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Gladstone Capital: New Term Preferred Completed

BDCs:
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On September 21, 2017 Gladstone Capital (GLAD) filed a Form 8-K and other related documents regarding the issuance of its new Term Preferred. The BDC Reporter has already written two Premium articles, here and here. In this final article, we provide the final details regarding the new Term Preferred issue and analyze the impact on both shareholders and Term Preferred holders of the BDC. We end with a detailed discussion of what we are doing as a BDC Investor in Gladstone’s common stock and Term Preferred.


NEWS

According to the 8-K, the new Term Preferred transaction will be completed by September 27, 2017.

The filings reminds GLAD’s shareholders of the substantial rights granted the Term Preferred holders by the issue:

(i) consistent with the rights of the Company’s existing and outstanding Term Preferred Shares 6.75% Series 2021, par value $0.001 (“Series 2021 Term Preferred Stock”), the Articles Supplementary (defined below), prohibit the Company from issuing dividends or making distributions to the holders of its Common Stock while any shares of Series 2024 Term Preferred Stock are outstanding, unless all accrued and unpaid dividends on the Series 2024 Term Preferred Stock are paid in their entirety; (ii) like the Series 2021 Term Preferred Stock, the holders of the Series 2024 Term Preferred Stock, together with the holders of the Series 2021 Term Preferred Stock, have the right to elect two directors of the Company; (iii) like the Series 2021 Term Preferred Stock, in the event that the Company owes accumulated dividends, whether or not earned or declared, on its Series 2024 Term Preferred Stock equal to at least two full years of dividends, the holders of the Term Preferred Stock have the right to elect a majority of the Board; (iv) the Series 2024 Term Preferred Stock have a liquidation preference equal to $25.00 per share plus all accrued but unpaid dividends in the event of an acquisition, dissolution, liquidation or winding up of the Company; and (v) the holders of Series 2024 Term Preferred Stock generally vote together with the holders of the Common Stock.

After the issuance of 1,440,000 shares of the new Term Preferred, which will trade under the ticker GLADN, another 5,440,000 Term Preferred shares remain outstanding and available for issuance by GLAD.

The first monthly distribution for GLADN will occur on October 31, 2017, but the record date has not yet been set.

The final redemption date is September 30, 2024. However, GLAD may redeem the new issue as early as September 30, 2019.

The document also reminds sets out under which conditions GLAD may be required to pre-pay a portion or all the Preferred. Most notably these include:

Upon certain change of control triggering events, the Company will be required to redeem all of the outstanding Series 2024 Term Preferred Stock.

Also:

The Company may also be required to redeem certain outstanding Series 2024 Term Preferred Stock if the Company fails to maintain an Asset Coverage ratio (as defined below) of at least 200% as of the close of business on any Business Day (as defined in the Articles Supplementary) on which Asset Coverage is required to be calculated, and such failure is not cured by the close of business on the date that is 30 calendar days following the filing of the Company’s SEC report with respect to such date on which Asset Coverage is required to be calculated (referred to in this report as an Asset Coverage Cure Date). In such case, the Company is required to redeem, within 90 calendar days of the Asset Coverage Cure Date, shares of all of the Company’s capital stock classified as preferred stock under the Articles Supplementary, including shares of any series of the Company’s Term Preferred Stock (the “Preferred Stock”), (including the Series 2024 Term Preferred Stock) equal to the lesser of (1) the minimum number of shares of Preferred Stock that will result in the Company having an Asset Coverage ratio of at least 200% and (2) the maximum number of shares of Preferred Stock that can be redeemed out of funds legally available for such redemption. Also, at the Company’s sole discretion, the Company may redeem such number of shares of Preferred Stock (including the Series 2024 Term Preferred Stock) that will result in the Company having an Asset Coverage ratio of up to and including 240%. Asset Coverage for purposes of the Preferred Stock is a ratio calculated under Sections 18(h) and 61 of the 1940 Act, as in effect on the date of the Articles Supplementary, and is determined on the basis of values calculated as of a time within two days (excluding Sundays and holidays) preceding each determination.

The new Term Preferred is already trading in the “grey market” under the ticker GDDLP.

In a separate filing GLAD called in for full redemption the existing Term Preferred with the ticker GLADO for redemption on September 29.


ANALYSIS

Everything appears to be going to plan with the fully underwritten new Term Preferred.  Based on the above, there will only be a two day period when both issues will be outstanding and costing GLAD interest.

The new Term Preferred will be a monthly payer – which is in line with its two prior issues and what Gladstone Investment (GAIN) does.

The disclosures about the Term Preferred rights which affect the common shareholders are standard in these types of issues.

GLAD has managed to negotiate with the underwriters a two year “no redemption” period, rather than three years in the case of GLADO.

Our broker – MS Howells out of Arizona – has indicated the new issue has been trading at or just below par value.


VIEWS

Almost Signed, Sealed And Delivered

Helped by a still very accomodative market, GLAD has been able to successfully (just about) complete this significant medium term capital raising.

Minimal

As we’ve noted in earlier articles, the actual interest savings will be relatively modest, with only a 0.75% lower interest rate on the GLADO refinancing.

However, the portion of the existing GLADO repayment funded by the Revolver will be at roughly 5.3%, or a (1.45%) lower rate.

We May Not Be Done

We continue to project GLAD will eventually raise additional long term debt capital, which might eat into that interest rate differential.

Doing The Numbers

In any case, the cost of the underwriting and the out-of-pocket legal and other costs associated with the GLADN issuance will also diminish any

The BDC projected those costs in a filing as $370,710.

In total, we estimate the total cost of raising the new capital – between underwriters fees, legal costs and other expenses- will be around $1.8mn.

The annual savings in interest will be under $0.600mn, and that could drop if i) new Term Preferred is raised from the underwriters or from another round of financing; ii) short term Revolver rates increase as is expected later in the year.

Then there’s the acceleration for GAAP purposes of un-amortized costs associated with the early termination (4 years in advance) of the 2014 GLADO Term Preferred.

Time Horizon Extended

However, GLAD has reset its most junior debt liability (Term Preferred is essentially like debt with its stated maturity, covenants and fixed rate) for an additional three years.

In Your Name

Nonetheless, GLAD shareholders should not be complacent. As the filings remind us periodically, there is a trade-off involved from raising Term Preferred, which common stock owners need to contend with.

(The most important item from the Investment Advisor’s standpoint is that – under certain conditions of extended non-payment of Preferred interest – control of the Board can switch to the holders of the Term Preferred).

Shareholders will note that, and the key provision that no common stock distribution payments are allowed if the Term Preferred is not being paid.

Most important of all is that the balance of the Term Preferred gets paid down if “asset coverage” drops below 200% until that stat changes to a 240% coverage.

In other words, a lot of money could go out the door to the Term Preferred in a situation where asset coverage was impaired.

We’ve Been Watching And Taking Note

These are not theoretical risks, as we’ve seen other Closed-End Funds like Oxford Lane (OXLC) grapple with declining asset coverage and have to redeem a portion of their Preferred.

In a slightly different context KCAP Financial (KCAP) redeemed some of its Baby Bonds to stay within the 200% coverage rule.

No Problemo ?

None of this is currently a problem with asset coverage at 249%, according to the Prospectus.

However, a series of bad debts and/or a marked decline in loan values as occurred in 2008-2009 and to a smaller degree in late 2015-2016 could trigger a breach of the asset coverage rule.

For as far ahead as we can see, that risk remains remote.

Both Sides Now

From the perspective of Term Preferred holders the special rules pertaining to Preferreds (especially the Board control) versus unsecured Notes are an additional protection against potential loss.

Term Preferred holders can take substantial comfort from all the disincentives to both the Investment Advisor and GLAD shareholders to allow a default to occur.

Start With The Worst And Work Backwards

In a Worst Case – as best we can anticipate – timely redemption of the Term Preferred or of interest payments might get delayed, but ultimate repayment in full appears assured in all but the most extreme scenarios.

Currently – with the Revolver drawn close to $100mn in order to repay GLADO, there are still $250mn in assets at fair market value as support for the $45mn in GLADN Term Preferred soon to be outstanding.

Other Considerations

Term Preferred holders, though, have to contend with the uncertainty surrounding the real likely life of their investment.

Should market conditions be favorable, the Term Preferred could be paid off in two years. If the issue goes to Term or, at least, closer to a “normal” lifespan, this could be a 5-7 year time horizon.

GLAD’s fiddling with the early redemption term may keep GLADN trading closer to par – or below- in the years ahead.

Much more popular with investors – if premium to par pricing is any indication – are issues which have many years of not being redeemable.

See TICC Capital’s 2024 unsecured notes with the ticker TICCL , which are not redeemable till 2020 and trade at over $26.00 a share.

In any case, the BDC Reporter will be adding GLADN and deleting GLADO from its slightly misnamed “BDC Notes Table” once the two transactions are really completed. Here is the current state of play:


BDC INVESTOR: INVESTMENT STRATEGY

Common Stock

We have no position in GLAD, in either our Special Situations or Long Term Income strategies.  See our prior posts for the reasoning. Nothing has changed with the latest developments.

We don’t anticipate any change in our view in the short term.

Baby Bonds/Term Preferred

However, we do have a position in both GLADO for a few more days, and GLADN  in our BDC Fixed Income strategy.

What We Own And Why

We’ve held the GLADO position (and GLADP which GLADO replaced) in varying amounts in our Fund since 2014 and have been satisfied with the investment, and appreciate the monthly distribution.

(Our Fund – which is 98% invested in BDC fixed income- pays out interest monthly so issues like GLADO/GLADN provide a consistent pay-out which investors appreciate).

We were disappointed that GLADO did not last longer, but are not terribly surprised by the Investment Advisor’s move.

Marrying the close to 6.75% effective yield we’ve been receiving with 2x leverage at an average cost of under 1.5% a year and GLADO has been – effectively- earning us a current return in the high teens (before fees and other expenses).

Brief Roller Coaster Ride Included

However – given that the Term Preferred is reportedly heavily held by retail investors- the volatility of GLADO can be higher than some other fixed income issues.

Here’s a chart that shows how GLADO dropped (12.5%) in price for two months at the end of 2015 as markets everywhere went into Worry Mode.

Ares Capital‘s Note with the ticker AFC – also on the chart – did not drop nearly as much.

Of course, all issues began recovering after a few weeks in the doldrums and were back to where they had been by mid-2016.

Deja Vu Prospectively

We were able to keep our nerve at the time- and even added to our position warily- but the volatility was unnerving.

A repetition of this scenario is not unlikely in the 2-7 years ahead, even if there is no sign of stress at the moment.

Why We Bought The New Term Preferred

The above notwithstanding, we’ve taken a full position (usually about 5% of total investment assets) in the new GLADN Term Preferred in the “grey market” at an average price of par, purchased on September 21, 2017.

Again, with the use of 2x margin borrowing which we’re budgeting the cost of at 2.0% a year over the life, and with a 6.0% yield, our net yield before fees and other expenses but after borrowing should still be 14.0% per annum.

Concerns

We’ll be worrying, though, about future price volatility and looking out for an unexpectedly sharp reversal in GLAD’s credit and earnings performance.

(The BDC is currently performing at its best level – as is its stock price – in years. Nonetheless, GLAD’s credit track record has been mediocre historically, and bears watching).

Likely Time Frame

We’ll be surprised if GLADN lasts very much longer than 2-3 years before being redeemed unless the Next Recession shifts timelines.

In most of our portfolios where we have Fixed Income positions we take a long term perspective and we are ready to go the longer distance if that’s what happens.

Two Edged Sword

However, the biggest risk for our Fund – as opposed to other portfolios we manage which are un-leveraged and which might purchase the new issue – remains the margin borrowing involved, which we seek to manage at the portfolio level.

(In other words, we de-leverage the Fund’s portfolio when overall market conditions are unfavorable to avoid having to sell issues like these during a short term price reversal. There is no easy way to make double digit returns in this ever-lower yielding BDC market).

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