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Saratoga Investment: Earnings Results UPDATED

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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.

UPDATE:  The book-keeping for CLOs always confuse, bother and bewilder. Nonetheless, SAR appears to have had a good  first quarter. From a balance sheet viewpoint the FMV of its most subordinated debt securities in the vehicle increased in value from $11mn to $11.6mn. The cost was written down to $9.5mn to $9.35mn as distributions received are partly applied to write down the loan.

According to the 10-Q the subordinated position (the most junior in the structure) paid out a remarkable effective interest rate of 22.56% (see note e). That came to $453,586 or $1,815,424 annualized. (Last year SAR earned $1,941,914).

The Class F Notes – which were most recently added and which pays LIBOR + 850 bps – paid $105,992 on $4.5mn invested.

The Management Fee was the most surprising, earning $480,976 or or $1,923,904 annualized versus $1,499,001 in all of last year. Seems like SAR hit a a threshold and is receiving a bonus incentive.

The various income streams related to the CLO contributed 12% of Total Investment Income, but accounted for only 5% of assets.

We will continue to monitor quarter to quarter, but continues to be a positive contributor to SAR.


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.

UPDATE:  We were wrong in our guess that the portfolio would not grow that much this quarter. Apparently – as the press release mentions – repayments were unusually light.  Plus, SAR added 5 new companies ($45mn) to bring portfolio companies to 32 from 29, with 2 being sold off.  Finally, the promised restructuring of Easy Ice, which was supposed to result in some of SAR’s $34.5mn exposure being replaced by third party debt, has not yet occurred. However,  some sort of financing is expected imminently. In any case, the value of SAR’s overall portfolio increased by $37mn, or 13%. 

The new deals are in Business Services and in Education, all in first lien position and yielding between 8.21% and 10.0%.

Most of the growth in assets was funded by the Madison Capital Revolver, which jumped to $25mn. Unfortunately this form of funding is expensive, averaging 5.8% in the quarter and still on the rise. 

Investors expecting a big boost in earnings from these additional assets should not get too excited. All the new positions were funded with Revolver or SBIC debt (whose weighted average interest rate is 3.2%).

We estimate the average cost of debt is about 5.0%. Add to that the Management Fee at 1.75%, and assuming an incremental operating expense of 0.25%. That’s 7.0% in total. With the new assets generating just over 9.0% on average, the incremental gain is probably just over 2%. Once an Incentive Fee is taken into account, the incremental income dropping to Net Investment Income is probably only 1.2% or 13% of the gross investment income.


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.

UPDATE:  As we’ve seen above SAR did draw down  more of its SBIC debenture capacity in the quarter, bringing total debentures outstanding to $134mn. That leaves only  $15mn to draw plus $2mn in cash in the subsidiary. On the Conference Call, the Investment Advisor mentioned that discussions were still being held with the SBA – presumably about getting its “Green Light” switched back on. While the Conference Call was packed with other information, the Investment Advisor was very tight lipped about what’s happening (or not) about getting a new SBIC license, and new borrowing capacity, even when asked directly by an analyst on the Conference Call. (This may have as much to do with not wanting to tick off the SBA as anything else).  With the available liquidity reaching its final dregs, this subject is becoming ever more pressing.

As we’ve seen above, the cost of capital for funding incremental investments is high. Using the Madison facility or issuing new Inter Notes (with interest rates likely to be between 6.0%-7.0% all-in) and adding the incremental management fees and likely higher incremental operating costs, and factoring in some degree of Incentive Fee and essentially nothing drops to the bottom line where shareholders are concerned.

The Investment Advisor makes much of its available liquidity in its press release and on the Conference Call, but that’s largely misleading, and as we’ve seen affords shareholders very little in incremental earnings while pushing up the BDC’s risk profile.  The asset coverage ratio is already reaching maximum levels (even when not counting in SBIC debt) and SAR has long ago reached Highly Leveraged status. At May 2017, the BDC had $330mn in assets at FMV and $27mn in cash, or $357mn. Of that only a third is funded with equity capital and two-thirds by debt.  Despite an At The Market (ATM) stock issuance program and a generous dividends-for-stock program SAR sorely needs to raise additional equity if its growth is to be funded.  For existing shareholders, this probably means that we’re reaching close to maximum recurring earnings per share, which ended the quarter at $0.50 on an adjusted basis.


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 pay 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.

UPDATE:  While SAR has done a very good job in recent years, and has become a dependable dividend payer (after years of giving shareholders mostly more stock in lieu of cash) the Investment Advisor can be – in the eyes of the BDC Reporter – a little too much like a “cheerleader” about its results and outlook and not as transparent or forthcoming as we’d like to see. It’s a problem across the BDC space, but that’s not an excuse in itself. For example, look at the 10-Q Consolidated Schedule of Investments for notes as to which loans are on non-accrual and you” find none. Yet we know from the Conference Call that 3 different loans are on non-accrual, or a tenth of the total. If you go to Subsequent Events in the 10-Q to learn about any loans booked or repaid, you’ll be out of luck there too, even though most BDCs do provide such information even if the strict letter of the law does not require that level of information.

Likewise, when discussing credit difficulties and valuations, there is a seeming shortfall in candor. The Investment Advisor blames confidentiality requirements with its portfolio companies. On the latest Conference Call an analyst was bothered by the valuations of both Elyria Foundry and Mercury Network, LLC. We won’t replay the entire back and forth but suggest investors read the transcript (which we don’t have as we’re writing this minutes after the Conference Call ended) and make up their own minds.

Likewise, something is happening at Easy Ice, where SAR seems to be providing the bulk of the financing for a management buy out and has become a super sized investment for the BDC at $34.8mn between the First Lien debt and Preferred. We understand from what the Investment Advisor said on the latest Conference Call and the prior one that a third party lender will eventually be found to take the most senior position in the capital structure, while SAR remains involved in the Preferred (which is being charged at a 10.0% Pay In Kind rate). Judging only by the confidence in the Investment Advisor’s tone, the BDC Reporter supposes this will all be alright, but investors are going to have to wait to find out what is going on.

All this is preamble to say that putting our BDC Credit Reporter hat on (and we noticed a couple of the analysts on the latest Conference Call had been plowing in the same field) SAR’s credit quality appears to have worsened in the IQ of 2017 from what we’ve been able to work out and despite the BDC’s own credit metrics (see page 43) showing a modest improvement. At May 31, 2017, SAR’s internal system has investments with only $2.7mn in FMV in its Red category (their idiosyncratic rating method), down from $7.1mn. In the Yellow group (under-performing), the dollar value is $8.3mn, just barely below the prior quarter’s $8.4mn.

The BDC Credit Reporter has a different methodology and strict comparisons are not possible. However, we’ll offer up what we ascertain, sitting on the outside looking in. As with last quarter, we count 6 credits on our Watch List.  Several of these Usual Suspects have taken a turn for the worse since February 2017 (i.e. not so log ago). The Big Kahuna is My Alarm Center, LLC , which we called out in the Preview. That’s been written down to $2.7mn in FMV from a cost of $10.3mn. Just a quarter ago, the cost was $9.4mn and the FMV $7.1mn.  As the Investment Advisor (to their credit) did warn us on the last CC, My Alarm Center has been on non-accrual since March. Not explained is why exposure increased (rescue financing ? accrued interest ?). In either case, this is a major reverse – albeit one that was in the cards- and there is no resolution as yet. SAR is losing out on over $300K in Investment Income from the new non-accrual.

Also on non-accrual (since 2016) is TM Restaurant Group LLC (Taco Mac to you and me) whose $9.4mn First Lien loan has been turned into a PIK loan and a new Revolver added for $0.4mn, also on PIK. Both facilities are presumably not being accrued and the valuation has dropped marginally.

Dropping in value is Ohio Medical, LLC ,whose $7.2mn Senior Subordinated debt is still on accrual, but was written down by 10% in the quarter, and its small equity stake by nearly 30%.

Elyria Foundry’s equity was written up in the quarter, but the small debt tranche of $0.4mn remains unchanged, with a 15% PIK. That credit seems a long way from recovery as the equity remains discounted by 85%.

Targus Holdings – a last ditch effort by lenders to rescue a company in a debt for equity swap, in which SAR has $2.8mn invested at cost in both debt and common remains under-performing and any income received in the form of PIK. Finally, there’s a tiny remaining exposure to M/C Acquisition with a value of $6,320. 

When we total all these credits up at FMV, the number comes to $20.6mn, nearly twice SAR’s number.

On the positive side, the Investment Advisor has a good track record of both working out of difficult situations and of investing profitably. There are multiple equity “bites” that could be sold down the road for modest gains, but investors (and the BDC Credit Reporter) should keep an eye on what’s happening to the value of HMN Holdco, LLC and Mercury Network (the analyst’s skepticism notwithstanding) , which might offset losses that occur elsewhere.

Overall, though, the BDC Credit Reporter would say SAR’s overall credit quality trended down in the quarter, following a pattern that is several quarters long. Nonetheless, the BDC’s credit performance remains within our long term expectations.


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”.

UPDATE:  Halfway through the trading day, and the market does not appear to have been delighted by the SAR news, despite the face value metrics. The stock price is down (6.4%) to $21.08.  Investors may be reacting to the concerns we’ve expressed about transparency and credit quality and the radio silence from the SBA. We note the stock dropped right out of the gate, suggesting readers of the 10-Q were not impressed by the slightly higher Net Investment Income Per Share (much of it from PIK income on under–performing companies and that boost to the CLO incentive fee). On the other hand, investors could also be worried about a potential equity raise and are positioning themselves to buy-back after the offering (so many astute investors out there).  Now the stock price is below NAV…

For BDC investors, the initial negative reaction is a reminder that with BDCs at record high prices, the news has to be almost universally good (and there were several positive developments in the period where SAR is concerned) for the stock price to remain in the stratosphere. With earnings season getting underway in earnest in late July and early August that bears remembering. We’ll continue to provide previews in advance of the IIQ results but there is so much not even the BDC Reporter with its huge resources (we’re saying this tongue-in-cheek which does not always show up on the printed page) can divine in advance. Then there are the BDC investors themselves, swinging (as we’ve seen just in the range of SAR’s stock price in the last two years) from optimism to dire pessimism. We have sympathy for SAR’s Investment Advisor who must wonder what went wrong after most of the numbers on paper (higher Net Investment Income, higher distribution, more assets, more companies, CLO zooming along) seemed so positive at a first glance of the earnings release. This is a tough business.

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