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BlackRock Investment: Investment Returns Disclosed

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On September 28, 2017 BlackRock Capital Investment (BKCC) filed an 8-K regarding disclosures made for marketing purposes about the performance of certain of the BDC’s investments. The BDC Reporter – which has discussed the subject on an earlier occasion when BKCC made a similar filing – reviewed the numbers and the assumptions used by BKCC, and compared with a March 28 2017 filing. The BDC Reporter uses the opportunity to delve into the micro-economics of this BDC’s investment returns, and make a broader point about the benefits – or otherwise – of using leverage to build a loan portfolio from a shareholder’s viewpoint.


NEWS

The 8-K explained that BKCC calculates internal rate of return (“IRR”)  achieved on investments made since BlackRock took over as sole investment advisor at the BDC in March 2015 to June 2017

The IRR numbers are mentioned in marketing materials, presumably related to institutional investors with a view to demonstrating the Investment Advisor’s performance as a solo act. Here is an extract:

For the Advisor’s marketing purposes unrelated to the Company, the Advisor has calculated an implied IRR (internal rate of return) for that portion of the Company’s portfolio which was invested on or after the Acquisition Date. Such implied IRR has been calculated gross of any fees and expenses as well as net of Applicable Fees…The calculation covers a period (the “Calculation Period”) beginning on the Acquisition Date and ending on June 30, 2017 (the “Calculation End Date”).

Here is how BKCC calculates  IRRs, both gross and net:

The implied IRR calculation includes the performance of all new monies invested during the Calculation Period. For such investments exited during the Calculation Period, all actual cash inflows and outflows during the Calculation Period that were attributable to the investment were used to calculate the implied IRR. For all other such investments, the implied IRR was calculated (i) using all actual cash inflows and outflows during the Calculation Period that were attributable to the investment and (ii) assuming that the fair market value of the investment as well as any accrued but unpaid interest on the Calculation End Date were realized in cash as of such date.

The gross and net IRRs were 13.6% and 9.3% respectively over the given period “based on $566 million of cash invested in 29 different investments across 23 companies, of which 4 investments across 4 companies were exited during the Calculation Period.”

Back in March 2017 when BKCC undertook a similar calculation for a Calculation Period ended December 2016 the gross  implied  IRR was 14.6% “based on $480 million of cash invested in 25 different investments across 21 companies, of which 3 investments across 3 companies were exited during the Calculation Period”.

There was no net IRR calculated last time. BKCC appears to have added this feature in the latest numbers only.

Drilling Down

When the calculation is broken out between investments sold and those still on the books, the IRR numbers are different.

The 8-K shows the 4 sold investments achieved a gross IRR of 18.9% and 14.6% net. (Back in the earlier report, the gross IRR on 3 sold investments was 24.8%).

Still-on-the books investments have a gross IRR of 13.0%, and 8.7% net. (In the prior 8-K, the gross IRR on these retained investments was 13.7%).

In this latest 8-K, as we mentioned above, BKCC has included a net IRR, which is after fees and expenses. Here is how that’s explained:

The implied IRRs on a net basis are calculated using cash flows that are net of Applicable Fees. “Applicable Fees” equal the annualized base management fee, incentive management fee (before giving effect to any fee waiver during the most recent fiscal quarter) and operating expense (excluding base fee, incentive fee and interest and credit facility fees), respectively, incurred by the Company during the most recent fiscal quarter (Q2 2017) expressed as a percentage of total investments of the Company, at fair market value, as of the end of Q1 2017. The Applicable Fees are applied to total invested capital throughout the Calculation Period for the purpose of calculating net implied IRR. Because the net implied IRR is calculated on the basis of the Company’s gross assets and IRR is not affected by the amount of the Company’s leverage, Applicable Fees do not include leverage expenses and are expressed as a percentage of the Company’s total invested capital (instead of being expressed as a percentage of the Company’s net assets, as expenses typically are expressed in the Company’s financial statements).


ANALYSIS

There are a lot of numbers here, but BKCC is seeking to show that new deals booked , held and eventually sold are achieving very good returns.

However, with the passage of time, the comparison of the two 8-Ks show those actual implied gross IRR returns have dropped by a quarter: from 24.8% to 18.9%.

Moreover, the remaining portfolio gross IRR returns are down, but less spectacularly, from 13.7% to 13.0%.

The recently included net IRRs show a relatively modest return for the unsold investments: 8.7%.

Furthermore, BKCC has not included any interest expense that might be involved in buying those assets. We’d suggest the net IRR might be between 2%-4% if all those investments were financed by borrowings.

The 8-K actually warns readers about this fact:

Investors should not rely upon the implied IRRs shown above as a measure of the performance of the Company or its portfolio as they do not represent returns experienced by an owner of the Company’s common stock. A common stockholder’s actual returns are subject to higher expense ratios when expenses are expressed as a percentage of the Company’s net assets and leverage expenses are included. [Emphasis added by BDC Reporter]

Furthermore, the filing also warns that investments acquired by BKCC before the advisory change and still on the books are likely to have even lower returns than those for the post-change investments.


VIEWS

Anybody taking the IRR results that BKCC is offering as conclusive evidence that the new Investment Advisor is performing well in its new capacity will be misleading themselves.

First of all, the sale of 4 investments out of 29 – which account for just 15% of total assets – is too small a sample to tell us anything useful.

Second, we are only 2 and a quarter years into this measurement period, and many of the investments have been on the books for very brief periods.

We would require a 5-7 year period -which is likely to include  much greater IRR erosion from bad debts than experienced to date – before any conclusions could be drawn.

Unintended Consequences

Unfortunately the data only serves to underscore that i) expenses are very high, even before we include leverage.

One third of the gross IRR being achieved on new investments still held on the books is being absorbed by Applicable Fees. Plus:

Gets Worse

ii) As shown above, if debt service costs are included the net IRR drops very low.

iii) If we assume reasonable credit losses over time, the IRR is likely to drop even more and is probably a negative number.

For prospective BDC investors who don’t take potential credit losses into account we would remind you that BKCC has written off, or down, assets equal to 27% of all their capital raised since becoming a public company.

In absolute dollars, that’s equal to close to a quarter billion dollars…

Bigger Picture

If nothing else, these BKCC calculations only support the BDC Reporter’s oft-mentioned point that many BDC assets acquired with debt (especially with expensive Convertible and Baby Bond financings) are “non-accretive”.

Or put another way, at the end of the day the investor will be losing money on every dollar of its capital allocated in this fashion.

Controversial

We can make a credible case that over a full cycle that the net IRR on ALL loan investments financed by BDC borrowings of any kind, and taking into account all costs, interest expense and credit losses is zero, or very close.

Essentially virtually all the return on equity achieved by a BDC through a full cycle is on investments financed by its equity capital.

Investments funded by borrowing are either “non-accretive” or generate a minuscule return.

There are exceptions to this rule, but very few.


BDC INVESTOR

Common Stock

We have no position in BKCC’s common stock, either in our Special Situations strategy or our Long Term Income strategy.

Regarding the latter, the BDC’s credit track record has been too poor to allow us even to add BKCC to our Watch List.

We are hopeful the new management and strategy in play since 2015 will eventually improve the BDC’s business model and long term performance.

However, we will need a far longer period to evaluate whether BKCC has made a permanent improvement or is just jumping from frying pan to frying pan.

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