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Great Elm Corporation: IQ 2017 Earnings

Great Elm Corporation (GECC) – successor to Full Circle Capital – announced IQ 2017 earnings, and released its 10-Q, both of which the BDC Reporter reviewed over the week-end.

EARNINGS GOOD

From an earnings standpoint alone, GECC did very well in the quarter, with Net Investment Income Per Share at $0.32 (or $1.32 annualized) versus a recently announced dividend policy of paying $1.0 a year or $0.0833 a month. (In fact, we wonder why the External Manager reneged on its earlier promise to pay out $0.09 a month).  Any sustained difference between what is paid out and what is earned will probably pop up in a Special Distribution this year or next. However, Taxable Income (on which distributions are supposed to be based) could be different than the GAAP earnings reported. That’s BDC investing: nothing is straightforward.

TURNOVER

Even more encouraging for the newest, tiny BDC with the unusual business model of investing in the secondary market alone was the progress made in turning over its portfolio during the period and since going public last year. Page 4 of the 10-Q shows that $42mn was disposed of in a few weeks in 2016 and another $79mn in the IQ of 2017. In Recent Developments on page 9, we learn another $16mn has been “harvested”  in this quarter to date. At least one of the troubled Full Circle portfolio companies has been sold off and a number of other key assets including  -in April – the BDC’s only non-performing loan: Everi Payments.

COOKING ANALOGY

Of course, with the Investment Advisor’s stated strategy of investing in higher yielding but publicly traded debt of middle market companies -$76mn of which was added in the IQ 2017 – we don’t know if this is a matter from going from the frying pan to the frying pan. The average yield of the portfolio -nominally 94% in senior investments – is a very high 12.63%. Moreover, much of the quarter’s capital went to existing portfolio companies (6 of 8 investments made) at a rate of 12.29%.

RETURNING TO OLD THEMES

However, the BDC Reporter’s principal concern remains the very un-BDC-like concentration in one investment: Avanti Communications.We’ve been writing about this subject for many months, including a post  as early as August of last year, and an update just a few weeks ago.  Avanti’s $68mn of debt (and a tiny equity stake)  represents nearly 40% of GECC’s assets. As the 10-Q shows, the two, recently restructured, “senior debt” pieces which GECC owns account for 28% of the BDC’s equity, even at fair value. Finally, Avanti accounts for 30% of total investment income as far as we can tell. Yet, the satellite company remains a questionable credit, written down again this quarter both by GECC  ($3.2mn) and another BDC lender.

BIG PIK ?

GECC’s 10-Q is not clear about the subject saying coyly only “Security pays, or has the option to pay, all or a portion of its interest in kind” but from our reading of the footnotes and from what we’ve learned in the past, most-if not all-the interest income being earned on the two Avanti tranches is in the form of Pay-In-Kind. Here is a description from the prior quarter’s financial statements:

“On January 27, 2017, Avanti announced the completion of its previously announced refinancing, with the settlement of its (1) consent solicitation to
permit, among other things, the incurrence of up to $132,500 in super senior indebtedness (the “PIK Toggle Notes”) and the payment of PIK interest
on the Existing Notes in lieu of cash for certain future interest payments due on the Existing Notes, (2) the New Money Offer and (3) offer to
holders participating in the New Money Offer to exchange a portion of their Existing Notes for additional PIK Toggle Notes. Holders who elected to
backstop the New Money Offer also received their pro rata share of additional common equity issued by Avanti in an aggregate amount equal to
9.09% of Avanti’s total outstanding shares. Through completion of the consent solicitation and the New Money Offer, Avanti received $80,000 of
new cash funding, with an additional $50,000 of funding available on a delayed draw basis, and will have the ability to defer up to $112,000 of future
interest payments through April 2018. The Company took part in the refinancing, exchanging $22,900 of Existing Notes for new PIK Toggle Notes
and purchasing an additional $9,200 of PIK Toggle Notes for $8,900 of funded cash. The Company continues to hold $47,200 of the Existing Notes.”
As a result, the BDC Reporter assumes that more than 30% of GECC’s Investment Income is or might be in PIK form. (Besides Avanti, there are two other loans with a cost of $9mn which also have the PIK option).
INTERTWINED
As we’ve said before, GECC’s future is intertwined with what happens to the satellite operator in which GECC has both a debt and equity exposure and which the External Manager, through other funds under management, has a substantial equity exposure and some degree of control at the Board level. However, the outcome of Avanti’s business prospects may take several years to play out as its new satellite launch is still many quarters away. We’ve looked at the publicly available financial statements, and we’re concerned that the “senior debt” exposure is essentially equity risk in another form and a major – or even total write-off- is possible down the road. Or, Avanti could yet be turned around, which would not materially impact GECC’s earnings (given the income is already being booked) but could greatly increase its book value by as much as $30mn.
CASH IS KING
However – in the interim – GECC’s liquidity position is looking increasingly strong, even after completing a buy-back of shares in May for $10mn at 85% of NAV. At March 31, before the buy-back, the BDC had $67mn in cash. Netting out the buy-back that leaves $57mn available. We’re guessing that with the “self tender” completed; the only non-accruing loan paid off and with much of the portfolio that the Investment Advisor started with now “turned over”, attention will turn to the only debt on the balance sheet: the $33mn in Baby Bonds inherited from Full Circle. If that was paid off, GECC would see an immediate boost in earnings from a lower interest expense (the Notes bear interest at 8.25%) going forward. Add-in the benefit to EPS from a lower share count from the “self tender” offer and GECC’s quarterly Net Investment Income could jump close to $0.40, from $0.32.
Even more importantly from the BDC Reporter’s perspective, a debt-less GECC would be more bullet-proof should the Avanti investment go terribly wrong. Very roughly speaking (and remembering that this Investment Advisor is a risk taker so Avanti is not an  anomaly), GECC could presumably come close to meeting its current $1.0 a year dividend even if Avanti goes the way of all flesh.