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Alcentra Capital : Insights From The 10-K

Here a few interesting items culled from Alcentra Capital’s ( ABDC)  10-K for the year ended December 31, 2016 which were either not covered in the earnings press release or on the subsequent Conference Call, or which amplify brief mentions therein. There are no great revelations here, but we do add a few pieces to the huge puzzle that is involved in the analysis of this smaller sized BDC, and should be of interest to shareholders who’ve not had the time to review the 124 page annual filing.

 

1. Portfolio Turnover (Pages 68-69)

BDCs typically make loans with nominal maturities of 5-7 years. However, in the overheated financial conditions that have prevailed in recent years, very few loans go to maturity, being subject to early repayment due to mergers and acquisition activity; dividend recaps; refinancing to reduce borrowing costs and improve debt structures, etc.

ABDC is no exception, and 2016 was a banner year for portfolio turnover. At year end 2015, the BDC had just over $300mn of investment assets at cost. In the year just ended a remarkable $184mn, or 60% of ABDC’s portfolio was repaid. At that pace the portfolio is turning over completely in just over a year and a half.

This is important for a series of reasons. First, such an unusually high level of repayments is often associated with an unsustainable boost to fee income, and may give the wrong impression about the level of income a BDC can generate. There are many moving parts in the Other Income category of ABDC’s income statement, but we note that in 2016 the BDC generated $4.8mn of Other Income versus $2.0mn the year before. In 2015 the volume of repayments was only one third of 2016’s.

Second, a huge volume of pay-offs places a great burden on any lender’s recurring income levels. This requires shifting gears in loan origination to make up the lost income generating assets, with all the risks associated with adding new assets to existing and new companies.

In 2016 ABDC was able to keep up in terms of number of companies in portfolio (32), but not in dollar terms. $153mn of new investments were booked, $28mn of which was to existing relationships. That means ABDC, despite the very large origination of the Alcentra Group, which itself is owned by the even larger Bank of New York. Pages 3-4 of the 10-K throw around a lot of impressive numbers about the market capitalization and assets under custody of BNY ( which really make no difference to the BDC’s shareholders) and (more pertinently) the assets under management and staff of the Alcentra Group. The key numbers,though, are more modest. The Alcentra Middle Market Group, which includes the public BDC, and which is run by the professionals of the Investment Advisor lay claim to having booked $800mn of investments in middle market companies over their 12 years together, and in three different funds.

We made some simple calculations and determined that about $500mn of investments have been made in the BDC alone since its establishment in 2012, suggesting that the depth and breadth of the Manager’s track record may be somewhat more modest than the huge numbers being thrown around might suggest.

This might also mean that the funnel of new deal opportunities which the Alcentra organization is able to generate may not be able to keep up with the BDC’s demands. As with so many other asset management organizations that have captive BDCs, the parent organization is not prepared to limit its activities to ABDC alone. Alcentra, says the 10-K, have 3 other (private) mid market funds under their purview, and apparently other accounts.

The Risk Factors disclosures spell out in that matter of fact legalese which the BDC Reporter so enjoys reading how the Investment Advisor faces a host of conflicts of interest between its various funds, and may direct deals one way or another depending on the compensation involved, and/or may spend time that could have been used finding new deals for the BDC raising and tending to new funds. Given that the Board has been appointed by the very same Investment Advisor and the investment advisory agreement is not negotiated on an arm’s length basis, and the Investment Advisor has no liability (all disclosures in this and most every other BDC’s 10-K) shareholders can hardly expect much of a “checks and balances” on how investments are apportioned. “You pays your money and you takes your chances”.

Finally, from a credit standpoint the addition of so many newly booked loans and investments is always a time for increased vigilance. We’ve found – and it’s been backed up by academic studies and common sense- that loans are the most vulnerable to facing credit difficulties shortly after being booked. More on current credit quality a little later.
2. Sale of equity investment. ( Page 75 )

As reported on the Conference Call and in Subsequent Events, ABDC sold its equity investment in Wholesome Sweeteners in January 2017 for $3.7mn.

We would only add that the cost of the initial investment was $5.0mn, but was carried at $3.7mn at year end 2016. As a result, we should expect a ($1.3mn) Realized Loss in the IQ 2017 results.

The likely good news is that the $3.7mn will get redeployed into a yield bearing investment. ABDC is trying to reduce the non-income producing portion of its portfolio. That could add up to $200,000 a year to Net Investment Income.
3 . Black Diamond Rentals Exposure. (Page 75).

Both in the IVQ of 2016 and in the new year, ABDC has added to its already substantial exposure to one of its energy related investments, Black Diamond Rentals.

In 2015 the BDC had $13.1mn invested, all in first lien senior secured debt. By year end 2016, the loan had been restructured and repriced (twice) and increased in cost to $14.7mn.

The first repricing brought the all in yield down from 17% (!) on all the debt to 17% on only a portion and just 4% on $8mn of debt. This last quarter the 17% debt got reduced to 14%.

As a result, ABDC is lending more and earning less on this energy services company that seems (according to the Conference Call) to be on the mend. However , the overall FMV discount is still nearly $5mn.

The BDC will benefit from a nice asset write up if the company returns to a normal performing status. However, we can’t help pointing out the continuing dangers of lending into the energy sector, and the difficulty of saying No once a commitment has been made. Clearly Black Diamond needs capital right now and the obvious source in any troubled situation like this is the existing lender who has so much to lose. Just when ABDC may have hoped to reduce their exposure both to the company and to the sector they have little choice but to dribble in more capital. This could go either way and deserves tracking in the months ahead.

4. Increase in LIBOR. (Page 75).

At a time when many BDCs are publicly touting the potential benefits they will garner from higher short term interest rates, ABDC is staying very calm and carrying on, and does not expect much benefit from that source. In a weakly worded disclosure on page 75 the BDC says a 1% or 2% increase in short term rates would only have a 2% effect on its portfolio. Unlike other BDCs ( we are especially impressed with Goldman Sachs BDC’s disclosure) there is no table showing the impact to investment income at different interest rate levels, both higher and lower. Nor is “effect” even defined. Shareholders should probably expect that if interest rates rise on a sustained basis ( and the BDC Reporter has much to say how that might play out in real life) that any increase in investment income forthcoming will be largely offset by higher interest expense on the Revolver.

5. Watch List. ( Pages 82-85).

Unlike many-but not all-other BDCs, ABDC does not offer a portfolio risk rating in its quarterly filings. Readers will have to rely on the BDC Reporter’s analysis. We won’t get into great detail here, but can report that out of 32 companies in portfolio, 30 are yield producing, and 8 are on our Watch List (including Black Diamond Rentals) and 7 of those are income producing. That last fact is important in assessing the potential risk to recurring income and to distributions. In total, Watch List assets are valued at $53mn, a not insubstantial 30% of the BDC’s equity at year end 2016. Yes, no loans are on non accrual, but having a quarter of the portfolio companies on the books on a Watch List status deserves-as we like to say-watching.