Furthermore: “AINV’s Investment Advisor, Apollo Investment Management, L.P., or “AIM”, is waiving the base management and incentive fees associated with this equity capital for a one year period.”

Finally, Apollo announced its intention NOT to raise any additional equity at current price levels, just two months after indicating the Board had given the Company the green light to explore raising $200mn in new capital. No explanation was given for the change of heart.

View the full AINV chart at Wikinvest

No, we’re not done yet with our Apollo news. In a separate press release Apollo announced that it was searching for a new Chief Financial Officer to replace their new Chief Financial Officer who was announced in February but who never actually joined the firm due to being unable to be released from his prior employer. There’s a whole behind-the-scenes story here presumably, but the bottom line is that Apollo is still in search of a CFO.  Please send all resumes to the Company.

COLOR US UNIMPRESSED

The stock market appears to have been impressed by the news from Apollo: the stock was up as high as 6.6% over the Friday close, and nearly a $1.0 from the low of a few days ago before an upgrade raised the price.

Apparently, based on comments made by Apollo’s management on the last Conference Call, the Company is regularly in touch with the analyst community and large investors, getting feedback about the BDC’s future plans. We don’t have any such access to Apollo, but the facts as we know them do not cause us to be enthusiastic. We’ve got three reasons, which we’ll expand on:

Will They ? Won’t They ?; The indecision about whether or not to raise capital underlines the sense of  confusion coming from the Company. No explanation was given as to the change of heart. Certainly the BDC market is as vibrant as could be hoped for right now with BDCs raising equity and debt left right and center, so general market conditions cannot be the reason. Has there been a strategic shift ? What could have happened in 8 weeks to forgo the need for $150mn in new capital ?
The news about the renewed CFO search only appears to add to a picture of confusion and uncertainty at the Company.  No word about whether Ed Goldthorpe, who was announced as the new CEO of Apollo, has taken up his post. His name was absent from today’s press release and there have been no other announcements about his status with the Company since February.
A Modest Vote of Confidence by the Parent. The parent of Apollo Investment has invested $50mn in the stock of the BDC, and at the NAV price, or a 13%-15% premium to the current market price. In addition, the parent has agreed to waive management and incentive fees for a year. To some this might seem a ringing endorsement of their publicly traded subsidiary.  In fact, Apollo Management has no obligation to do anything at all.

At the risk of sounding unappreciative, though, we’re a little underwhelmed by these steps, which seem more token than substantive. $50mn in new capital is a drop in the bucket with a market capitalization (even after a huge drop in the stock price in the last year) close to $1.5bn.  As a % of total capital raised over Apollo’s history, it’s under 2%, and when you assume AINV will leverage that new equity by 50% implies under 2% in incremental investment assets.  As the press release itself boasts, Apollo Group has $75bn in investment assets. Here’s a link to their website. This $50mn infusion is hardly a game changer for AINV or anything but small change for the parent.

Likewise, the proposed 1 year fee waiver is something of an anti-climax. Two months ago when Apollo announced that its parent would invest $50mn in new equity as part of the $200mn potential equity raise there was no twelve-month limitation on the fee waiver. We calculate that this waiver will be worth about $3mn to Apollo’s shareholders. To put that into context, Apollo earns over $100mn a year in management and incentive fees annually. Moreover, AINV has written off over $1bn in failed investments over its history and $330mn just in the last 9 months. From its 52 week high to its current price Apollo’s market value has dropped by $930mn.  The benefit to shareholders of the 1 year fee waiver, though, will be less than 2 cents a year.

DO THE RIGHT THING IN PARENTHESIS

(We’d have been more impressed if Apollo had reduced is Base Management Fees on a permanent basis on the entire $2.7bn investment portfolio by 0.25% or 0.50%. As it is Apollo remains one of the most expensive BDCs to invest in while sporting one of the worst investment records and largest credit write-offs).
Anyway, getting back to why we were underwhelmed by today’s news:

The NAV increase in the first quarter was very modest. Today’s announcement has given us a sneak peek at Apollo’s first quarter NAV, weeks before the data is usually released. Some investors might be encouraged that NAV is up from $8.12 at year-end to an estimated $8.45 as of the end of March.  Sorry to be a stick-in-the-mud but we’re not excited about a 4% increase given the sea change that has been occurring in loan market valuations since year-end.  Apollo, because many of its assets are liquid and tradable, is more affected than the average BDC by changes in market prices for loan assets.  We would have expected a larger bounce-back in the Company’s NAV than seems to have been the case. Moreover, despite much selling off of loss making assets and three years after the official end of the Great Recession, we’re concerned that Apollo continues to have a quarter of a billion in Unrealized Depreciation on its investment assets suggesting that the portfolio is hardly squeaky clean, despite a very benign credit environment.

CONCLUSION

Notwithstanding Apollo’s announcement that it would not seek to raise any more capital than the $50mn being contributed by the parent, much uncertainty remains: Who will be the leaders of the BDC? What will be the “new” investment strategy? How will the Company improve credit underwriting? What capital will ultimately be needed for the above?  Without answers to these questions any investment in Apollo is more than usually a “shot in the dark”.

However, another recent and unexpected development has been the issuance of medium term Notes in publicly registered form, which trade on the exchanges with a ticker symbol just like a stock and can be bought/sold by anyone. Ironically, the leading BDC in this form of financing is also Ares Capital. The company inherited publicly-traded debt issued by Allied Capital Corporation upon acquiring that ill-fated BDC a couple of years ago. The issue has a nominal maturity of 2047 (!), pays a yield of 6.875%, is rate investment grade and trades under the ticker AFC. Subsequently, Ares has also issued its own  30 year unsecured publicly-traded Note in 2010, with a yield of 7.75%, and the symbol ARY. Most recently Ares was at it again: issuing in January of this year $125mn in 2022 Notes, with a yield of 7.0%, trading under the ticker ARN.

View the full AFC chart at Wikinvest

THE MORE THE MERRIER

In recent weeks,though, the number of issuers for publicly traded BDC debt has exploded. First we had Gladstone Capital, which issued the first “Preferred Stock” instrument in the industry. Reading the prospectus,though, underscored that the new issue bore a closer similarity to debt than to preferred or equity. The Preferred yields 7.125% (paid monthly) and matures in 2016. Sister company Gladstone Investment issued a similar Preferred instrument, back in February.

Also joining the party has been Triangle Capital (ticker: TCAP) with Unsecured Notes due in 2019 and bearing a 7.0% coupon, which raised $67mn in net proceeds for the company in March.  Medley Capital (ticker: MCC) raised $40mn of 2015 Notes at a 7.125% interest rate. The debt will trade under the ticker MCQ. The latest issuer to join the party is Horizon Technology Finance (ticker: HRZN), with an issue maturing in 2019 and yielding 7.375%.

EQUITY INVESTORS SHOULD BE CHEERING

For equity investors in these BDCs (and the many more likely to tap this source of funding while the window remains open), this is good news. The BDCs are able to access medium to long term capital at reasonable rates, and with virtually no covenant requirements and without providing any collateral. If LIBOR rates do move up sharply in the near to medium future fixing these borrowings at or around 7.0% will appear even more beneficial. Admittedly the cost of capital is higher than what these BDCs pay for Revolving debt but the gap is only a couple of percentage points in some cases and without the ongoing cost of unused line fees, frequent renewals etc.

In fact, management and equity investors should consider themselves very fortunate. Even 6 months ago the prospect of smaller BDCs such as Triangle Capital, Gladstone Investment etc. being able to tap multi-year long debt was unthinkable. David Gladstone, the eminence grise behind GLAD and GAIN has been seeking out medium to long term financing for his companies since the cut and run approach of its previous lender in the Great Recession demonstrated the risk of funding 5-7 year loan investments with 1-2 year Revolvers. Gladstone had apparently talked to insurance companies and other long term institutional investors for years, without being able to arrange the right amount of funding for the right period of time and at the right price.

We’re very surprised that micro-cap companies with short histories as BDCs such as Medley Capital and Horizon have gained access to the public debt markets in this way. Both BDCs have performed well in their brief time on the BDC stage, but have had difficulty raising as much secured Revolving debt as they might like from banks. Horizon is paying off its former main lender West LB, and has managed to raise $75mn from Wells Fargo but with far more stringent advance rates and pricing than West LB previously allowed.   Medley Capital has nearly $250mn in investment assets but had managed to only arrange a Revolver limit with ING Capital /Credit Suisse (apparently not all European banks have abandoned the U.S. market-but we digress) of $100mn.  MCC is coy about the advance rates on the Revolving  facility but they must be conservative. Then there’s the pricing, which adds up to an all-in cost north of 5.0%-5.5%, and a 4 year maturity. Compare that with the new Notes, which have no borrowing base or any meaningful covenant, pricing only 1.5%-1.75% higher and three more years of length. As MCC is able to generate new loans at a yield around 14.4% the new debt should result in higher earnings even after interest cost and the 1.75% management fee, additional operating costs, and 20% of incentive profits the management company earns are taken into account. MCC’s shareholders should earn 3.0% on the $46mn (including over-allotments) in new capital, or about 8 cents a share. At a 10x multiple that increases MCC’s stock market value by $0.80 on a pro-forma basis.

FROM A DEBT HOLDER’S POINT OF VIEW

However, what’s good for the shareholder may not be so good for the holders of the newly minted debt of these BDCs. Here are a few words of caution, gleaned from reading the Horizon, Medley and Triangle Capital prospectuses.

1. Remember that the issuers are smaller BDCs with less diversified portfolios than a larger BDC such as Ares Capital. For example, Horizon Technology Finance points out on page s-75 of its Prospectus that its 5 biggest loans represent 28% of its total assets, and 21% of its income. A few key defaults from HRZN’s borrowers and both the Revolving debt and the company could face troubles.

2. How much the new issues will trade remains to be seen. Activity on the Gladstone Capital Preferred has been modest: anywhere from a few hundred to a few thousand shares a day. For a very small position getting in and out should not be a problem but for larger positions it may not be so easy.

3. The Notes may call themselves ‘senior obligations”, but the fact is that they’re structurally subordinated to the issuing BDCs secured Revolver lenders. Effectively this means that the Notes are deeply subordinated. This relates to how the financing structure of the BDCs work. Bankruptcy-remote subsidiaries are set up, and the bulk of investment assets that the BDC has made are included therein. These subsidiaries then borrow from the Revolver lender on the strength of this investment collateral. However, the unsecured Notes are issued by the parent BDC, which has little or no assets on its books. Any assets that exist are not pledged to the Noteholders and can be pledged to the Revolver subsidiaries at any time.

As long as the subsidiaries remain in covenant compliance all goes well. The subsidiaries receive interest income from their loans, pay their Revolver lender and distribute excess income up to the parent who uses the proceeds to service the Notes.  However, should asset values fall and/or bad debts increase at the subsidiaries and a default occur the gates suddenly swing shut. The Revolver lender will want to ensure getting repaid and forbid excess income distribution to the parent. The Note holders will cease to receive interest payments until the Revolving debt is resolved.  This could take weeks to years.  The good news is that the BDC industry has a very good record of paying off its Revolver lenders and the 200% asset coverage required by BDC regulations means that the Note should ultimately be repaid in full but there could be considerable delays, much drama and the potential for a substantial drop in the value of the Notes (the value of Allied Capital’s public notes dropped 86% before Ares Capital came on the scene).

4. Judging the balance of power between the Revolver and the Notes is difficult using the regulatory filings. It’s hard to determine what assets are held by which subsidiaries. We go to the quarterly list of all investments, which has a note that lists to whom every loan is pledged. However that can change at any time and requires making your own calculations and assumptions.  Moreover, most BDCs are very reluctant to provide much information about the advance rates and borrowing rates available at any time from their Revolver lenders. As a result it’s difficult to determine how close or how far a subsidiary might be from defaulting.  We trawled through the Horizon and Medley Capital Prospectuses and quarterly filings with this subject in mind, and came away completely unclear as to what would have to happen before a default would occur.  Even if you are able to stay awake long enough to read through the loan agreements between lender and borrower which set out the framework of the Revolver, the ever changing nature of the collateral and the arcane calculation of facility availability make an independent assessment impossible.

CONCLUSION

We don’t want to sound too gloomy about the new public debt issues of the BDCs. If we avoid a new recession, chances are matters will go seamlessly, BDC earnings will rise to the benefit of shareholders  and Noteholders will earn a superior rate of interest. Moreover, not all the issues that we’ve discussed are structured in the same way, so doing the homework is essential. For example, we are much more positive about the structure and outlook for the  Ares Capital and Gladstone company investments than what we’ve read about the Triangle Capital, Horizon and Medley Capital deals. Even if there is a recession, if a BDC can remain in compliance with its debt agreement the Notes may be unaffected.  Nonetheless, given the opaque reporting and the new nature of these instruments note holders  could find themselves flying blind.

P.S. Although nobody has asked us, we would suggest that a more attractive structure would be for a BDC intent on tapping the public market for medium term to jettison Revolver borrowing and the pledging of assets. Instead, we’d suggest keeping all investment assets-unsecured and unpledged- at the parent level, with an asset coverage test whereby the Notes would be paid down if asset values dropped below a pre-determined threshold. That would provide note holders effective security and the knowledge that income could not be suddenly stopped. The benefit for the BDC would be longer term funding, still virtually no covenants and less dependence on fickle bank lenders. With an investment grade rating this type of unsecured debt might cost only marginally more than borrowing from a bank, and would match a BDC’s assets and liabilities better.

Or else, BDCs could keep some loans assets as collateral at the parent level and the rest pledged to Revolver lenders. If the latter were to default and income be cut off, at least the note holders at the parent would have access to some income sufficient to pay expenses and interest.  This is similar to how Kohlberg Capital (ticker:KCAP) was able to continue paying a dividend through the Great Recession despite being in violent dispute with its bank lender. The company had access to a separate pool of assets/income sufficient (despite some non-performing loans) to remain operational.

One of the capital raisers is Fifth Street Finance (ticker: “FSC”), which announced its intention to offer 10mn shares (plus 1.5mn shares for over-allotments) on January 23^rd.  At time of writing, the final price for the new stock was not set but should be around $10.0, which suggests FSC will be raising around $115.0.  That will grow the share count by over 15%.  It’s quite an accomplishment for a company that was notable in 2011 for being one of the very few BDCs to cut it’s dividend.  Moreover, stock price action has been dramatic. After peaking just below $14.0, FSC’s stock price dropped as low as $8.38 : a 40% decline in just 6 months. Even today, after recovering from its August low, FSC still trades 30% below the 52 week high.

View the full FSC chart at Wikinvest

 GRAB WITH BOTH HANDS

FSC is raising a boatload of cash, but does not have any pressing need to put the money to work. As the company’s own newsletter reveals, financing activity has shrunk in recent months (as you’d expect) with new lending almost completely offset by repayments.  However, FSC says it makes money by turning over its portfolio from front-end fees, back-end fees and syndications to other lenders. As we’ve noted in earlier posts, though, the wise BDC knows to grab the chance to raise new equity if the opportunity presents itself and this is such a time.

Presumably investors are drawn to the fact that the company is trading at the discounts mentioned above, and the fact that loan spreads are elevated after months of market turmoil, dire predictions about double dip recessions and less competition from banks concerned about capital ratios and maintaining solvency. The analysts were projecting higher earnings in fiscal 2012 (which ends in September) than in fiscal 2011, and another increase in FY 2013. Valuing FSC as a multiple of FY 2013 earnings per share of $1.19, the $10.0 stock price for new shares implies a forward multiple of just 8.4x. As of September 2011 the Net Asset Value was $10.07, and will probably be close to that when the December results are announced.

 WORRIED ABOUT THE DIVIDEND

FSC has a chequered history when it comes to paying a steady dividend. Twice in recent years the dividend has been cut as the dividend liability increased faster than the company’s ability to pay. Recently FSC’s management has promised to keep its payouts in line with earnings.  However, 11.5mn new shares to “feed” in an anemic new loan environment may put pressure on the company’s ability to keep paying the current monthly dividend $0.0958 ($1.15 annually)  as recurring earnings per share will probably drop in the next  couple of quarters until the new capital is deployed. In the longer run, assuming FSC steers clear of adding new non-performing loans, earnings per share and dividends should increase, if only modestly.

WE ARE LONG FSC