Capitala Finance: Credit Troubles
We’re reminded as BDC earnings season proceeds with more funds reporting results that – at the end of the day – far and away the most important factor is credit quality. It’s sometimes hard to remember in the torrent of information about loan yields, management fees, interest on debt, fees waived, one time costs and so on. However, if you take a longer term view the issue that will fundamentally make or break any BDC’s price is how well management performs in the credit underwriting department.
Of course, both our readers and the BDC Reporter know this. In our case, we put on our BDC Credit Reporter that periodically and look just at a BDC’s credit risk profile and performance before getting back to all the other news that affects -if only on the margins – a BDC’s ultimate long term return.
Credit Is Hard
There are many difficulties in effectively evaluating a BDC’s credit quality. First, investors have very little information forthcoming from the funds, which offer up the quarterly valuations and a few comments on a Conference Call that might touch on a twentieth of the investments in portfolio. Second, credit timelines for every under-performing investment vary in how long they take to play out. One day a loan can be performing as expected and in the next quarter can be in default and about to be written off. Or, more commonly and in the way that Saturday Night Live reported on the coma of President Franco, these timelines can go on for many, many quarters as the managers of the firms involved, sponsors and lenders all seek a solution. Of course, that’s all happening behind a curtain from whence the BDC manager will occasionally pop out to provide a cryptic update. Third, the BDCs themselves only have very partial information and limited tools to effect appropriate resolutions. Borrowers have their own agendas, as do many other parties involved in troubled companies.
Staying Focused On What Matters
This is very frustrating to most investors who wander off to look at more seemingly tangible information such as the latest earnings, or how many new loans were booked or repaid in the quarter. Yet at the end of the day investors are best served keeping as close an eye as possible on what’s happening or otherwise in those investment portfolios.
Finally Getting To Specifics
We point to two examples coming out of earnings season, one of which we discussed last week and one new player. Last week, Triangle Capital (TCAP) had to admit credit problems were continuing to mount, which we wrote about. The market didn’t wait around, and has written the stock price down by 17% since earnings and over 50% since the problems began.
This Week’s Evidence
This week, Capitala Finance (CPTA) reported after the close on Monday. Although the press release led with its refinancing efforts, the real story was an upsurge in non-performing loans. On Tuesday the stock price was down -14%, underscoring how credit issues are once again front and center. Even though we’d promised ourselves just to look at earnings press releases only during Earnings Season and dive more deeply into CPTA and all the other BDCs that have announced results later, we recognized that what matters at CPTA is credit and insights into how that’s really going is not found in the earnings press release, but in the 10-Q. Instead of recapping for our readers what they already know about BDCs that are performing more or less as expected, we decided we’d look under CPTA’s hood and bring you some insights you may not find elsewhere.
So we’ve spent several hours looking through the filing in some detail, and comparing against our prior spelunking into the detail of the BDC’s filings. From a credit standpoint, the results are mixed. There’s a lot of bad news for CPTA’s shareholders, but there are also a couple of potential positive issues, which we’ll also get to.
Let’s start, though, with a look at the CPTA portfolio as a whole. At June 30, 2017, the BDC had assets at cost of $473mn and a FMV of $487mn. That makes matter sound better than they are. CPTA has 46 companies in portfolio. By the BDC Credit Reporter’s count 12 of those are under-performing, and have a FMV of nearly $100mn. To put that into context the net book value of CPTA is $230mn. Thus, roughly 1 portfolio company in 4 is in some kind of trouble and the amount at risk of being partly or fully written off is equal to 40% of book capital.
By CPTA’s own account, 6 of the 12 companies we’ve identified as underperforming are not paying interest on their loans. These investments by themselves have a cost basis of $86mn, and a FMV of $51mn. In just 6 months the value of non-performing loans has almost tripled.
Just to add to the misery – and quoting from the press release and not our own numbers – these non performing loans reduced Net Investment Income in the quarter by $3.7mn or $0.23 per share. It’s fair to say this represents a serious set-back from a credit standpoint, even more than the drop in Net Asset Value Per Share from $15.79 at year end 2016 to $14.97 might suggest. After all, Net Investment Income a year before was $7.4mn…
Journey Of A Thousand Miles Begins
Obviously CPTA is seeking to restructure/work-out of the 6 different companies, but has only one resolved at this point, and that wasn’t very encouraging as to the impact on recurring earnings. Sierra Hamilton – an energy deal- exchanged $15mn of first lien debt for a 14% equity stake, which will be non-income generating. That’s $1.8mn in annual interest income gone. The only “good news” is that $0.9mn of interest was received in cash and another -loan to Sierra for $1.2mn was repaid at par. So on $16.2mn invested in Sierra, only just over $2mn will be available to generate income going forward. Shareholders may comfort themselves with the prospect of a gain on the 14% equity stake down the road but in the quarters ahead that will be no solace to income.
Left are 5 other non-performing loans. The most important include Kelle’s Transport Service, which went in a quarter from Watch List to non-performing, and includes a $13.7mn loan at a 14% annual rate that is not being collected. The total investment at cost is $17.1mn and is already valued at a nearly 50% discount. That’s $2.0mn in Investment Income up in the air. We have no idea about recoverability.
Another big blow is Cedar Electronics Holdings. This borrower was performing just a quarter ago and was valued at par. Now the $22mn in debt is valued at $16mn. More importantly, the 12% yielding loan is non performing, costing CPTA a whopping $2.6mn in annual forgone income. For investors sharp credit movements like this are a nightmare and almost always result in drastic resetting of a BDC’s stock price if the amounts are material. That’s the case here. We have no idea about recoverability.
Then there’s American Exteriors, with a $4.9mn First Lien loan at 10% also on non accrual . Another $2mn loan to Immersive Media Tactical Solutions LLC has a zero interest rate, and zero value.
These are just the immediate problems and enough by themselves to cause shareholders to panic, which they have. However, the BDC Credit Reporter has identified 6 other names that might cause troubles in the future. The good news is that only one is in our Category 4, which means that we consider the chances of a loss greater than full recovery. 5 borroweers are under-performing, but we’re still hopeful a full recovery is possible. CPTA took pre-emptive action and sold under-performing CSM Bakery Solutions(a Category 3 credit we’d noted for awhile) for a 12.5% loss, and collected $4.9mn, so the net number of CCR 3 credits is down to 4.
Next Stop: Turnaround Town
Nonetheless, poor old CPTA management is now probably condemned to spend several quarters focused on working out the 5 non-accruing investments and taking evasive action where other troublesome credits are concerned.
Who Says We Never Point Out The Positive ?
There are a few positive elements that will mitigate this credit set-back, but as we said at the top, that will only modestly temper what happens to CPTA’s stock price. First, the BDC does have several equity investments which might be “harvestable” in the future and re-deployed into yield bearing investments. We count 7 such names and count up $45mn in value. In fact, CPTA is already busy tapping those sources. As recently as August 4 (!), CPTA was repaid a loan to B&W Quality Growers, and partly redeeemed some of its warrants for $1.5mn . (Every bit counts). On July 31, CPTA sold its equity investment in Source Capital Penray for $1.3mn, which we’ve not counted in the Munificent Seven above.
As BDCs always remind us, the control over the timing of an equity sale is usually not under their control so tapping all its equity stakes will take time and much may happen in the interim. Moreover, CPTA will be hard pressed to seed new equity investments in the quarters ahead, with obvious implications for the longer term.
Another positive element is that CPTA’s Investment Advisor is not paying itself an Incentive Fee while its earnings and NAV are getting hammered. Last year at this time $1.667mn was going out to the manager, but not in this quarter and presumably not the next few. The Advisor has voluntarily offered to waive the Incentive Fee. That could be rescinded, but that’s unlikely and should save shareholders several million dollars. So far in 2017 the waivers amount to $1.0mn.
No Problem From That Quarter
Also, CPTA should not face any problems with its Revolver lender, which can happen when credit and book value is imploding as covenants can get breached. Here CPTA management appears to have seen the trouble coming, which probably explains why the BDC not only redeemed its Baby Bond with a new Baby Bond, but also issued Convertible Debt as well. (Some investors in the Convertible may be miffed that the extent of the BDC’s credit troubles was not known at the time of the Convertible issuance. As a result, the chances of the stock price ever reaching its conversion price of $15.71 seems very low).
We’ll share – if only to underline the BDC Reporter’s hard nosed skepticism – that we invested in the Convertible with no expectation of any future conversion, but were drawn in by the fact that the security cannot be redeemed for 5 years. In our Fund we use leverage, and even after accounting for potentially higher borrowing rates over the period- the Convertible is projected to earn us a double digit return, and the longer the better for medium term opportunities.
Cost Of Capital
Armed with all that net cash, and various loan and equity repayments, CPTA has repaid its Revolver for the moment. That’s not good news from an interest expense point of view given the Notes bear interest at rates of 6.00% (the new 2022 Notes) and 5.75% (the Convertible) while the Revolver is a little less expensive at LIBOR + 3.0% (around 4.0% all in). At June 30, 2017, the 10-Q had $30mn outstanding but has subsequently been paid down to just $10mn.
Top Of Cap Structure
The Revolver at June 2017 still had – presumably after taking into account its problem credits – $214mn of availability, even though the facility is capped at $115mn currently. That’s important for a number of reasons. First, that suggests the Note and Convertible holders -with $127mn owed to them -can look at the non-SBIC assets as their principal source of repayment, and will essentially be the first to be paid after the $10mn owed to the Revolver lender, is cleared.
Second, CPTA has plenty of liquidity – notwithstanding its current credit crisis – to rebuild its balance sheet in the future. We doubt that the Investment Advisor is in any hurry to grow back up until its issues are on the way to being resolved, but that untapped Revolver and the remaining cash on the balance sheet will prove a useful resource in 2018 and beyond.
The Big Question
However the question the BDC Reporter – and any long term investor – will be asking is whether CPTA’s Investment Advisor is up to the challenge of being a BDC ? Do they have the right business model; management team and resources to generate a decent shareholder return ? After all, CPTA came public at $20 a share less than 4 years ago. NAV has dropped since then by more than a quarter already. The distribution was at $0.47 a quarter, has dropped to $0.39 and will likely drop again. The stock price is headed towards a 45% decline since the IPO.
We have no doubt that CPTA – like most BDCs that have tripped up before – will forge on. However, investors don’t have to follow them. The BDC Reporter – in any case – is not concerned that CPTA will fall apart, but needs to be convinced the Investment Advisor has a credible plan to avoid this episode being just one of many in a long term decline. Of course, the critical element to determine – and the most difficult to assess in the here and now – is how CPTA will perform from a credit standpoint going forward.
Capitala Is Not The First
From our standpoint, “once bitten, twice shy” has to be the guiding sentiment. We remind our readers of other BDCs that have faced credit imbroglios, promised to start a new leaf (new strategy, new staff, new guidelines) and yet been back to writing off more a disportionately high number of investments a few quarters later. The list is depressingly long, but market memories are short as most investors (according to studies) rarely stay invested for even a year. Here- from memory – are just some of the bad debt recidivists: Apollo Investment, BlackRock Investment, Triangle Capital, Fifth Street Finance, OHA Investment, Gladstone Capital, Medley Capital , Horizon Technology Finance and THL Credit.
The BDC Reporter hopes CPTA can do what only very few BDCs with poor credit records have been able to do: turn theirloan underwriting around. (Saratoga Investment is one of the few exceptions and that required a new strategy, a new Investment Advisor and several years of paying distributions mostly with new shares). However – even with the best of intentions and if everything goes swimmingly – it will take several quarters to play out and to convince the BDC Reporter. We blame the puncture marks from ten years of investing in BDCs for our skeptical approach.
As the above makes clear, the BDC Reporter is in no hurry to place CPTA on our Buy List for either our long term Income Strategy or our short term Special Situations strategy. In both cases, there are too many uncertainties involved, wherever CPTA’s stock price goes. Moreover, we expect another distribution cut in the year ahead. Even if the market expects a cut, the stock price will often take one final leg down when the actual announcement is made. So even with our Special Situations hat on we’re more likely to remain on the sidelines for the moment.
We will continue to hold both CPTA’s 2022 Notes and Convertible in our Fund and in a couple of other portfolios which have lower risk-lower return strategies. Admittedly, we are concerned that 3/5ths of the BDC’s assets are in SBIC assets which are not immediately available to support the unsecured debt if needed. However, if need be those investments could eventually be liquidated and there may be as much as $175mn in equity value therein that couild be paid up to the parent to meet its obligations.
Furthermore, as we discussed above, there are over $200mn in non-SBIC assets to cover the $122mn in unsecured debt as well, net of any Revolver outstanding.
We wouldn’t be surprised if the Investment Advisor reacted to the current credit episode by becoming more conversative in its portfolio construction and credit choices. That may be good or bad for shareholders depending on your perspective (earnings would drop but risk adjusted returns might go up) but is usually positive for the BDC’s Note Holders.
If there is any wobble in investor confidence we may buy more of either instrument in order to bolster our potential gains in this low yield market.Already a Member? Log In
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