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KCAP Financial: Establishes JV, Pays Off Debt

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On July 20, 2017 KCAP Financial (KCAP) announced in a press release the establishment of a joint venture with a third party credit firm; the sale of certain assets to the JV and the repayment of an on balance sheet facility. All the details are discussed below, and the BDC Reporter analyzes why KCAP undertook the transactions and the likely impact on the BC’s balance sheet and earnings:


NEWS

KCAP established a joint venture with a private New York Credit group called Freedom 3 Opportunities, LLC.

Both firms contributed loans into the JV as their “capital contribution”. KCAP contributed $35mn and Freedom 3 $25mn, or $60mn in total.

In a second step the new JV purchased $183mn of assets from KCAP by using “cash on hand and borrowings”.

In a third step, KCAP used the proceeds from the asset “sale” to pay off $148mn in debt on its balance sheet.

The press release adds these further comments:

The joint venture agreement will allow the Company to invest in senior middle-market loans as well as provide additional sources of investments through its Joint Venture partner.

Dayl Pearson, President and Chief Executive Officer of the Company, noted, “We are pleased to enter into this joint venture transaction which is similar to those entered into by other business development companies and will allow us to continue investing in senior middle-market loans and provide significant liquidity for balance sheet growth. Following the completion of the debt redemption, KCAP Financial will have the financial flexibility to pursue attractive investment opportunities that generate strong free cash flow and drive value for our shareholders.”


ANALYSIS

KCAP has provided only a press release at time of writing and omitted key details, so this analysis is preliminary:

The BDC has transferred over half its portfolio assets to the new JV, which will be managed by one of its two secretive wholly owned advisory firms.

KCAP seems to be the active manager partner in the JV, which may be reflected in the entity’s compensation arrangement, which is not given.

The JV appears to have arranged third party financing – also not explained in the press release – which allowed for the purchase of the additional $183mn in assets.

A portion of KCAP’s loan portfolio is of relatively lower risk, syndicated and liquid loan assets so receiving funding secured by those assets seems plausible.

However, the JV third party debt financing appears to be at an aggressive advance rate, with the new lender providing 75% of the capital.

Effectively asset coverage (portfolio over debt) at the JV is 400%, twice the permitted level for a BDC on balance sheet.

We don’t know what interest rate is being charged by the third party lender, but we surmise the portfolio assets involved yield around 7.0%.

Repay

KCAP seems to have used the JV proceeds to pay off its $148mn securitization program.

That facility – first established in 2014 – is secured with $186mn in 75 portfolio companies.

The re-investment period for the securitization ended in July 2017, which explains why the new arrangement has occurred.

Notes ?

At a stroke KCAP has reduced most of the debt outstanding on its balance sheet with the repayment of the securitization facility, and is still left with $35mn in cash.

No announcement was made, but chances are the BDC will use some of the proceeds to pay off the remaining balance of its expensive Baby Bonds which have the ticker KAP.

KCAP recently repaid a portion of the KAP Notes outstanding ($6.5mn). That left the balance at approximately $26mn.

Left Overs

Should that occur- and the process may take a few weeks – KCAP will have reduced its investment portfolio from $355mn at FMV to about $172mn, and paid off all its debt liabilities.

Net assets should remain unchanged unless there is a GAAP gain or loss associated with the portfolio asset sale.

The principal remaining assets on KCAP’s balance sheet will be its investment in those two investment advisers who manage the CLOs which the BDC indirectly sponsors; the junior tranches of its sponsored CLOs.

And the $35mn stake in the new JV.

And some miscellaneous assets and cash.

Income

We have too few details to calculate the impact on KCAP’s income going forward. We can estimate that the proportion of income coming from the CLOs and the management fees of the wholly owned advisers will increase.

The income from the $218mn of on balance sheet assets now transferred to the JV will diminish as interest will have to be paid to the third party lender.

Last quarter KCAP had Net Investment Income of $7.7mn. That is likely to drop by ($2.5mn) everything else being equal.

However, interest expense and certain operating costs should drop too by ($2.2-$2.5mn).

That would leave KCAP – which is internally managed – with only personnel and BDC administration expenses.

Unfortunately those are famously rather high and will continue to be, but some portion may be shifted to the new JV or the wholly owned adviser subsidiaries.


VIEWS

From a financial engineering standpoint, this is a bold and clever move by KCAP.

At a stroke management has solved several problems which have bedeviled the BDC for years.

First, KCAP had problems staying within the 200% BDC asset coverage rule. That’s a problem no more given there is no more (on balance sheet) debt to cover.

Second, KCAP was paying a very high absolute level of interest, far and away its largest single expense.

All of that goes away once all the debt is repaid.

Third, shareholders were challenging the high cost of running the BDC.

Now many of those costs can be shifted to wholly owned subsidiaries or the JV, where disclosures are far more patchy.

On the other hand, we don’t really understand how this transaction allows KCAP to grow its own balance sheet given that essentially all the proceeds are used for debt pay-offs.

Going forward, we’d expect (but we’re guessing) any new middle market loans might be originated by KCAP but booked in the JV.

We also don’t understand how KCAP avoids the 30% rule for non-qualifying assets with this move.

There may be further shoes to drop and details to follow.

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