BDC News Of The Day: April 13, 2017
Here are the main news items and SEC filings from all the publicly traded BDCs that the BDC Reporter tracks for Thursday April 13, 2017 at 11:30 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. Where appropriate, we add brief comments. We’ve covered several BDCs, including Main Street, TICC Capital, Horizon Technology Finance, and FS Investment. However, the piece de resistance is inspired by a news story regarding Medley Capital. However, the subject at hand affects most of the Business Development Companies out there, and is not getting the attention deserved:
Medley Capital (MCC) : Dow Jones Newswires Announces Medley Wins United Towing Bankruptcy Auction
MCC- a second lien lender to United Towing, which recently filed for Chapter 11- made a bid to acquire the company, and won. MCC’s principal currency in the United Towing deal was its substantial exposure, which totals $47mn. The BDC Credit Reporter, which follows most of the under-performing companies in the BDC universe, posted the following story back on February 7, 2017 about MCC’s tangled relationship with the towing company. The key liability, though, was the $19mn in second lien debt. According to the news story MCC’s $40mn bid included $16mn of debt forgiveness. (Not surprisingly the second highest bidder-a corporate competitor- could not match MCC’s offer, offering only $24mn, given that they did not have a similarly large existing investment in United Towing).
We don’t know the composition of the $40mn MCC offer, besides the almost complete write-off of the second lien loan, previously priced at L + 900 basis points. We surmise that MCC, which is becoming the new owner of the business, will need to be advancing new monies to United Towing as the company exits Chapter 11. We do know that Wells Fargo was the first lien lender with a debt of $14mn. We don’t know if Wells is being repaid or will re-enlist in a similar role going forward.
Also hard to determine is how MCC will book this transaction in the IIQ of 2017 (assuming all goes well and the bankruptcy judge approves the deal). How much of the $43mn invested at cost to the pre-Chapter 11 United Towing will get written off ? MCC had $25mn invested in common equity and Preferred below the second lien debt. Common sense would suggest that if all but $3mn of the second lien debt is being forgiven the Realized Loss booked should be $41mn ($25mn + $16mn of second lien debt). However, BDCs have considerable latitude about how to book these restructurings- which have become a common feature in the industry- so investors will have to wait for the release of the IIQ 2017 financial statements. It’s possible that MCC might point to its own $40mn bid as the enterprise value of the Company and use that as a starting point for valuing its investment. That might allow MCC to avoid a drastic write-off, and keep the remaining assets valued at par post bankruptcy exit.
We can hear readers yawning from here but what happens to the value of restructured portfolio investments in Business Development Companies is a very important and controversial subject. In the current easy money environment and aided by the United States remarkable corporate bankruptcy process, which is the envy of the rest of the world, most companies that get into trouble-like United Towing-are not being liquidated and individual assets auctioned off. Instead, companies are being restructured-quickly- and being returned to normal operations, typically by the conversion of some portion of debt or unsecured obligations to equity and the injection of new capital in some form. The oil and gas sector-which has just undergone the biggest set-back in a generation from 2014 till today-owes its very existence in its current form to this forgive-restructure-recapitalize trifecta. However, there are many other companies in a variety of industries operating out there where former lenders have now become owners (sometimes minority, sometimes control).
In the “good old days” when banks ruled the lending world they were far less willing to take on the role of new owner. There are legal obstacles involved; inevitable challenges from other creditors and former equity owners to worry about and unsympathetic regulators encouraging the debt to be written off and the bank to move on. If there was a bank group involved, there were additional complexities as there were as many opinions about how to turnaround a credit as there were lenders. In those days, the banks would often pull back and let the under-regulated private equity and distress asset managers step in and lead the change of ownership process.
Now with so much of non investment grade leveraged lending already abandoned by the banks (as every BDC marketing document will tell you) and replaced by a range of non-bank lenders such as finance companies, hedge funds, private credit funds, specialized “distress” seeking funds as well as non-traded and publicly traded BDCs, the whole manner in which troubled companies are handled has changed. After all, the lenders to these companies do not need to access alternative finance groups because that’s their own in-house expertise. Moreover, there’s no regulator tut-tutting at every turn about whether good money is being thrown after bad, and what reserves need to be booked.
Furthermore, there’s a disincentive in the way many asset management groups (which includes BDCs) are compensated to sharply writing off assets. If a troubled investment can be restructured and the various tranches reshuffled, the asset manager- paid on the basis of the fair value of assets outstanding- can maintain a good portion of its management fee therefrom and keep alive the hope that some future increase in the underlying company’s fortunes might increase the value, and the fees. In some cases an investment in a troubled company can be written down in Chapter 11 (or even outside thereof) as part of a lender-led restructuring and at a later date the business sold at a higher price if all goes well, allowing the asset manager to book a capital gain fee (20% of the increase in value), besides whatever management and incentive fees might have been earned along the way, and despite the prior loss.
As an aside: That’s why you’re seeing a number of clever BDC External Managers seeking to redraft Investment Advisory agreements to permit capital gains to be counted on an annual basis. (Historically before an Investment Advisor could nab a capital gain fee the value of all Realized and Unrealized Gains-as well as fees already paid out thereon-from the time of the initial IPO had to be taken into account. That’s why you’ll see that only handful of BDCs ever book any capital gain fees. Too much history). As usual, neither the BDC Boards, or the analysts or any of the shareholders are objecting to this self serving re-writing of the rules in what is already a highly compensated sector. Why ? Probably because this is not a very exciting subject (except to the External Manager) and everybody wants to get back to looking at Net Investment Income and distribution metrics.
Anyway, the “new normal” when BDC portfolio companies get into trouble is for large scale restructurings to occur and for the former lenders to become owners. Of course, if these restructurings work-whatever the compensation incentivization involved- BDC shareholders will have dodged a bullet and will have their Investment Advisor to thank (even though that same Investment Advisor booked the flawed loan in the first place). What the BDC Reporter and the BDC Credit Reporter are concerned about-and we have a multitude of examples to point to across the BDC space-is about the ways that this approach can go wrong.
Risk Number One: More capital at risk. Typically when a BDC restructures a troubled business, new capital is needed going forward. Also typically the best (only ?) source of that incremental capital is the party with the greatest current interest in the success of the company: the BDC “owner”. So BDC shareholders effectively end up doubling down (not literally, but you get the idea) on companies which-by definition-are proven under-performers. Look at Great Elm Corporation’s recent restructuring of Avanti Communications as one example amongst many of what this looks like.
Risk Number Two is the most ironic. Once a BDC takes control of an under-performing company the flow of information about what’s going on is greatly reduced. Usually there are no financial statements for the BDC Credit Reporter to peruse (so many current BDC portfolio companies are public or private with public debt); no reports from the ratings agencies; far fewer press releases. BDC Managers, typically still struggling with the turnaround, tend to get close mouthed about what’s working and not at the companies they are now running. Moreover, quarterly valuations of the restructured businesses-fraught with conflicts of interest and less market comparisons available-become more art than science. The irony is that BDC shareholders end up knowing less about the very companies that they “own” than they did before when their relationship was that of lender.
Risk Number Three is investment pricing. Once a BDC is the owner, the terms and interest rate charged to a company are no longer negotiated on an arm’ s length basis. Sometimes credit facilities are offered at discount rates. More often, the Investment Advisor charges very high rates, but usually in non-cash form to keep the business afloat. Prospect Capital (PSEC)-with over a third of all its investments in the Control category- is a master of maximizing income in this way. Instead of focusing on the common equity, PSEC draws value out of its owned businesses by charging very high rates. We had time recently on an overseas flight to go through PSEC’s IVQ 2016 controlled investment list in its 10-Q. There are 17 names on there. 3 were on non-accrual and 3 were non-income producing equity investments only. Of the remaining 11, 10 were charging huge rates to their borrowers (see pages 6-8). Here are a few examples: Valley Electric’s Senior Secured Note is at a floor of 3%, plus 5% plus 2.5% PIK, or 11.5% in toto. MITY, a commercial services and supplies company, has a Senior Secured Note B which also has a 3% floor, plus 7% plus 10.0% PIK, or a 20.0% all-in rate. The Senior Secured Term Loan B to CCPI, a metals and mining company, is at a fixed rate of 12.0% cash pay and 7% PIK, or 19% in total. Tied for first place in the yield paid department is Nationwide Loan Company, a consumer finance lender (again, the irony given what unsecured personal loans cost !), which pays 10% on its Senior Subordinated Term Loan in cash and 10% in PIK, or 20%. At a time when most BDC lenders are struggling to find qualified third party borrowers to lend to at a 7% yield, PSEC is able to generate triple that return by lending to its Controlled companies. We’re not saying there’s anything wrong with PSEC’s approach, but are pointing out that there are no offsetting market forces when you negotiate terms with yourself.
Risk Number 4 is “zombie companies”. Once a BDC controls a business, knowing when to accept that the entity is not viable is not as easy as it sounds. The risk is that BDC owners keep portfolio companies alive by restructuring debt facilities; injecting more capital and spending many valuable hours on fruitless attempts to make a pink purse out of a sow’s ear. Add to that the previously referenced dearth of information and many BDC shareholders-whether they know it or not-could be the owners of “zombie” companies without even knowing it. Just another name tucked into a list of dozens or hundreds of portfolio companies. No regulator or outside party to raise an objection. Independent valuation groups only get to “value”, not to pass judgement on whether a business has long passed its sell-by date. Boards have delegated these kind of decisions to their Investment Advisors and managers. Even the BDC Credit Reporter does not have much to say because there is so little information to go on. We just know that there are many portfolio companies on BDC books which hang on for year after year…
Many BDCs have chosen the restructuring and ownership route and the number of companies in this category increases every quarter. Occasionally there’s a success story. More often the companies involved just slip into the portfolio, initially valued back at par and off shareholders and analysts radar. For what it’s worth the BDC Credit Reporter does not consider a restructuring sufficient to take any portfolio company off any BDC’s Watch List. If anything-given all the above-we are more intrigued than ever about what is and what is not happening behind the curtain. We’ll be tracking United Towing (“Medley Towing”) with great interest-albeit from a great distance in the weeks ahead. BDC shareholders and investors should consider taking a critical look at their favorite BDC’s portfolio list to see how many companies on there fall into this category. Is your BDC a lender or a restructuring fund ? Of course, the answer is never just one or the other, but it’s a subject worth exploring.
TICC Capital (TICC): Announces Completion Of New Public Notes Issuance.
TICC’s press release only confirms the details of the new Baby Bond offering (“TICCL”), which we began covering on April 4th, and added further about insights the following day. Although TICC is not popular amongst many of its owners (the Investment Advisor almost got voted off by shareholders after seeking to cash out of its role) and outside investors are wary of the high proportion of its very volatile CLO equity investments and now an increasing proportion of higher risk second lien loans, this capital raising is a win for the Company and the External Manager. Without this Baby Bond, TICC would have had to continue selling off assets, as has been the case for over a year now. Still, how do investors feel about investing in a BDC with a big emphasis on CLOs, with an Investment Advisor who not long ago-as part of the departure speech in advance of what would become the failed sale-suggested the instrument was not well suited for the public BDC format ? In fact, that same Investment Advisor introduced TICC’s shareholders to another asset manager whose first goal was to completely change the composition of the BDC’s portfolio. Still, memories are short and a regular distribution (even a much smaller one) salves many wounds…
Horizon Technology Finance (HRZN): Provides IQ 2017 Investment Portfolio Update.
The technology oriented Business Development Companies, including HRZN, have taken to providing-outside of the quarterly filings-these summaries of quarterly business activity. Sometimes the press release recaps earlier press releases about individual portfolio companies, sometimes there’s new “news”, as is the case here. Moreover, we get some insights into portfolio movements, as this quote illustrates:
Horizon experienced early pay-offs during the first quarter of 2017 totaling $27.2 million, compared to early pay-offs totaling $12.7 million during the fourth quarter of 2016. During the first quarter of 2017, Horizon received regularly scheduled principal payments on investments totaling $12.3 million, compared to regularly scheduled principal payments totaling $12.9 million during the fourth quarter of 2016.
Overall,though, these press releases don’t tell investors much. There’s no pricing information. We don’t know from this press if “spread compression” (even the BDC Reporter is getting tired of our own harping on the subject) is happening in the venture lending space or to HRZN. We’re not told anything about credit quality. Shareholders would probably be more interested in knowing that there are 2 more or 2 less non-performing loans (numbers chosen at random) than a new $4.0mn loan has been made to an app publisher, whose name is not even given. At least from the BDC Reporter’s standpoint we’re really nowhere further in our understanding of HRZN after these press releases, and there’s a danger that the talk of “increased investment activity” and “potential for future additional return” from warrant positions misdirects shareholders. With that said, we read every such press release anyway. Because, like Everest, it’s there.
FS Investment (FSIC): Announces IQ 2017 Earnings Release Date
The mega BDC, part of the FS Investments organization, announced its intention to release its first quarter 2017 results after the market close on Wednesday, May 10, 2017. FSIC will host a conference call at 10:00 a.m. (Eastern Time) on Thursday, May 11, 2017, to discuss its first quarter 2017 results.For readers who don’t get to every issue of BDC News Of The Day, the BDC Reporter did delve into FSIC related issues just a few days ago.
Main Street Capital (MAIN) : Announces IQ 207 Earnings Release Date.
MAIN has scheduled its own earnings release date. The BDC Reporter only has this to add: at a time when the BDC sector remains in “bull market” mode, it’s only appropriate that the most successful participant should see its stock price at or close to an all-time high at $38.72, after going public in the last great ‘bull market” at $14.50 a share.