012, ATP filed for protection under Chapter 11 of the U.S. Bankruptcy Code, and received authorization to incur debtor-in-possession financing of approximately $600 million. ATP failed or refused to deliver our proportionate share of production proceeds for the production months of May and June 2012, which proceeds were due to be distributed on July 31, 2012 and August 31, 2012, respectively. On August 23, 2012, the bankruptcy judge presiding over ATP’s case signed an order allowing ATP to pay amounts received after August 17, 2012 to those parties entitled to receive them, including the ORRI holders, provided that the owners of the ORRIs execute the Disgorgement Agreement providing for the repayment to ATP of any amounts that the bankruptcy court later finds to have been inappropriately paid. We executed the Disgorgement Agreement and began receiving monthly distributions in September 2012 from ATP of our share of production proceeds received by ATP after August 17, 2012. On October 17, 2012, we filed a lawsuit against ATP in the U.S. Bankruptcy Court, seeking a declaration that the ORRIs are valid, fully enforceable, and not voidable. ATP has responded by seeking a determination that the ORRIs are not enforceable as a conveyance, but rather are in the nature of a debt instrument. In that connection, ATP seeks disgorgement of amounts paid to us in accordance with the Disgorgement Agreement. This lawsuit is currently pending and trial is scheduled for April 30 – May 1, 2013. We intend to vigorously defend our position that the ORRIs constitute real property interests and are fully valid and enforceable pursuant to their terms. Our unrecovered investment as of December 31, 2012 was $37.0 million, and we had received $8.9 million subject to the Disgorgement Agreement, of which $2.9 million was recorded as investment income in our statement of operations for the year ended December 31, 2012. Our unrecovered investment as of February 28, 2013 was $33.6 million, and we had received $13.1 million subject to the Disgorgement Agreement [Emphasis added by the BDC Reporter].”

Later on in the filing is greater detail about the legal arguments going back and forth, which deserves detailed reading by any existing or prospective investor:

“On August 17, 2012, ATP filed a petition for relief under Chapter 11 of the U.S. Bankruptcy Code, in the U.S. Bankruptcy Court for the Southern District of Texas. We own limited term ORRIs in certain offshore oil and gas producing properties operated by ATP. On August 23, 2012, the bankruptcy judge presiding over ATP’s case signed an order (Docket No. 191) allowing ATP to pay amounts received after August 17, 2012 to those parties entitled to receive them, including the ORRI holders, provided that the owners of the ORRIs execute an agreement providing for the repayment to ATP of any amounts that the bankruptcy court later finds to have been inappropriately paid (the “Disgorgement Agreement”). We executed the Disgorgement Agreement and began receiving monthly distributions in September 2012 from ATP of our share of production proceeds received by ATP after August 17, 2012. As of December 31, 2012, our unrecovered investment was $37.0 million, and we had received $8.9 million subject to the Disgorgement Agreement, of which $2.9 million was recorded as investment income in 2012. As of February 28, 2013, our unrecovered investment was $33.6 million, and we had received $13.1 million subject to the Disgorgement Agreement.

On October 17, 2012, we filed a lawsuit against ATP styled: NGP Capital Resources Company v. ATP Oil & Gas Corporation , Adv. Proc. No. 12-03443, in the U.S. Bankruptcy Court for the Southern District of Texas, seeking a declaration that the ORRIs are valid, fully enforceable and not voidable. ATP filed an answer and counterclaim in which it (a) denies that the ORRIs are valid and enforceable, (b) seeks a declaration that (i) the ORRIs are a financing agreement and not a true sale and (ii) the ORRIs are executory contracts that are subject to rejection under 11 U.S.C. Sec. 365, and (c) seeks disgorgement from us of amounts paid to us since August 17, 2012, the date of filing of ATP’s Chapter 11 proceeding. The United States has sought to intervene in the lawsuit arguing that the underlying leases are unexpired leases of real property or executory contracts (and not real property conveyances), subject to rejection by ATP. Certain service companies holding mechanics and materialman’s lien privileges have intervened in the lawsuit for the purpose of establishing that their liens and privileges are superior to our rights. The Bank of New York Mellon Trust Company, N.A., the secondary lien holder, has also intervened in the lawsuit, arguing (i) the ORRIs are a financing agreement and not a true sale, (ii) our claims are barred, waived, released and/or otherwise foreclosed by the express terms of the conveyance of the ORRIs, and (iii) either we have not met a condition precedent or we failed to perform or substantially perform our contractual obligations. The issues in the lawsuit have been bifurcated. This lawsuit is currently pending and trial is scheduled for April 30 – May 1, 2013. We intend to vigorously defend our position that the ORRIs constitute real property interests and are fully valid and enforceable pursuant to their terms.

Separately, the Official Committee of Unsecured Creditors of ATP (the “Committee”) filed a motion (the “Motion”) requesting authority from the U.S. Bankruptcy Court to be allowed to bring a fraudulent transfer action against us, in which the Committee seeks to allege (a) that ATP was insolvent at the time of the assignment of the ORRIs to us (b) that ATP received less than fair value from us in exchange for the assignments of the ORRIs and (c) as a result, the assignments should be set aside. The Company vigorously denies these allegations and opposes the Motion. The Motion has been abated until a date after May 1, 2013″

If NGPC loses in court, the Company will have to “disgorge” $13.1mn to ATP, and may see their investment pushed down the balance sheet of the bankrupt company.  Management is confident they are on solid ground, but if they are not..

Sadly, there’s more as ATP is seeking to close down some of it’s wells from which NGPC is receiving royalties, and this too may affect cash flow in the short term. Here’s the language in the filing:

“On February 24, 2013, ATP filed an emergency motion for an order approving the shut-in of the Debtor’s Gomez Properties and granting related relief [Docket No. 1494] (the “Shut-In Motion”). As more fully set forth in the Shut-In Motion, ATP asserts that the Gomez Properties should be shut-in because their continued operation negatively affects ATP’s cash flow. The Gomez Properties are burdened by the ORRIs, and we receive distributions of production proceeds attributable to our interests in the Gomez Properties. An emergency hearing was conducted by the Court on February 28, 2013, and on that date the Court entered its Order Regarding Shut In of Gomez Wells [Docket No. 1531] (the “Gomez Order”). The Gomez Order sets a final hearing on the Shut-In Motion for March 28, 2013 and reflects an interim compromise by certain ORRI holders and contains provisions for the accrual and distribution of production proceeds generated from the Gomez wells for the period March 1, 2013 through the date any order is entered authorizing the shut in of the Gomez wells. To the extent the Court grants the Shut-In Motion and the Gomez wells are shut-in, the cash flows attributable to the ORRIs will be negatively affected.”

IF WORSE COMES TO WORST

The rest of the Company’s energy loans  and a couple of newly booked health care investments appear to be performing normally. However, should both these troubled situations go the wrong way, the Company’s revenues could drop by as much as a third, and Net Investment Income by more than half. The Company is carrying the ATP investment at close to fair value, and has no liability booked for the potential disgorgement proceeds. If worse came to worse the Company could have to write off in excess of $50mn (adding together the FMV of the GMX Notes, the “unrecovered” ATP investment and the $13.1mn potential to be “disgorged). The potential hit to the NAV would  be $2.57, which could bring the book NAV to $7.00, just above the current price.

IMPACT ON BORROWING FACILITY

Unfortunately, NGPC is not swimming in liquidity right now after making several major new loans. We are worried that should the worst come to pass (and that may not turn out to be the case) this loss of asset value and Net Investment Income might result in a default under the Company’s Revolver debt. Here are the covenants we worry most about (quoting from the filing):

maintaining a ratio of net asset value to consolidated total indebtedness (excluding net hedging liabilities) of not less than 2.25:1.0,

maintaining a ratio of net asset value to consolidated total indebtedness (including net hedging liabilities) of not less than 2.0:1.0,

maintaining a ratio of EBITDA (excluding revenue from cash collateral) to interest expense (excluding interest on loans under the Treasury Facility) of not less than 3.0:1.0″

Admittedly some of the assets NGPC owns can be readily sold, so we’re not anticipating anything threatening the existence of the business, but losing access to the Revolver would compound an already grim situation and make rebounding that more difficult.

CONCLUSION

There is trouble ahead potentially for NGP Capital. The next few weeks will be critical. If the Company’s views on ATP win the day, and the GMX bankruptcy leaves some value to the Company neither asset value or cash flow will be much impacted. If matters go the other way, Net Asset Value and cash flow and the direction of the Company will all be affected.

The post NGP Capital : Troubles Ahead ? appeared first on BDC Reporter.

Welcome to the re-launch of the BDC Reporter! We have been writing in-depth articles about the Business Development Company industry for the past two years. Now we have expanded our coverage to bring you constantly updated feeds of every relevant article we can find about the industry, the players and the trends underway using a powerful web aggregation service called RebelMouse. Wait ! There’s more: To provide a broader context, we also hunt down and publish the most useful articles on other forms of “leveraged debt” (admittedly a nonsensical term, but an industry favorite) sectors such as High Yield Bonds, and Floating Rate Loans . For an ever bigger picture perspective, we also track developments in the Private Equity industry, which is the principal driver of Leveraged Debt, and we monitor changes in the U.S. economy, whose direction is the key determinant of what happens to the credit performance of leveraged loans.

All these news fees are just the beginning. Besides News, we are bringing you Views. This consists of analysis written by third parties on Seeking Alpha, Motley Fool and elsewhere aout specific Business Development Companies, whether bullish or bearish. Moreover, you’ll find in our Analysis section our own in-depth analysis.

NEWS OF THE DAY: FRIDAY APRIL 19, 2013

The only news item of the day in the BDC sector was that American Capital (“ACAS”) announced 3 new transactions in it’s Sponsor Finance Group. Notable mostly to underline that the once-dominant BDC is back making new loans on a frequent basis. Expect to see many more announcements as American Capital puts an under-leveraged balance sheet to work.

The post NEW AND NOTABLE appeared first on BDC Reporter.

“ Main Street Capital Corporation (MAIN) (“Main Street”) announced today that it has amended its $287.5 million credit facility (the “Credit Facility”) to extend the final maturity of the Credit Facility to five years, through September 2017, with the Credit Facility fully revolving for the first three years of its five-year term.  In addition, Main Street continues to maintain two, one-year extension options under the amended Credit Facility which could extend both the revolving period and the final maturity of the Credit Facility for up to two additional years.  The amended Credit Facility also contains an upsized accordion feature that allows for an increase in total commitments under the facility up to $400 million of total commitments from new and existing lenders on the same terms and conditions as the existing commitments.  The amended Credit Facility provides Main Street with access to longer term financing capacity in support of its future investment and operational activities.  Main Street currently has $76 million of outstanding debt under the Credit Facility.”

THAT WAS THEN 

Prior to the Great Recession, most BDCs own borrowings were in the form of Revolving loans, secured by the portfolio assets, and with a relatively short maturity: typically one to three years. Both the bank and the BDC saw these as evergreen facilities which rolled over on a regular basis.  The BDC appreciated the shorter term nature of the loans as an opportunity to negotiate lower rates as their size and credit profile improved. Many BDCs came to market in the years after 2004, and were becoming increasingly popular with lenders and were able to drive better and better loan deals as the go-go years through early 2008 proceeded. Given the very optimistic tenor of the 2003-2008 period, BDCs were not shy in drawing heavily on their Revolvers. The funding was cheap (if I remember subordinated debt lender Pennant Park Investment was able to borrow at LIBOR + 1.0%), the advance rates were generous (even technology lender Horizon Financial-which was not public at the time but will serve to illustrate the point-was able to get a 75% advance rate against it’s portfolio loans from it’s Revolver lender) and easy to access (just calculate your borrowing base, see how much availability you have and send in a request to the lender and get your money wired within 24 hours).

THE GREAT RECESSION CHANGED EVERYTHING

The Great Recession placed this cozy arrangement between the BDCs and their lenders under great pressure. First, as risk in the economy increased and the relatively high leveraged character of many BDCs showed up, their bank lenders became frustrated at the risk-return they had signed up for. The result was that most every lender used any opportunity available to unwind or drastically change their lending arrangements with their BDC customers. Often the banks had the upper hand due to the short term nature of the Revolvers. When the facilities expired, the banks just refused to extend them at any price. Suddenly BDCS like TICC Capital (ticker: TICC), Hercules Technology (ticker: HTGC), Gladstone Investment (ticker: GAIN) and Gladstone Capital (ticker: GLAD) faced an inability to roll over their Revolvers and had to sell off assets in a hurry to avoid default.  Worse off were the BDCs which were in technical default (often due to the precipitous drop in the fair market value of their loan assets: up to 40% in a few months, which caused asset coverage tests to be breached). In most cases the lenders were ruthless and the BDCs were scrambling for survival, locked in endless and contentious negotiation with their bankers. Just a few examples are American Capital (ticker: ACAS), which had a mix of different loans and notes in default and took two years to straighten matters out, GSC Investment, now Saratoga (ticker: SAR), which ended up needing a capital infusion and a change of management/ownership, Patriot Capital and Allied Capital, which had to sell themselves to Prospect Capital (ticker: PSEC) and Ares Capital (ticker: ARCC) respectively.

IMPACT ON DIVIDENDS

We often point out that the BDC sector cut it’s dividend pay-out 53% during the Great Recession. The principal reason was not the number of non-performing loans (although they did increase), but the almost across the board need to de-leverage balance sheets to satisfy Revolver lenders. With less assets, you have less income and so dividends drop. No BDC was bankrupted, but it was very close in several cases.

MISMATCHING ASSETS AND LIABILITIES

The irony is that the panicky de-leveraging, dividend cutting and sense of the world coming to an end didn’t need to happen. The principal problem was the capital structures of the BDCs relied too heavily on short term borrowing facilities. It’s a tale as old as time when finance is concerned: lending long (most BDC loans are 5-7 years in length) and borrowing short (1-3 year Revolvers), compounded by relatively tight bank covenants because BDCs wanted to get their cost of capital as low as possible.

LESSON LEARNED

Anyway, in the post Great Recession era both the lenders and the BDCs appear to have learned their lesson. Revolver borrowing continues to be a staple at 90% of the BDCs. However, as Main Street illustrates, the length of the facilities has been extended. Three years is the new normal. More importantly, if a banker panics (as they will do at every recession) the BDC has a two year amortization period to pay back the debt. This means no rushed selling of an illiquid asset at a huge discount, or requiring borrowers to pay you back at the worst possible moment.   The theory is that in the next recession-if a bank lender wants out-there will be an orderly de-leveraging.

However, this is no panacea. Most BDCs have realized that they cannot rely on fickle bank lenders for the bulk of their debt capital. As we’ve seen in the past two years, whenever possible BDCs have been raising long term convertible debt and unsecured debt. The former has generally been placed with insurance companies and the latter with the public. From the BDC perspective the benefit is a matching of assets and liabilities, and  essentially no covenants that could cause the debt to default and be called. Revolver borrowings, in most cases, have been relegated to a supporting role: used for short term funding, and in far smaller quantities than before.For example, in today’s Main Street announcement the balance on the Revolver was given as $76mn, or just 26% utilized. As a percentage of Main’s total investment assets of $800mn plus, the Revolver is funding under 10%.

CONSEQUENCES

Short term the consequence of the re-assessment of the Revolver and it’s replacement with long term debt has been higher interest cost on both kinds of debt. The bank lenders, who have to place longer term facilities on their books, are charging more for the privilege. On average BDCs are paying 1-4% more than they did before the Great Recession. Remember PNNT ? They renewed their 1.0% over LIBOR Revolver at 2.75% in 2012. Revolver outstandings (net of cash) amount to 19% of total assets. The revised Revolver has a 4 year maturity (3 year active and 1 year pay-off).  Still, the Revolvers are cheap compared to the long term debt capital which ranges between 5.5%-7.75%. There is no free lunch.

BENEFICIARIES

The BDCs expect that the long term consequences of reducing their dependence on Revolvers will mean smooth sailing through the next recession. Hopefully with no enforced de-leveraging and availability under their under-utilized Revolvers, BDCs will be able to offset credit losses with earnings on new loans at generous rates (in the Great Recession many BDCs had no funds to lend out, missing many great opportunities for earnings and conservative capital structures). From the management groups viewpoint, it also means steadier management fees, no need for rights offerings and other disruptive capital raising tactics, and the risk of being bought out at a discount.

For the unsecured debt holders the BDC debt should be a relatively safe investment in the next recession given the more conservative approach the industry has taken in it’s lending practices since the Great Recession, and the structural limitations on debt inherent in the BDC structure (maximum debt to equity of 1:1).  Many of the issues are rated BBB or have the characteristics thereof.  The yields compare very favorably with equivalent risk junk bond issues.

For the common shareholder, the benefits of the new approach are a mixed bag. On an equal amount of leverage, earnings and dividends will be lower as 20-35% of a BDC’s assets will be funded with long term debt which is more expensive than the previously relied upon Revolver. On the other hand, the capital structure of the BDCs should be more stable, and earnings and dividends more consistent, even in a recession. As a result, shareholders should benefit on a risk-adjusted return basis, but I have no way of quantifying that benefit.

WE WORRY ABOUT EVERYTHING

We worry that new loan yields will drop sharply in the years ahead, thanks to a combination of QE Infinity and the ever-more competitive market for leveraged debt (worthy of an article by itself). As many BDCs will have financed themselves with relatively expensive long term debt at 5-7%, the net spread between income and interest cost might become very narrow. Virtually all the reduction will be borne by the shareholders, as the lenders and the external manager will continue to receive their contractual rates. Shareholders will absorb 80% of the drop, and the external manager 20%, as a reduction in their “incentive income”.  We do take some comfort from the fact that some of the debt issues can be called by the BDC issuer after a few years, but that’s not universally the case, and depends on the management of the BDC taking such action. We also note that BDC shareholders will benefit greatly should LIBOR rates sharply because the mostly floating rate loans which the BDCs own will generate far greater income but the bulk of their interest expense will be fixed.

We also worry that the perverse result of the safer capital structures which the BDCs are constructing will cause them to increase their use of leverage. Till a year ago most BDCs debt to equity maxed out around 0.5: 1.0. Today many BDCs have reached or exceeded 0.7:1.0, and those that have not for various reasons are anxious to do so. Moreover, there is legislation looming (and I have not had an update in weeks) which would allow BDCs to increase their statutory leverage more. The result would be higher earnings in the short run, but greater reliance on debt capital and eventually greater credit losses, which will be borne by the shareholder. Already a number of BDCs are not counting SBIC debentures in their leverage calculations, with the result that total debt to equity is already greater than the nominal maximum of 1:1. Most BDCs appear to relish the opportunity to leverage themselves more, and therein lies a potential problem down the road.

Of course, that’s all in a hypothetical future. In the here and now, we should see BDC earnings slowed down slightly by their higher interest expense long term debt added in recent quarters, but their exposure to unpredictable bank lenders reduced as well as the the chances of forced de-leveraging. Next time it will be different. But will it be better ? That remains to be seen.

The post BDC Sector’s Changing Approach To Leverage appeared first on BDC Reporter.

“American Capital Infrastructure plans to manage investments in global energy infrastructure assets, including power generation facilities, power distribution and transmission networks, energy transportation assets and fuel production opportunities. Joining Mr. Hanrahan are Rich Santoroski, Managing Director, and Rajeev Garside, Vice President. The creation of American Capital Infrastructure will expand American Capital’s energy investing efforts globally. To date, American Capital has invested $606 million in domestic mid-market oil field services and related companies led by Kevin Kuykendall out of its Dallas, TX office. These investments have produced excellent returns for American Capital shareholders.
“I am very pleased to join and head American Capital Infrastructure,” said Mr. Hanrahan. “Worldwide energy consumption is expected to increase substantially by 2030 and significant investment in energy infrastructure is required to satisfy this demand. This demand is driven by emerging markets experiencing robust economic growth, a rapid expansion of middle class populations and limited existing energy infrastructure. All of these factors create significant investment opportunities for American Capital Infrastructure and I am delighted that our team can lead American Capital into these targeted investments.

“We are delighted to welcome Paul, Rich and Rajeev, leading industry professionals with extensive experience in the global energy industry, to head American Capital Infrastructure,” said Malon Wilkus, American Capital Chairman and Chief Executive Officer. “The team’s background as both investors in and operators of energy infrastructure assets in high-growth and developed markets make them uniquely qualified to lead American Capital’s initiative into energy infrastructure investments. The team’s track record of managing and investing in energy infrastructure assets across the energy value chain during multiple stages of development is a tremendous advantage for the future development of American Capital Infrastructure.”

American Capital Infrastructure is part of American Capital’s asset management affiliate, American Capital, LLC. American Capital, LLC is dedicated to creating, capitalizing and managing alternative investment funds across asset classes, including real estate, private equity and private finance. American Capital has committed $200 million to support American Capital Infrastructure initiatives.

“The launch of American Capital Infrastructure is an important milestone for American Capital, LLC,” noted John Erickson, American Capital’s Chief Financial Officer. “We’ve already achieved significant success building American Capital’s asset management platform. We believe the addition of Paul Hanrahan and his team gives us the capability to continue this success.”

Mr. Hanrahan joins American Capital after serving as the President and CEO of The AES Corporation (AES) (“AES”), a Fortune 150 global power company, from 2002 through 2011. Under his leadership, AES generated total returns for stockholders over three times that of the S&P 500. Prior to assuming the CEO position at AES, Mr. Hanrahan was COO and Executive Vice President of AES and President and CEO of AES China Generating Co., Ltd. During his tenure at AES, Mr. Hanrahan was responsible for establishing operations in Europe, Asia, Latin America and the United States. He was directly involved in multiple acquisitions, expansions, and greenfield development of energy and natural resource businesses around the world ranging in size up to several billion dollars of enterprise value. Mr. Hanrahan currently serves on the boards of Arch Coal, Ingredion, Great Point Energy, LLC, and AquaVentures Holdings, LLC.

The post American Capital launches a new initiative appeared first on BDC Reporter.

Credit Suisse

We are expanding coverage of the business-development-company sector.

We are initiating on PennantPark Investment (ticker: PNNT) at Outperform, and Medley Capital (MCC), Fifth Street Finance (FSC) and BlackRock Kelso Capital (BKCC) at Neutral. We are also downgrading Hercules Technology Growth Capital (HTGC) to Underperform.

View the full PNNT chart at Wikinvest

Our two preferences within the business-development-company (BDC) sector are for higher returns, with a focus on returns on equity (ROE), and confidence in the coverage of the dividend.

The BDCs should deliver an 11.2% ROE in 2013, a 70 basis-point increase from 2012. We expect Medley and Fifth Street to deliver the highest ROE in 2013 through both strong return on assets and leverage.

With the BDC structure this higher ROE will flow through to investors as a dividend. A key challenge for the BDC business model is maintaining appropriate amounts of leverage to optimize ROEs to shareholders.

We view coverage of the dividend through net investment income as a key measure of the quality and sustainability of the current level of dividends. We see Medley Capital, Hercules and PennantPark as well positioned to cover the current dividends in 2013 with possible dividend increases from Medley Capital and Hercules.

We expect continued interest in the higher-yielding sectors like the BDCs as this current low-rate environment persists. The BDC sector is cheap versus history on a relative basis, but in line on an absolute basis on dividend yield and price-to-book.

We believe the absolute level of valuation will act as more of a ceiling for the sector and limit the majority of the total return to the dividend yield.

BDC REPORTER TWO CENTS: This is written in analyst-ese, but suggests that Credit Suisse thinks most BDC dividend pay-outs will hold or increase in the months ahead, but don’t expect prices to rise much. (The same is being said across the leveraged debt space. We’ve been reading similar comments about junk bond and floating rate loan investments).

We don’t know if analyst calls such as these are useful, but the wording of the release does suggest that Credit Suisse is highly focused on the earnings of the BDC sector, and where those earnings are versus the dividend. The theory is that if the BDCs continue to make similar or higher earnings than they are today, the dividend will be sustained, and the value of the investment will be maintained. In the short run that’s all well and good, but somewhat obvious.

STORMY WEATHER ?

More interesting would be a discussion of what might happen to earnings and the dividend in a modest recession, with resulting higher bad debts in the portfolio. It is easy for most every BDC to make money now when the sun is shining, but what happens when a little rain doth fall ? Amongst the names mentioned above, our bet would be on the one name Credit Suisse reduced to Underperform: Hercules Technology.  This mid-sized, specialty BDC has a good track record of minimizing credit losses during difficult times. Moreover, the Company has a very large portfolio of borrowers, which diversifies risk. HTGC has adopted a relatively conservative dividend policy so a modest drop in earnings due to a recession, should it occur, would not immediately impact the distribution. Furthermore, the Company does have considerable capital resources available to deploy, whose earnings might offset any losses.  Finally, with virtually all debt outstanding in the form of SBIC and Term debt, HTGC won’t be pressed into selling assets at fire sale prices to avoid defaulting under it’s Revolver loan agreements.

If we ranked the five names mentioned by Credit Suisse as to how well they would weather a pro-forma recession in the near future, we would give a thumbs up (trademark pending) to Hercules Technology, Pennant Park Investment (mostly because of it’s track record in the last recession even though that credit history has been tarnished somewhat of late). We would be more cautious about Fifth Street Finance, and Medley Capital (mostly due to a short history as a public company and suggestions in their initial prospectus that they had credit issues during the Great Recession when they were operating as a private partnership). Bottom of the list would be BlackRock Kelso, which is competing in a very unfavorable segment of the market and has racked up substantial bad debts in recent years, and has limited “dry powder”.   Only time and a recession will tell if we are right, but that’s our Two Cents.

We are Long Hercules Technology, Fifth Street Finance and Pennant Park Investment. We have no position in medley Capital. We are short BlackRock Kelso.

The post BDC Reporter’s Two Cents On A Credit Suisse BDC Sector Call appeared first on BDC Reporter.

View the full FSC chart at Wikinvest

Text of Newsletter:

Fifth Street Posts Record Originations for Month of October

The “risk on” trade in credit markets continues as the increase in deal volumes meets a wall of liquidity. From our vantage point, we are seeing sponsors and lenders pricing transactions as if the liquidity spigot never shuts off. While this may work in the short-term, Fifth Street does not believe it is a long-term plan for success. Markets face multiple risks after the election and in 2013 with either candidate for U.S. President likely to make the tough decisions early in their term.

As a result, we are using our broad platform and deep sponsor relationships to pick our spots. We continue to work with sponsors that value a partnership with their lenders rather than the tightest terms the market can bear. Our ability to hold positions across the debt capital structure in larger hold sizes enables us to generate a premium when investing in quality transactions. Furthermore, we are able to take advantage of the frothiness in credit markets by exiting certain positions and realizing gains. So far, the December quarter is off to a strong start with $120 million in gross originations closed in the beginning of October. This is the most Fifth Street has ever originated in the month of October, and positions us well for a potential record December quarter in gross originations.

Our sponsor relationships, underwriting expertise and market reputation are creating opportunities for Fifth Street’s capital markets platform to agent and syndicate attractive risk/reward deals, while producing a wider universe of potential investments. Our ability to invest up and down a company’s debt structure enables us to generate excess returns where there is relative value within the structure. We see our capital markets activities growing over time to enhance our market presence and become a meaningful contributor to growth in our net asset value.

We are also looking to expand our sponsor outreach effort by attracting experienced professionals in our White Plains, NY, Chicago, IL and Greenwich, CT locations. The right candidates will have the backgrounds and skills to help us augment the origination platform, develop new sponsor relationships and maintain the visibility of Fifth Street’s brand and awareness in the marketplace.

BDC Capital Raises Bring New Entrants

BDCs were busy raising capital with some analysts calling the September quarter a post-credit crisis record for capital raising. Investor demand for the stable yields offered by BDCs is also bringing new competitors into the market. Several new BDCs are in the queue to raise capital in public and private markets. We believe institutional quality managers with brand names using the BDC structure are a net positive for the sector, but with the barriers to entry high, we expect our competitive position will remain strong.

First Baby Bond Offering a Success

We recently closed our first baby bond offering which extends the duration of our liabilities and provides investors a lower risk way to invest in Fifth Street (because it is senior in the capital structure to our common equity). The offering was well received by investors and provides Fifth Street with $75 million in aggregate principal amount of 5.875% senior unsecured notes due in 2024. The pricing was also in line with the top-rated BDCs.

By adding 12-year unsecured debt, we are able to reduce risk in our balance sheet by extending the duration of our liabilities to over 5.5 years. Furthermore, assets purchased with unsecured debt can be pledged to our existing credit facilities, thereby increasing our borrowing base and overall debt capacity. Adding fixed rate debt also positions us to benefit from a potential future increase in interest rates.

Over time, we believe pricing for investment grade rated BDC baby bonds should tighten as investors demand less of a finance company premium for BDCs due to their much lower leverage than traditional finance companies. Fifth Street is applying to list the bonds on the New York Stock Exchange under the trading symbol “FSCE,” and if the application is approved, expects trading in the bonds to begin within 30 days from the original issue date.

$1 Billion Market Cap!

Fifth Street’s shares recently traded at a 52-week high which brought our market capitalization to over $1 billion. Crossing this important threshold opens up a new investor base for our shares and further demonstrates our importance in the marketplace to our lenders. This should ultimately lead to a lower cost of equity and debt capital in the future.

Until Next Time

We look forward to meeting with our Midwest-based sponsors at the 2012 Midwest ACG Capital Connection Conference on October 23, 2012. Len Tannenbaum, our CEO, will be a speaker at the conference luncheon and will discuss the success of our Midwest market penetration. The long-term investment in our Chicago office continues to bear fruit and has become a larger part of our originations mix.

Our investors and analysts can look forward to our September quarter-end and fiscal 2012 year-end results on November 28, 2012. Our results will be released after the market closes on November 28, 2012 with a conference call to be held at 10:00 AM ET on November 29, 2012.

As a reminder, Fifth Street generally does not release a newsletter in the months it reports earnings.

Sincerely,

The Fifth Street Team

The post Text Of Fifth Street Finance Newsletter And A Few Comments appeared first on BDC Reporter.

“Fifth Street Finance (FSC 10.90); tgt $11.50, Medley Capital (MCC $14.14); tgt $14, THL Credit (TCRD, 14.00) tgt $15.00, and TICC Capital (TICC 10.34); tgt $11.00 initiated with Buy. They expect all of these business development companies to deliver total returns of more than 15% in the next 12 months and to continue to deliver dividend yields of about 10%, with modestly increasing book values and modestly increasing stock prices. In their view, the macro environment is favorable right now for the type of longer-term senior and junior lending to middle-market companies that BDCs focus on, due to: (1) less competition from commercial banks (due to regulatory issues) and hedge funds (historically, these are two of the BDCs’ major competitors); (2) a relatively stable economy; (3) very low interest rates (producing relatively low funding rates); (4) an abundance of funding; and (5) a friendly capital markets environment (for raising common equity and term debt).

Frankly we had not heard of the Maxim Group, except for the men’s magazine, which apparently is not related. Tough. So we did a little internet digging. Maxim, as we said, is an investment bank that specializes in covering many stocks which don’t get coverage elsewhere, according to their website.  The firm hired a new analyst back in the late spring to cover mortgage REITs and BDCs, amongst others. The analyst is called Michael Diana, and he is ex-Cantor Fitzgerald. Here’s an extract from the Maxim Group press release at the time of his arrival at the firm:

“5/22/12 – Maxim Group LLC, a leading full service investment banking, securities and wealth management firm announced the appointment of Michael Diana as a Senior Financial Services Analyst covering Mortgage REITS, Commercial Banks and BDC’s.

“Michael’s 20 year’s of Wall Street experience and deep contacts across myriad sectors of the financial services industry, including REITs, makes him an ideal addition to our expanding Research team”, said Anthony Vendetti, Director of Research at Maxim Group LLC.

Prior to joining Maxim Group, Mr. Diana was a research analyst at Cantor Fitzgerald where he covered mortgage REITS and small and mid-cap commercial banks. Previously, he held similar positions at Citigroup, Bear Stearns and Prudential Securities. Mr. Diana began his Wall Street career at First Boston as a financial services investment banker. He received an MBA in Finance from The Wharton School at University of Pennsylvania and a JD from Cornell University.”

The BDC Reporter has no argument with any of the calls above. There’s virtually no BDC at this point which is not on the ascendant.  We happen to be Long three of the 4 names (the exception is Medley Capital, but we own their public debt traded under the ticker MCC).

The post Maxim Group Has Multiple Buy Initiations For Several BDCs. Read All About It ! appeared first on BDC Reporter.

View the full ARCC chart at Wikinvest

“Ares Capital Corporation (ARCC) announced that it has agreed to sell to initial purchasers in a private offering $200 million aggregate principal amount of its 4.75% Convertible Senior Notes due 2018. Ares Capital has also granted the initial purchasers an option to purchase up to an additional $30 million aggregate principal amount of the Convertible Senior Notes to cover over-allotments, if any. The Convertible Senior Notes will be offered only to qualified institutional buyers (as defined in the Securities Act of 1933, as amended (the “Securities Act”)) pursuant to Rule 144A under the Securities Act. The closing of the transaction is subject to customary closing conditions and the Convertible Senior Notes are expected to be delivered and paid for on October 10, 2012.

The Convertible Senior Notes are unsecured and bear interest at a rate of 4.75% per year, payable semiannually. In certain circumstances, the Convertible Senior Notes will be convertible into cash, shares of Ares Capital’s common stock or a combination of cash and shares of Ares Capital’s common stock, at Ares Capital’s election, at an initial conversion rate of 50.3290 shares of common stock per $1,000 principal amount of Convertible Senior Notes, which is equivalent to an initial conversion price of approximately $19.87 per share of Ares Capital’s common stock, subject to customary anti-dilution adjustments. The conversion price is approximately 17.5% above the $16.91 per share closing price of Ares Capital’s common stock on October 3, 2012. Ares Capital will not have the right to redeem the Convertible Senior Notes prior to maturity. The Convertible Senior Notes will mature on January 15, 2018, unless repurchased or converted in accordance with their terms prior to such date.

Ares Capital expects to use the net proceeds of this offering to repay or repurchase certain outstanding indebtedness, which may include repaying outstanding indebtedness under its debt facilities and, to the extent not applied for such purpose, for general corporate purposes, including investing in portfolio companies in accordance with its investment objective.

Neither the Convertible Senior Notes nor the common stock that may be issued upon conversion thereof will be registered under the Securities Act. Neither the Convertible Senior Notes nor the common stock that may be issued upon conversion thereof may be offered or sold in the United States absent registration or an applicable exemption from the registration requirements of the Securities Act”.

BDC REPORTER’S TWO CENTS: We’re impressed with the terms Ares was able to achieve on the new Convertible issue.  The interest rate is below their average long term capital cost of 6.1% (as of June 30th) and the premium for conversion at a lofty price.  The “rally” in the stock price may be explained by the disclosure of the terms.

The post Details of the Ares Capital Convertible Senior Notes appeared first on BDC Reporter.

Market leader BDC Ares Capital Corporation (ticker: ARCC) announced today “plans to make a private offering of $200 million aggregate principal amount of its Convertible Senior Notes due 2018. Ares Capital also plans to grant the initial purchasers an option to purchase up to an additional $30 million principal amount of the Convertible Senior Notes to cover overallotments, if any. The Convertible Senior Notes will be offered only to qualified institutional buyers (as defined in the Securities Act of 1933, as amended (the “Securities Act”)) pursuant to Rule 144A under the Securities Act“.  The exact terms of the conversion have not been announced. The stock price dropped on the news.

View the full ARCC chart at Wikinvest

BDC REPORTER’S TWO CENTS: The latest offering is one of many that Ares has been involved.  Just two weeks ago the Company raised $200mn in much longer dated  and publicly traded “baby bonds” at a 5.875% interest rate. Before that was an increase in Revolver debt commitments with Sumitomo and in August was an equity raise. Regardless of anything else, Ares Capital knows how to jump through an open window (for raising capital). If there was a prize for tapping the capital markets on the best terms and with the greatest frequency it’s a contest between Prospect Capital (ticker: PSEC) with which Ares had a famous feud over the acquisition of troubled Allied Capital, and Ares.

View the full PSEC chart at Wikinvest

WHAT THIS MEANS FOR SHAREHOLDERS IN THE SHORT RUN

Anyway, what are the implications for investors from this series of capital raising ? First, it appears almost certain that Ares will shortly be paying off the $230mn in publicly traded long term notes inherited in the Allied acquisition, which bear interest at a rate of 6.875%, and have been callable since April.  The AFC notes have traded around par for months as investors are expecting a repayment.  That still leaves Ares with 3 other publicly traded Notes.

LOWER EARNINGS BUT LESS RISK ?

Second, the BDC continues to use a mix of medium term and long term debt to finance it’s investment portfolio, at the expense of the low cost, and under utilized Revolver borrowings from Sumitomo and other willing lenders. This will be very good news for management and shareholders in the next recession as the risk of defaulting under bank lending agreements and/or having to liquidate loans in a hurry to de-leverage and satisfy panicked lenders will be greatly reduced.  On the other hand, in the interim, Ares is paying about 3.5% more on their borrowings than they would if they financed themselves with the Revolver debt (see the latest Earnings Presentation where this is explicitly spelled out). Multiply that out by $1.5bn and have you have $52.5mn in additional interest cost than with a riskier but less expensive Revolver only strategy.  On a per share basis that’s nearly $0.25 a year of Net Investment Income Per Share. Netted out for ARCC’s 20% profit sharing take, shareholders are giving up $0.20 a share a year in income that could be earned and distributed.  If you believe-as we do-that the Fed means it when they say interest rates (and therefore Revolver rates) will be kept down for the next three years, shareholders may be giving up $0.60 ($0.20 x 3) because of the Ares play-it-safe strategy.

BLAME BERNANKE

Frankly, we don’t mind if that was all that there was to this approach. We’re all in favor of giving up 10-12% of potential distributable earnings to reduce long term risk, which is what Ares is doing. However, there’s another risk which is growing for Ares, and all the  BDCs , and all lenders generally:  lower yields on new loans.  The very phenomenon that is allowing Ares to tap 30 year money at interest rates unimaginable a few years ago is going to work its way into the Company’s own loan portfolio.  Clearly there is going to be yet another refinancing boom in the leveraged loan market. In the junk bond sector that boom is already well underway, with September seeing more new issues that at any other time in history, thanks to the lure of lower interest rates across the risk spectrum. Ares Capital operates in the market for larger borrowers but which are too small or too complicated for the junk bond and floating rate loan markets. We expect to see huge pressure on the Company’s average loan yields as double digit interest rate loans booked in 2009-2011 get refinanced as borrowers seek to take advantage of the lowest rates in memory.

HUGE PRESSURE ON YIELDS COMING

How low can they go ? Judging by the relationship between the Ares market segment and the junk bond/floating rate loan market, we ‘d expect to see new loans  written at rates of 6%-8%, versus 10-12% previously for equivalent credit risk. This phenomenon has actually been underway for awhile but Ares has been able to keep it’s average yield nominally high at 11.7% by doubling down on it’s JV with GE Capital. The so called Senior Secured Loan Program now accounts for 20 % of the total portfolio, and is resulting in mid-teen yields.  However, that’s because in the joint venture (as in life and Animal Farm) some are more equal than others. By that we mean that Ares has agreed to take most of the initial credit losses that the JV might incur, in return for a bigger share of the earnings.  At the moment Ares is getting the benefit of this arrangement, but in the next recession the Company will have to pay the piper.

Yield gravity,though, should begin to show up in ARCC’s earnings reports in the months ahead, Senior Secured Loan Program notwithstanding. Our ball park projection is that within a year Ares’ average portfolio yield will drop by at least 2.0% to 9.7% , or nearly a 20% drop. Of course, the Company could seek to keep it’s yields up by taking on more risk (besides the Senior Secured Loan, the Company could take on a greater proportion of second lien and subordinated notes).  However, we’ve been impressed by management’s credit discipline (except for the GE JV, which we consider ill advised).  We doubt that management will do anything foolish.

LOWER YIELDS MEET HIGHER BORROWING COSTS

Once this dynamic plays itself out (if it should), shareholders may begin to ask themselves if ARCC’s strategy of funding 50% of its borrowing requirements in the long term debt markets provide much incremental advantage.   If you’re earning 9.7% on your investments, but paying 6.0% on the long term debt, about 2.0% in management fees and incremental operating expenses, the net contribution to gross Net Investment Income is 1.7%. After ARCC gets it’s 20% profit share (which currently accounts for more in fees than the base management fees, and to which management is understandaby attached), a shareholder is getting 1.4%, or just 14% of the gross income generated by those assets.

LET’S NOT FORGET BAD DEBTS

Maybe somebody is saying:” Hey, I’ll take that. Better than nothing”. However, the unknown in these calculations is what the eventual impact of what bad debts will be. Let’s say 10% of the investments eventually go into default, go on non-accrual and are written off. Everything else being equal that will knock investment income down by 10% too, and the net contribution to shareholders by two-thirds.  That would mean a shareholder would get under 5% of the income that was initially generated from these investment assets, and the asset value would drop by 10% to boot.

WE CONCLUDE

We have the greatest respect for the Ares Capital management team. They have built the BDC into the leading player in the industry, maintained bad debts at reasonable levels, successfully acquired and integrated Allied Capital and paid a consistent and growing dividend through very difficult market conditions.  However, we believe that the institution of QE Infinity is changing the rules of the game, and putting at risk the economic model of many BDCs.  Limited on leverage, with high fixed operating costs/management fees, BDCs will be highly challenged  by the very low rate environment, which could last 3 years or 10 (the IMF today announced it would take a decade for the global economy to put fiscal matters in order).  For BDC management, the availability of long term borrowings which allows their BDCs to continue to grow assets, generates  higher profits  and  motor through any future recession without being accountable to their bank lenders is like catnip to a cat. However,  for shareholders, who will be the first to suffer from future bad debts (which are like death and taxes…), though, the risk-return does not calculate.

The post Why We Worry About Ares Capital… appeared first on BDC Reporter.

View the full AINV chart at Wikinvest

October 1, 2012: Thanks to the wonderful Trading Desk at MS Howells, we have some key details about the Apollo Investment (ticker: AINV) Note issue:

“Apollo Investment Corporation (NASDAQ: AINV) or the “Company,” “Apollo Investment,” “we,” or “our” today announced today that it has priced an underwritten public offering of $150 million in aggregate principal amount of 6.625% senior unsecured notes due 2042. The notes will mature on October 15, 2042 and may be redeemed in whole or in part at any time or from time to time at our option on or after October 15, 2017. The notes will bear interest at a rate of 6.625% per year payable quarterly on January 15, April 15, July 15 and October 15 of each year, with the first interest payment due on January 15, 2013.

Merrill Lynch, Pierce, Fenner & Smith Incorporated and Morgan Stanley & Co. LLC are acting as joint book-running managers for this offering. The offering is expected to close on October 9, 2012, subject to customary closing conditions. Apollo Investment intends to apply to list the notes on The New York Stock Exchange and if the application is approved, expects trading in the notes on The New York Stock Exchange to begin within 30 days from the original issue date under the ticker symbol “AIB.”

 

The post Just the Facts About the Apollo Note Issue appeared first on BDC Reporter.

Unlike a number of other recent equity issuances by BDCs, the new shares will be sold below the most recent Net Asset Value (“NAV”) of $9.10. That’s nearly an 18% discount.  However, if the Company is ever to get back on a growth curve in terms of investment assets a new capital raise was critical. We doubt that management will reduce the current $0.60 a year dividend (paid monthly) , suggesting the yield on the new stock will start out around 8.0%.  We don’t have much hope for any increase in the dividend in the short or medium term, as Gladstone Investment invests 25-30% of it’s capital into non cash paying equity and preferred investments in portfolio companies.

View the full GAIN chart at Wikinvest

A MIXED RECORD

We’re impressed that  investment bank Jefferies, as the manager of the offering, has been able to help GAIN tap the public market again. Gladstone’s business model of lending and investing in a relatively small group of lower middle market companies for both current income and long term capital appreciation (most often to be accomplished by an ultimate sale of the portfolio investment) has not yet proven itself. The Company is a veteran in the BDC space,  going public over 7 years ago at $15.0. The Great Recession was not kind to the Company as main lender Deutsche Bank did not renew a lending facility and management had to de-leverage and cut the dividend in half, from $0.96 annually to $0.48.  GAIN’s dividend has recovered since then to reach the current $0.60 level , but is still down 38% from the high.

A key problem-besides the need to de-leverage by selling a book of semi-liquid larger syndicated loans-has been that the Company’s track record of investing in lower middle market companies has left something to be desired.  During the Great Recession many portfolio companies had to be restructured and incurred both realized and unrealized losses.  More problematic, GAIN had no winning investments to point out as a validation of their private equity-like approach to investing.  Thankfully, in 2010-2011 a number of portfolio companies were exited at a profit, which helped GAIN reduce Realized Losses from over $50mn to under $10mn.  These successes encouraged management to resume new investments, and to raise Preferred stock (which is essentially debt) to improve the Company’s capital structure.

SHADOW OF THE RECESSION

Nonetheless, as of June 2012, GAIN still had a number of troubled portfolio investments on it’s books. Here is what the June 2012 press release says:

“As of June 30, 2012, the Company’s portfolio was fair valued at 83.2% of cost, as compared to 84.7% as of March 31, 2012.  The Company’s aggregate investment portfolio depreciated during the quarter ended June 30, 2012, primarily due to the net unrealized depreciation experienced in certain control and affiliate investments”. 

It’s unlikely that all the Company’s portfolio company challenges have been resolved in the past few weeks, so kudos to being able to raise new equity given the mixed results at the Company. We had noticed in recent days-as we commented on in one of our Daily Wrap-Ups-that GAIN’s stock was trending higher.  Now we know… However, we would expect to see the stock price drop sharply from the $7.80 close (already at $7.60 in the after-market). However, if the experience of other BDCs selling stock in recent days is anything to go by, the drop should not be permanent.

TWO QUESTIONS GOING FORWARD

Once the equity raise is out of the way, we have two questions about GAIN. First, how is management going to take advantage of this increased capital base to raise more capital for investment growth going forward.  Will we see another Preferred stock issue or a true Subordinated publicly-traded Note issue like the one Apollo Investment (ticker: AINV) is coming to market with (albeit smaller and for a shorter period)  ? Or will the Company seek to enlarge its Revolver, notwithstanding the history of what happened in the Great Recession.  Or arrange a convertible or private placement ? All are theoretically possible.

Secondly and more fundamentally: will GAIN be able to consistently identify investment opportunities sufficient to increase Net Asset Value ?  The Company is following the model of super-successful Main Street Capital (ticker:MAIN) which is able to pay a consistent and growing dividend from loans made to portfolio companies while realizing repeated gains from their substantial equity stakes in the companies which they are involved.  That company’s Net Asset Value has grown over the years, and the stock price risen dramatically (another all-time high today).  Can Gladstone Investment follow in their tracks ?

View the full MAIN chart at Wikinvest

[We have no position in GAIN, but we do own GAINP-the Preferred Stock offering].

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View the full HTGC chart at Wikinvest

Is HTGC A “Good Buy” ?  We have mixed feelings. Certainly, the Company is the clear leader in the venture debt niche, with Horizon Technology Finance (ticker: HRZN), and a new unit of Ares Capital (ticker: ARCC) playing catch-up. Also, we were impressed during the 2007-2009 period, when Hercules was ditched by it’s lenders, how management navigated what could have been a disastrous episode.  Thankfully, the economics of venture lending are different than most conventional buy-outs. The average life of loans is shorter (even in recessions apparently) and Hercules was able to de-leverage without breaking a sweat.  Most surprising when you consider the pressures of the period, Hercules had very few loans go on non-accrual and write-offs were minimal.  In an industry where lenders can charge 12%-15% for loans, one would have expected more borrower casualties when market conditions deteriorate, but it’s a testament to the Company’s underwriting, and diversification across several technology sectors and different stages that Hercules avoided the disastrous losses that brought companies like American Capital (ticker: ACAS) and Saratoga Investment (ticker: SAR) , aka GSC Investment,  to the very brink of disaster at the time.

PRICE AND DIVIDEND HISTORY

Not to suggest, though, that Hercules was bullet proof during the Great Recession and in the years that followed. Like two-thirds of the BDC community, Hercules was forced to cut its dividend from a high of $0.34 a quarter in 2008 to as low as $0.20, as lower assets meant lower earnings. However, management has been carefully building back their dividend to $0.24.  The Company is being disciplined, keeping distributions in line with earnings.  The stock price has not recovered to the all-time high of April 2007 of $14.60.  Still, if you’d been unlucky enough to buy HTGC at the all-time high and held it for 5.5 years, the “total return” as of today would have been $15.55 (today’s stock price + all dividends).  That’s a measly 5.8% return over all those years, or about a 1% annual return but not bad for having patience.  We believe most investors are more worried about not losing a bundle than the prospective gains, so we like to look at the impact of buying at a historic top (and you couldn’t get much for of a top than April 2007).

NEVER HAPPY

Our hesitation about Hercules comes from two items. First, the Company’s expenses are high, and only half of investment income drops to the bottom line, and results in distributions to shareholders. The Company has grown to a very respectable size, and is internally managed. In some cases that would result in a greater percentage of income ending up as profit  through economies of scale (see Triangle Capital (ticker: TCAP) for a shining example thereof).  It’s not the case at Hercules, which is constantly building it’s infrastructure at the expense of current profits.  That may prove to be the right approach, but we are worried that there is little chance the Company will ever be able to return to the profitability achieved in 2007 on a per share basis.

Secondly, we were disturbed to see a rise in Unrealized Depreciation in the second quarter of 2012: up by -$21mn, in the middle of a very positive environment for the sector. That’s equal to 2.8% of investment assets at cost. Yes, HTGC also had offsetting Realized Gains of $12mn in the period. Nonetheless, we also begin to worry when there is are write-downs on loan values. Beginning of a trend or short term hiccup ? We’ll have to wait and see what the quarterly filings show in the next couple of quarters.

CURRENT STATUS

Anyway, as we write the stock is trading at $11.0 and 2013 projected earnings are $1.11,  which is a 10x forward PE multiple, neither very cheap or very expensive.  The yield is 8.7%, and may go higher. Liquidity is excellent due to all the capital raising, and the chances of a forced de-leveraging as was required in the Great Recession due to a lender defection very unlikely to recur as virtually all the Company’s capital outstanding : equity, SBIC debt and baby bonds is long term in nature, and has limited covenants. [We are Long HTGC and HTGZ, but undecided whether to buy any more of the stock at the lower prices brought on by the secondary offering).

The post Hercules Technology Raises New Equity Capital. Good Buy ? We Argue Both Ways… appeared first on BDC Reporter.

“Hercules Technology Growth Capital, Inc. (NYSE: HTGC) (“Hercules”) announced today that it is offering 3,100,000 shares of common stock pursuant to an effective shelf registration statement in an underwritten public offering. Credit Suisse is acting as sole book-running manager in this offering.

The securities described above are being offered by Hercules pursuant to a shelf registration statement previously filed with and declared effective by the Securities and Exchange Commission (the “SEC”) on March 29, 2012. A preliminary prospectus supplement related to the offering has been filed with the SEC and is available on the SEC’s web site at http://www.sec.gov. Copies of the preliminary prospectus supplement relating to these securities may be obtained from Credit Suisse Prospectus Department, One Madison Avenue, New York, NY 10010; telephone number: 1-800-221-1037; email: newyork.prospectus@credit-suisse.com.”

View the full HTGC chart at Wikinvest

 

We’ll have more to say tomorrow.

The post Surprise ! Hercules Technology Raising New Equity appeared first on BDC Reporter.

BDC Reporter Two Cents: Prospect has been adding capital in every direction recently: an open ended raising of equity capital, repeated Note issuances and today more Revolver capacity. The Company appears to be very protective of its investment grade issuer rating, so we ‘d expect PSEC to avoid the higher debt to equity levels that some BDCs are targeting (Main Street Capital, New Mountain Finance, Fifth Street Finance), and maintain total debt levels below 50% of equity, so don’t expect full usage of this Revolver any time soon.

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