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KCAP: Further Filings Re: New JV

BDCs:
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On July 20, 2017 KCAP Financial (KCAP) filed a form 8-K, which contained the operating agreement between the BDC and a third party (Freedom 3 Capital) creating a Joint Venture that was announced the day before. In addition, KCAP filed an amended N-2 filing for a potential capital raise up to $250mn. The BDC Reporter – which had reviewed and commented about the new JV in a post the day before – reviewed the legal agreement between the parties, and has come to a new conclusion. First, though, we review the main provisions of both the JV and the amendment to the Prospectus (the N-2 filing). We end with an update on how we have invested in both the common stock and Baby Bonds in light of the news out of KCAP. 

NEWS

The new JV is called – for the moment – KCAP Freedom 3 LLC – reflecting the two parties involved. This version of the Operating Agreement (the “Agreement”) is an amended version of an earlier version dating back to July 12.

Basically, both KCAP and an affiliate of Freedom 3 Capital – an investment firm specializing in credit – are parties to the Agreement and will be making the key decisions. However, the Administrative Agent is KCAP.

For the avoidance of any doubt, here the stated purpose of the JV, a matter we’ll discuss in the Analysis section below:

“2.5 Purpose.

(a)          The purpose and business of the Company shall be (i) to form one or more Subsidiaries or CLOs, to transfer all or any portion of the cash, cash equivalents, securities, investments, and other property and assets of any type of the Company to any such Subsidiary or CLO, and to take any and all actions in connection with any financing obtained by a Subsidiary or CLO of the Company or otherwise secured by assets held by a Subsidiary of the Company or such CLO (ii) to carry on any other lawful business, purpose or activity permitted to be carried on by limited liability companies under the Act, (iii) to exercise all rights and powers granted to the Company under this Agreement and any other agreements contemplated hereby, as the same may be amended from time to time and (iv) to engage in any other lawful acts or activities incidental or ancillary thereto as the Members deem necessary or advisable for which limited liability companies may be organized under the Act, including, without limitation:

(i)        to acquire, own, hold, sell, transfer, service, foreclose on, exercise rights or remedies under, syndicate, invest in, convey, safekeep, dispose of, pledge, assign, secure, borrow money against, finance, refinance or otherwise deal with, from time to time, all cash, cash equivalents, securities, investments, and other property and assets of any type of the Company;

(ii)         to acquire financing secured by all or any portion of the cash, cash equivalents, securities, investments, and other property and assets of any type of the Company; and

(iii)        to grant liens and security interests in all or any portion of the cash, cash equivalents, securities, investments, and other property and assets of any type of the Company.

(b)          Subject to the provisions of this Agreement, the Company shall have the power and authority to take any and all actions necessary, appropriate, proper, advisable, convenient or incidental to, or for the furtherance of, the purposes set forth in Section 2.5(a) .

(c)          Notwithstanding the foregoing, the Company shall not serve as or perform the functions of a CLO Collateral Manager, investment manager or comparable position in any CLO.”

Main Points

The key provisions include:

The right by Freedom 3  to be bought out if KCAP is acquired by a third party.

The right by KCAP to be bought out if there’s a change of control at Freedom 3; if there is a material adverse tax treatment of the JV or if the two parties get deadlocked about investment decisions more than 4 times and Freedom 3 exercises its veto rights.

The assets of the JV will be valued quarterly but expressly allow no discount to applied for the illiquidity of any investments.

Freedom 3 has observer rights to KCAP’s CLO Investment Committee, but no voting rights.

N-2 Filing

Turning to the Prospectus, the document was previously discussed by the BDC Reporter on June 12. The only material change – based on a brief review – appears to be updating the document with information for prospective investors about the JV.


ANALYSIS

The key change in our analysis is that we previously believed  – given no guidance by KCAP’s press release or other disclosures – was that the JV was established to acquire the BDC’s regular loan portfolio.

Now the language of the Agreement – as we illustrated above but which runs through the entire document – suggests the JV will be purchasing some or all the BDC’s CLO debt and equity investments.

These are junior tranches of CLOs, which a KCAP wholly owned subsidiary is the investment manager of.

That would explain why Freedom 3 has requested and received observer rights at CLO Investment Committee meetings.

That also answers one of our earlier questions as to how KCAP proposed to remain within BDC rules where the 30% non-qualified basket is concerned.

By shipping the CLO investments to the JV the number of non-qualified assets drops, and is limited to the equity investment in the JV, which is half the value of the CLO assets at March 31 2017.


VIEWS

We do not have the full picture yet, so everything we say is qualified thereby.

At this point, KCAP appears to be “selling” all or some its CLO equity investments with a value of $53mn to the JV, as well as regular loan assets.

This has generated $183mn in cash proceeds for KCAP and $148mn has been used to repay “debt” , which almost certainly means the securitization, which had $145mn outstanding at March 31, 2017 (adding-back discounts).

Unknown is what will happen to the $35mn in left over proceeds and the $12mn or so in cash and restricted cash shown at the end of the IQ 2017.

Our view – which may prove wrong – is that the net proceeds will be used to repay the Baby Bonds, which were valued at $33mn at March but have since been partly paid down.

Also possible is that the net proceeds will be invested into new assets, whether CLOs or loans or kept available to finance new CLOs which KCAP proposes to launch.

Management would argue that keeping the Notes and re-investing in CLOs which offer the double benefit of high yields and management fees through the wholly owned advisor is accretive to shareholders.

Equally plausible is that KCAP will use the N-2 to raise new Baby Bonds to refinance the existing Notes, which are due in 2019.

Another issue which remains unclear is what KCAP’s earnings will look like after 40% of its CLO investment income goes to Freedom 3 as part of the JV, but its relatively inexpensive but maturing securitization gets paid off.


FULL DISCLOSURE

We are Long KCAP stock in our Special Situation portfolio on the assumption that the market might move up on the news of this drastic re-organization and potential solution to KCAP’s most pressing problems: refinancing its debt and breaching the asset coverage rules BDCs live by.

So far we’ve been mistaken and the stock price has gone nowhere fast.

Conversely, and out of an abundance of caution we exited our full position in KCAP’s Baby Bonds with the ticker KAP yesterday at $25.2739, slightly below our average cost of $25.4890, or (0.8%) off.

The premise was that the risk of KCAP calling KAP and causing us a (1.9%) redemption loss was not worth waiting around for.

Given that KAP has just paid out its June 30 distribution we figured the Notes would trade -if called – very close to par.

In any case, KAP is due to be repaid in just over two years and the moving of half the BDC’s assets off balance sheet weakened the credit profile of the BDC anyway, even if paying off the securitized debt was a positive.

We still have to see if that will prove to be the best decision, but given what we knew at the time we’re comfortable with our Sell decision whatever transpires.

Where Baby Bond investing is concerned – and our Fund uses leverage which adds another dimension of risk – caution is our by-word.

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