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Saratoga Investment: Earnings Release Preview

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Saratoga Investment (SAR) will be kicking off BDC earnings season with the release of its quarterly results through May 2017, after the close. The next day the BDC will hold its Conference Call. See press release for details. The BDC News Of the Day discusses the main issues investors should be looking for in the press release, filings and Conference Call:

1.PERFORMANCE OF THE CLO

SAR has a long standing investment in its own CLO with $300mn in assets, assembled and managed by the BDC since 2008. At February 2017 Saratoga’s equity investment in the CLO had a fair value of $11mn out of total SAR portfolio assets of $293mn. However, SAR also has a $4.5mn in Tranche F of the CLO’s Notes, which is junior to all other tranches held by third parties, and which was invested in as part of the refinancing of the vehicle back in 2016. Together, these two instruments, and the fees which SAR receives as the CLO Manager contribute a disproportionate and finite contribution to the BDC’s earnings. The 10-K on page F-5 reported $3.563mn in income in the last fiscal year on CLO-related assets with a value of $15.5mn. That’s an effective yield of 22%, and represented more than a tenth of total investment income.

To date, the CLO has been a great success (see F-20). The BDC Reporter remembers when the CLO was first launched in January 2008 with a $33mn investment. Since then SAR has accumulated $67mn in management fees and distributions. Moreover, the streak should continue for some time as the vehicle was refinanced in 2013 and 2016, and currently is still in a re-investment mode as loans get paid off till October 2018, and has a nominal expiry in 2025. Management has already suggested another refinancing, and the attendant tail of fees, interest and distributions to follow, is possible when the re-investment period ends.

We have no reason to believe this quarter’s results should show anything but business as usual at the CLO, with management fees and  interest on the F Notes being received as per schedule. We would expect the distributions received from the equity portion of the CLO to be potentially marginally lower due to spread compression and erosion from credit losses, but nothing very serious. Nonetheless, given the outsized contribution from the CLO, and the recent restructuring (which was at the expense of SAR), getting an update on the vehicle’s progress and contribution is worth doing.

2. PORTFOLIO GROWTH

SAR’s Investment Advisor has been very disciplined about underwriting only investments in which they have (rightly or wrongly) strong confidence. As a result the size of the BDC’s portfolio has grown relatively slowly compared to its peers even as new shares have been consistently issued under its controversial DRIP program. As we’ve noted above, the portfolio has a value just under $300mn and was at $284mn the year before and $241mn the year before that. Page 56 of the 10-K reminds readers that since February 2013 total assets have grown from $155mn. That’s not tepid growth but is slower than many other BDC peers. Even after 10 years as a public company SAR still has a relatively small and concentrated portfolio of 29 companies and more borrowers and assets in its CLO than on its own balance sheet.

With a very active refinancing market underway, the BDC Reporter will be wondering how the BDC is doing “getting money out the door” after only growing by $8mn in net portfolio assets in the whole last fiscal year. Of course, asset growth at a time like this when capital is flying around loosely, is not necessarily a Good Thing. On the other hands, shareholders will want to see what progress is being made on developing a more “granular” portfolio. Our own expectations – and we’re just guessing – is that no great change will show up from the situation at February 2017.

3. SBIC LICENSE PROGRESS

For several years, the Investment Advisor has been remaking SAR into a lower middle market lender and investor, financed partly by the SBA with low cost, long term SBIC debentures. At February 2017 SAR had invested $75mn in its SBIC subsidiary in terms of equity capital and had $113mn of SBIC debentures outstanding. Effectively SAR has already committed 60% of its capital to the SBIC.

The BDC and the BDC Reporter have been looking down the road for some time about the prospects of taking full advantage of what has become – on paper – a very generous SBIC funding program for lenders that qualify. Thanks to “new” regulations since 2015 an entity like Saratoga can technically borrow up to $350mn in debentures from the SBIC, through multiple licenses. We foresaw that SAR – one day – might be able to boast half a billion dollars of assets in SBIC subsidiaries, raising the BDC from the ranks of Minnows to something bigger and more substantial. In April 2015 SAR received a “green light” from the SBIC, inviting the BDC to continue the process of applying for a second license, as the first license was reaching its $150mn limit. That would have been stage two in a potential three part series.

Unfortunately, in September 2016 the SBA asked SAR to “update all previously submitted materials” and invited them to “reapply”. See F-26. That has pushed back the approval of the second license, and added an element of doubt into the question. With nearly a year gone since the SBA’s request, the BDC Reporter – and most investors – will want to know how the relationship with the SBIC is developing.

It’s not that SAR has no access to other sources of capital. However, the Madison Capital Revolver is very expensive and loaded with conditions and barely ever used by SAR. The BDC has also been issuing Baby Bonds almost at will, but that debt may have few conditions and matures years down the road but is nearly twice as expensive as SBIC debentures. Good news on the SBA – which we don’t expect this quarter – would be encouraging for SAR’s long term prospects (especially when the CLO fillip finally goes away) but would still leave the question of whether the Saratoga organization could take advantage and grow the portfolio to meet its funding.

4. CREDIT QUALITY

Of course, the big question mark at every earnings release at every BDC (or any lender, for that matter) is how portfolio credit quality is doing. SAR was flying high last year with two major Realized Gains which totaled more than Net Investment Income for the year. Nonetheless, this is the issue that never goes away and fluctuates up and down.

The BDC Credit Reporter – the other hat we wear – has reviewed the 29 companies in the portfolio and placed 6 on our Watch List as of February 2017.  Management – as is usual with BDCs – insists that credit performance is under control (even though 2 loans are on non-accrual at February 2017 and another was about to go on in the IQ of 2017). Nonetheless, there are a lot of moving pieces and investors will want to know what has happened to My Alarm Center, which was said to be about not to pay its March interest payment on the last SAR CC. That’s  $9.4mn Second lien Term Loan (gulp !) yielding over 12.0% that will not be paying interest presumably. For how long and what the ultimate loss – if any – might be will be important to know.

A different kind of uncertainty surrounds Easy Ice, LLC (not one of the 6 names on our Watch List) which SAR funded to allow management to buy out a shareholder and which has become a $35mn Control investment, over 10% of the BDC’s total assets. That deal was in process last we heard, with SAR optimistic a lender would be found to py down some of its exposure, but still expecting to keep $8mn of Preferred exposure, which is non-income producing.

We won’t spell out all the backstories of all the Watch List companies here. Suffice to say SAR has 4 names with $16mn of fair market value assets in our most two most serious credit  categories, as well as Easy Ice. Thankfully, and reflecting the Investment Advisor’s strategy and PE antecedents, several other investments are carried at an unrealized premium over cost and could offset any damage that might come from the Watch List.  As always the BDC Reporter will be keeping an eye on the portfolio news when the filing appears.

CONCLUSION

SAR has been trading within 3% of its all time highs in recent weeks in anticipation of continued good financial and credit performance, the SBA notwithstanding. At the open SAR traded at $22.00 a share, and the yield was just 8.5%, a reflection of its own success and a Happy Go Lucky market. No very dramatic news is expected from this latest earnings release, but investors will want to keep up with several strands which could affect the BDC for better of worse in both the short term and the longer term.

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