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Apollo Investment: Over Valued ?

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We promised a couple of days ago to review a couple of BDCs which have reported second quarter results, and which we believe remain over-valued by the market. However, we were distracted by the announcement of further credit troubles at Capitala Finance (CPTA) and turned our attentions there. This quarter three BDCs have disappointed the market where credit is concerned and paid a high price where their stock price is concerned : Alcentra Capital (ABDC),  Triangle Capital (TCAP) and the afore mentioned ABDC. A few other BDCs have had less dramatic credit set-backs – more spread out in time and size – but have also been dunned by the market, but in a less drastic fashion. Those BDCs include FS Investment (FSIC), which reduced its distribution weeks after hinting the cut was coming and blamed lower income from restructured investments; Horizon Technology Finance (HRZN) which claimed progress on its prior credit sore spots but also admitted to a new material problem loan and OFS Capital (OFS) which was in the wrong place in the My Alarm Center restructuring. First Lien lenders will get repaid in full, second lien lenders will become owners and recognize losses.

However, there are some other BDCs that have previously confessed to systemic credit problems and have publicly announced concrete measures to turn their fortunes around. Those names include BlackRock Investment (BKCC); Fifth Street Finance (FSC); Fifth Street Senior Floating Rate (FSFR); THL Credit (TCRD); PennantPark Investment (PNNT);Medley Capital (MCC) and Apollo Investment (AINV). Generally speaking the market has been generous to these previously “fallen angels” and in its constant search for an opportunity pushed up their prices from the lows achieved when the bad credit news first came out.

DON’T WORRY. BE HAPPY

AINV’s stock price has increased from $4.52 at its lowest point last to $6.27 as of the close on Thursday, not far below the IIQ 2017 NAV Per Share of $6.73 and at a 10.5X multiple to the latest Net Investment Income Per Share annualized.  (It’s been as high as $6.79). The market appears to be satisfied that AINV’s turnaround – which we’ve discussed before and which includes a new management team; a new strategy; fee concessions and (as we’ll show) a series of write-offs- has successfully been completed. The market – judging by the stock price and the comments of analysts on the Conference Calls – appears delighted with the promises of less investment concentration ; investing higher in the capital structure with less risk and leveraging Apollo Global’s credit platform. Investors appear to be confident both the new NAV and the recently reduced quarterly $0.15 distribution will hold, so while several BDC peers have seen their stock prices drop AINV’s has increased and stabilized.

TAKING A BREAK

However, the BDC Reporter – after a detailed review of the latest 10-Q and with a long history of tracking AINV dating back to when we first stumbled into the nascent BDC sector before the Great Recession – is less optimistic. From our perspective, the odds are high that the historic slide that AINV has suffered in earnings, NAV and distribution is only taking a brief break, and will continue before long. As we’ve mentioned before – and we’ll seek to show below- this is a result less of the skills and efforts of management whom we imagine to be as skilled and thoughtful as any of their peers – but of the weight of the BDC’s history and the unwillingness of the Investment Advisor to make some hard decisions that might cause the “turnaround” at AINV to be more than fleeting.

LATEST

Let’s begin with the latest 10-Q. At first blush the results all point to progress being made to “stabilize” AINV. For the first time in a while investment assets increased at fair market value to $2,417 mn from $2,317mn in the prior quarter. (However, investments at cost continued to drop: from $2,605mn to $2,465mn). Borrowings increased. Net Investment Income and on a per share basis dropped from $0.17 to $0.15, but that was still in line with the distribution.

CLEANING UP 

Most importantly AINV seemed to put its prior credit troubles behind it with a massive Realized Loss write-off of -$234mn. To put that in perspective, remember AINV’s current Net Investment Income after  waivers is $33mn. This bonfire of credit mistakes is equal to 7 quarters of recurring net earnings, nearly 8% of equity capital at par and 15% of all Realized Losses since AINV came public on April 8 2004.

CHANGE

At a stroke AINV’s Unrealized Depreciation was reduced by 90%, leaving the portfolio valued at 98% of cost, suggesting order has been restored. This is also reflected on the Investments On Non Accrual. Back in March 2016, 8.4% of assets at amortized cost and 4.2% at FMV were on non-accrual status a year ago . At cost that was nearly a quarter of a billion dollars.

This quarter, the numbers are 1.9% and 1.1% respectively, and the dollar amount $46mn, a vast improvement.

NOT ENOUGH

So everything is awesome, right ? The market seems to think so, but when we had one of our periodic looks at the portfolio, we came away still concerned. AINV has 84 companies in its portfolio. By our independent count – relying on the BDC’s valuations but also our own research and reading of the notes and application of reasonable skepticism – we count 12 names on our Watch List. Right off that’s a high percentage.

Very roughly, these 12 companies have a fair value of close to $400mn, or over a quarter of AINV’s Net Assets.

TMI

We break our Watch List into 3 categories: CCR 3 for companies that are worth watching but where the odds of full recovery remain higher than an eventual loss, CCR 4 for companies where the odds are greater of a loss and CCR 5 for companies already on non-accrual and wghere losses are already happening.

OUR “WORRY” LIST

Of late, we’ve been focusing on the CCR 4 category, which are companies that are still “performing” but should they stumble the impact on Investment Income would be felt. Of course, we’re working with little information and BDCs are notoriously unwilling or unlikely to confess an income loss could be coming, so our comments should be taken in that context.

GETTING INTO THE WEEDS

In this case, we count a too high 7 CCR 4 names. We’ll be the first to admit who we’ve included may be controversial and AINV and many other investors who follow such things might not agree, but this is our perspective. We’re especially concerned about credits where all or most of the investment income is payable “in kind” rather than in cash, confirming our suspicions that all may not be well. Some of the names include Maxus Capital Carbon (a long time resident in our analysis), which has a $59mn first lien loan at cost (450mn at FMV), all paid with a 5.22% PIK.

Then there’s Elements Behavioral Health, with a cost of $11.5mn and an FMV of $9.5mn, with a 13.18% PIK yield.

Sprint Industrial Holdings – as the 10-Q notes will tell you – has been restructured. Two loans with a cost of $16.8mn and a 13.5% yield are valued at $7.8mn. (That was $9.3mn just a quarter before). Again, all the interest is in PIK.

Together, these 3 investments generate $6.6mn of annual investment income. That’s about 2.5% or 5% of Net Investment Income.

ENERGETIC

However, the two CCR 4 names we worry most about are two energy credits. Wait, you’ll say, AINV is out of the energy business, which has caused it so much shareholder pain. Unfortunately that’s not the case. These are investments that the Investment Advisor is holding onto on the hope that all will eventually work out. In the interim, though, there are big dollars involved, and risks remain. Notably, AINV has close to $150mn invested in Solarplicity, mostly in first lien debt. The 8% yield has a PIK toggle option. That is the interest can be paid in kind.

TAKE WITH SALT

Currently one tranche of shares in Solarplicity is valued at zero and another at a premium. We don’t know that this investment will not eventually be a great success. However, from a risk assessment point of view, the size and the PIK option causes us to worry, and so it’s on our CCR 4 list. When one loan accounts for $12mn of annual investment income by itself, caution is the policy.

Then there’s another restructured energy credit: SHD Oil & Gas. One tranche of a loan to this borrower, which AINV  “controls” is deeply discounted from a valuation standpoint and is on non-accrual.  There are two other tranches outstanding which are “current” with a cost of $57mn. One has a yield of 14%, part paid in cash and part paid in you-know-what and a smaller tranche at 12.0% cash (there’s always an exception to our rules). Together these two loans generate $7.3mn in annual income.

MORE ENERGY

While we’re on the subject of “legacy” energy investments, we should note that in our CCR 3 category we include Glacier Oil & Gas (previously Miller Energy). AINV has $40mn in First Lien and Second Lien debt to the restructured company in which they have a 49%  equity interest. As always there is a PIK toggle option, but the debt in both cases is carried at par. However, the equity itself with a nominal cost of $30mn was valued at $24mn  in June 2016, over $18mn IQ 2017 and $17mn this quarter.

HOW WE THINK

By no means are we saying all -or any – of these investments will stumble in the quarters ahead. We just don’t have the data. We are mostly pointing out that the dollars involved and the income therefrom is very high, and many of the companies are involved in cyclical industries and have failed previously (which is why AINV owns and lends  rather than just lends to them). The downside risk is disproportionate to the potential gain, which is mostly booked into the current income of the BDC.

TURNING TO EARNINGS

The BDC Reporter is not just concerned about possible credit slip-ups, but also about AINV’s profitability and its ability to sustain its dividend. Of course, these are related issues. If some of these loans become non-performing the result will be lower earnings.

DECONSTRUCTION

As we saw at the top, Net Investment Income Per Share is already only just even with the new distribution level at $0.15 a quarter. Even that overstate the recurring Net Investment Income of AINV, which is temporarily buoyed by the fee waivers which the Investment Advisor has offered up at this transitional time, but which are scheduled to go away within 3 quarters. Taking out the waivers, Net Investment Income would be below $0.13 a share on a pro-forma basis.

LOWER YIELD

Furthermore, the laudable effort to steer AINV away from the riskier corners of leveraged lending is impacting recurring income. Whatever else they did energy loans and CLO investments kept AINV’s portfolio yield up and resulted in juicy fees. Now the Investment Advisor is dumping its CLOs, not adding to energy and placing more of its remaining capital in its captive leasing and asset based lending business- all with lower yields and fees. The portfolio yield has already dropped (notwithstanding those high yields in the legacy energy credits) from 11.0% to 10.3%. The downward pressure on yields will continue unless AINV starts to book riskier assets again. That seems unlikely, given its contradiction to all promised before.

GROW ?

That leaves the Investment Advisor to have to grow the balance sheet to offset yield losses and to cover the coming loss of the fee waivers. That’s a possible way forward, but a counter-intuitive one at a time when dog is eating dog for new loans, and difficult given the refinancing environment. As a result, the pressure on recurring earnings will be severe.

“REAL INCOME”

We’ll close by pointing out – as we have in prior articles – that when you strip away incentive fee concessions and PIK, AINV’s Net Investment Income is already insufficient to pay the $33mn in quarterly distribution. First let’s remove $5mn in fee waivers and then $5.8mn in PIK, and you’ll find the “real” Net Investment Income in the IIQ was $22.5mn, or $0.10 a share.

AINV – and other investors with a different perspective – might argue that it’s not fair to not count PIK income. After all, the income will be eventually collected and all will be well. That may be the case with some other BDCs, which book some PIK as an end of loan bonus.

However, in the case of AINV – and a number of other BDCs- much of the PIK income booked is concentrated in the most fragile credits and is resorted to usually after a credit has gotten into trouble, as we showed in our list of Watch List credits.

WHY WE ARE SKEPTICAL OF PIK INCOME

We would refer readers who believe PIK income is as good as cash interest received to page 45 of the 10-Q. The Investment Advisor – as part of its cleaning up process – wrote off PIK accumulated over the years.  In this quarter alone, AINV wrote down its PIK balance, which began the period at $53.3mn, down by $35.6mn. The latest balance is now $20.0mn. If you were wondering how much PIK income was collected in cash in the period from loan repayments: it was just $0.370mn.

Not all the $5.8mn in IIQ 2017 income will eventually be written off as uncollectible but investors who believe the dividend is being covered by current income may be on the optimistic side.

CONCLUSION

The BDC Reporter hopes AINV’s turnaround efforts will work out (pun intended). After all, we own the very expensive Unsecured Notes. However, the new Investment Advisor remains burdened  with numerous investments from their prior strategy which are major contributors both to NAV and earnings and which could yet drag down their results. Not helping is Apollo’s “aggressive” (to use the most diplomatic term we can come up with) restructuring of its under-performing investments which keeps income high in the short term but leaves the possibility of a sudden deterioration high.  Moreover, the unwillingness of the Investment Advisor’s parent – itself a public company with its own fiduciary responsibilities – to permanently reduce the cost of operating the BDC by cutting fees will also weigh on results from 2018 on.

We’ve not even had the time to weigh in on the continuing over-weighting of a few investments outside of the ones we’ve noted, which could bite the BDC and its shareholders in the future.

Taken as a whole, the BDC Reporter believes investors in the common stock are being asked to take too many “equity risks” at the current price level, which is why we believe the stock is over-valued. The new CEO may yet be able to steer through all these challenges and maintain the distribution at $0.15. However, our assessment is that at some point in 2018 – barring a drastic change in approach – AINV will be forced to admit that the pay-out cannot be sustained and implement another 20%-33% reduction in the dividend. Of course, with the market currently assuming everything is awesome at the BDC, such a move is likely to cause a sharp revaluation of the stock.  Just to throw out some price ranges, that could see AINV’s stock drop to $4.0 or below. For a stock paying $0.60 a year in distributions, the possibility of a $2.50 or more in price drop seems inappropriate risk-reward. We would be happy to be proved wrong but we point investors to AINV’s long term track record and ask why this time should be so much different ?

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