BDC News Of The Day: April 10, 2017
Here are the main news items and SEC filings from all the publicly traded BDCs that we track for Monday April 10, 2017 at 11:45 a.m. EST. External links to articles or filings are in blue, internal links to BDC Reporter’s prior posts on the subject are in red. We’ve written a lot about some of these subjects so there’s plenty of link reading to be done…Where appropriate, we add brief comments. There are a number of different items, most of which are routine but we we are including as part of our commitment to cover the whole waterfront of press releases and SEC filings. However, we did dig into another Proxy filing (usually very revelatory), in this case from one of the biggest BDCs out there: FS Investment. Moreover, another BDC has filed a Prospectus: THL Credit. As usual, we attempt to discuss these items from a shareholder’s perspective and weigh how someone who owns the stock now or in the future might be affected by what’s contained herein.
FS Investment Corporation (FSIC): Filed Schedule 14-A: Preliminary Proxy Statement
FSIC joined the myriad other BDCs in filing its annual Proxy in advance of a shareholder vote scheduled for June 14, 2017. There are two main proposals up for a vote: i) the re-election of 4 “Class A Directors”; ii) a proposal to allow the BDC to issue stock at a price below NAV, if deemed necessary.
The BDC Reporter reviewed the Proxy-as we’ve done for several peers of FSIC in recent weeks-and came away with several similar observations that we’ve made before. Yet, every BDC is somewhat different than the other so the details bear mentioning. Here are the highlights:
- Like many other BDCs, FSIC has a “staggered” Board, which is why the 4 individuals are grouped together as Class A Directors. Class B and Class C Directors will be voted on in each of the next two years. As we’ve said, staggering the Board has the benefit of protecting the Investment Advisor from any outside shareholder challenge, as some BDCs even mention in their Risk disclosures and some do not.
- Worth noting is the size of the Board: eleven members (the By-Laws allow 12). Why does that matter to shareholders ? That’s more cost for a Board-which like every other BDC- provides little in the way of a counter-balance to the Investment Advisor, a subsidiary of Franklin Square and one of the largest investment management firms out there, which happens to have a very high proportion of retail investors. The individual “independent directors” are relatively highly paid by BDC standards: ranging from $112,500 a year to $142,500. In toto, as reflected in the latest earnings report, Directors Fees amount to $1.139mn, or nearly a tenth (8.9% to be specific) of the BDC’s operating expenses (excluding compensation and interest expense). Unfortunately, we have to continue to question the true independence of these external directors, especially as many of them are drawing handsome compensation not only from FSIC (paid by its shareholders) but also by virtue of playing a similar role at several other FSIC funds (also paid for by their shareholders/investors). The top earning FSIC director receives $481,500 in annual directors fees. Very hard to bite the hand that feeds you at any time, but especially so when serving there for a few years will make you a millionaire several times over.
- Again, as with most externally advised BDCs, the Board has very limited powers and responsibilities. As usual (with the notable exception of THL Credit or TCRD) the Investment Advisor has reserved the role of Chairman of the Board for its own CEO and co-founder. We won’t revisit the arguments made in the Proxy for this arrangement because frequent readers will know the script. There is a Compensation Committee, but no one to compensate given the Investment Advisor pays all the staff. There is a Nominating and Corporate Governance Committee, partly tasked with selecting new directors. However, most of the “independent” directors already in place are being offered up for re-election for another 3 year term.
- As is the case with most BDCs, the Board has not renegotiated any significant terms of the Investment Advisory Agreement, even though that critical agreement which was amended and approved by shareholders in 2014, requires annual renewal by the Board. From a shareholder’s standpoint, there is an argument that the compensation arrangement with Franklin Square (and indirectly with GSO Blackstone, which does all the investing) deserves a second look given recent performance. Unfortunately, the Investment Advisor-relying on the services of one of the biggest asset managers out there-made an above average bet on oil and gas investments. The Company paid the price for the overweight positions by registering two years of substantial Realized Losses in 2015 and 2016 that aggregated ($126mn) as many energy-related credits saw debt written off, facilities restructured and much more. Those Realized Losses amount to 5.6% of the equity capital at par of the Fund. What’s more investment income dropped 10% or more between 2014/2015 and this last year.
- More importantly, the Investment Advisor has been suggesting that a distribution cut may be in the cards. (We reviewed the subject in some detail on March 6th). That’s partly because after the above referenced credit reverses and given the oft mentioned increase in risk in the current lending environment FSIC is targeting lower yielding-lower risk investments going forward. For what it’s worth, the average yield bearing investment (which is virtually all of them) was at 10.1% in 2016 (down from 10.4% in 2015) while new investments being added were yielding 9.1%. Given that loan spreads are being squeezed like the Charmin as we speak, it does not take much imagination to assume FSIC’s gross portfolio yield will be dropping in 2017 and beyond (this compression takes several quarters to play out but with refinancing at record levels the downward shift will show up sooner than usual).
A 1% drop in the average portfolio yield-on a pro forma basis-would have reduced 2016’s $207mn of Net Investment Income by ($38mn), or $0.16 a share a year. That’s nearly a fifth of Net Investment Income that’s at risk from the change in both strategy and in market conditions. Yet, under the Investment Advisory Agreement (despite the so-called Total Return provision included), the external manager still billed $113mn of Subordinated Income Incentive Fees in the past 2 years.
6.In 2016, the Investment Advisor was already making total fee compensation equal to 59% of what shareholders earned in Net Investment Income. In 2017, even if the Subordinated Income Incentive Fee drops marginally on lower income that relative percentage could go even higher. The BDC Reporter points out that HAD the Board renegotiated the compensation terms with the Investment Advisor two years ago as the Unrealized Losses began to mount and the writing was on the wall (which it was as far back as the IVQ of 2014) and required the waiver or elimination of the Subordinated Income Incentive Fee, the additional income that would have inured to shareholders would have largely offset the credit losses from the misguided and overly weighted foray into energy lending. (To be fair, once having gotten themselves into trouble in a host of energy deals, FSIC/GSO Blackstone did very effectively use their heft as one of the largest lenders in these transactions to negotiate favorable restructurings. In our sister publication the BDC Credit Reporter we spend much time reviewing Watch List transactions in detail-when available-and there’s no doubt GSO Blackstone is skillful in these restructuring negotiations. The downside is that FSIC’s exposure to energy remains high-albeit in a different form than before- and subject to further losses should energy face a second crisis. Some Boards would have questioned at the outset whether any exposure to an industry tied to highly volatile commodity prices is appropriate for a BDC. There is a reason the SBIC forbids its borrowers to invest in energy and many, many lenders over the years avoided the space except through highly specialized lending units and with much greater asset coverage.
The BDC Reporter recognizes that lending-like all contact sports- involves inevitable credit losses but when those losses exceed “normal” levels, we would expect independent Boards to seek some relief for shareholders. Or, at the very least, that the Investment Advisor -with a long term interest in the BDC- step up and make concessions when there’s been a slip up. That hasn’t happened here as yet. An optimistic market that forgives and forgets-as the BDC Reporter mentioned in our latest BDC Market Recap is partly to blame.
7. As we do every time, the BDC Reporter used the Proxy to look at director, officer and Investment Advisor ownership of the BDC in order to see if there’s any “alignment of interests” between those who run and benefit from FSIC and its shareholders. Unfortunately, as page 4 of the Proxy shows, most of the independent directors own very modest shareholdings in the BDC that they serve as the shareholder representatives of. There are 7 directors listed, 5 of whom own between zero and 15,000 shares each. Only 2 of these directors own shares worth more than a year’s worth of Board fees. It’s a similar picture amongst the non-director executive officers listed in the Proxy. Now it’s true that a first glance you will see that 2 of the top officers/Directors do own very substantial personal stakes in the BDC. However, as the footnotes show (we love reading the small type !) the bulk of those shares owned are through FS Investments and probably consist of compensation arrangements rather than shares purchased because they seemed like a good investment value to the individuals involved. In total the 18 individuals mentioned in the Proxy own nearly 2.5mn shares of FSIC’s total of 245mn. That’s already a not very impressive percentage if you like to see managers and directors owning a big stake of the BDC you’re invested in. However, if you deduct shares held by the Investment Advisor for its top people, only about 600,000 shares appear to have been acquired by this group in the open market, which is an even smaller percentage. If that is encouraging, discouraging or irrelevant to our readers while evaluating FSIC (this data is supplied for a reason by SEC and stock exchange edict) is up to you.
8. FSIC is asking for approval to sell shares below NAV. Unlike the director vote which requires only a plurality of votes cast to pass, this requires majority shareholder approval. See page 2 of the Proxy for all the complexities. As a rule, the BDC Reporter- with shareholder interests in mind- is against these blank cheque requests. Given what we’ve discussed above about un-generous fee concessions and modest insider ownership that remains our view, but that’s up to FSIC’s shareholders to decide. We will limit ourselves to musing about whether there’s much possibility-if the proposal is passed- that the BDC will actually take advantage of the opportunity. Currently the stock price is trading above NAV which makes the question temporarily moot. However, because of the Realized Losses in the last 2 years and the possibility of more coming down the pike, there is a modest risk that the Investment Advisor (sorry, the Board) will decide there’s a need to “top up” the equity capital account. Should the price of the stock drop that will leave FSIC shareholders having to worry for another year that they will wake up one morning to the news of a dilutive secondary offering at a time when credit risks are rising and the economics of new investments are increasingly unattractive. On the other hand, the BDC Reporter’s impression of FSIC’s management team (notwithstanding all the above about non-alignment of interests with shareholders and the normal desire to maximize their fee income, even if at the expense of shareholders) is that they’re sensible stewards where capital raising is concerned and would be unlikely to raise equity below NAV except in the most extreme circumstances (which we don’t envisage in the next 12 months). Again, shareholders will decide for themselves if that’s much of a risk. From the BDC Reporter’s standpoint, we believe there’s plenty of room to shrink and restructure the portfolio in times of stress if a BDC has not been pushing the leverage envelope (which FSIC has not with debt to Equity at 0.74), and a dilutive capital raising should be unnecessary.
Fifth Street Finance (FSC) : Filed Definitive Additional Materials to its Proxy.
As most readers will know by now, FSC and its newest CEO and Board member Patrick Dalton have parted ways. That occurred just before the Annual Shareholders meeting. (The significance of that-if any-is not yet clear). As a result, as we mentioned in earlier daily update, the meeting has been postponed till April 27th, Mr Dalton has been formally removed as CEO and he will not be on the ballot for the Board. FSC shareholders have been forewarned by this filing, and told they can revoke any vote already made or just leave the ballot alone and only the votes for the two other directors up for election will be counted. Routine.
THL Credit (TCRD): Filed a Preliminary Form N-1-Registration Statement.
TCRD filed a Prospectus on April 7th, with a view to potentially raising up to $300mn in debt and/or equity capital. The BDC Reporter quickly reviewed the “shelf offering”: There were no hints as to what type of capital the BDC might be seeking to raise. Currently TCRD, after a dividend cut and significant Realized Losses and with over a third of its assets on its own Watch List, is trading below Net Asset Value. Although TCRD did receive permission to issue shares below NAV back in June 2016 and is seeking the same option through June 2018, we would be surprised by a straight on secondary equity offering. The BDC Reporter does not pretend to have an ERA much above .250 when predicting what BDCs are going to do next from a capital raising standpoint. Partly that’s because our experience is principally in the lending and investing side of the business and less on the capital markets. Also, the Investment Advisor’s are deliberately close lipped about their intentions for tactical reasons, which leaves the BDC Reporter and shareholders playing a guessing game.
With that said, the likeliest courses of action would either be the issuance of a Convertible Note, appealing to public or private (probably the latter) seeking to benefit from a perceived increase in Net Asset Value and the stabilization of earnings expectations following the “cleaning up” of the under-performing investments in portfolio in recent quarters. The BDC Reporter does not believe TCRD’s troubles are over yet, but we may be more skeptical (or just plain wrong) than others.
Or, TCRD could be looking to issue additional Unsecured Notes, probably from the public, either to refinance existing issues (which seems unlikely) or to increase what’s already on the books (which would seem excessive but you never know).
Otherwise the N-2 had very little information that was not already contained in prior filings. The BDC Reporter recently reviewed the BDC’s Proxy.
Hercules Capital (HTGC): Filed an 8-K: Entry Into Material Definitive Agreement.
HTGC and Wells Fargo negotiated a 4th amendment to their Hercules Funding II, LLC financing facility, which has been in place since June 2015. The 8-K, which includes the text of the amendment, shows the changes made were relatively minor and afforded the BDC some flexibility in a funding arrangement which has barely been used, while adding some cross default between Funding II and another facility: Hercules Funding III. Routine.
New Mountain Finance (NMFC): Issued a press release regarding completion of secondary stock offering.
As we already reported on April 4th, NMFC has completed and priced a new equity offering. This press release was issued on Friday April 7th, and confirmed earlier information provided.