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Alcentra Capital: What Went Wrong

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INTRODUCTION

First, Triangle Capital (TCAP) reported poor results  and cut its dividend by one-third as everybody expected, but still saw its stock price crushed. Then, Alcentra Capital (ABDC) reported its own poor IIIQ 2017 results – and like TCAP – cut its distribution, in this case by a quarter. The stock price was “crushed”, just like TCAP. However, after the ABDC earnings Conference Call the slide in ABDC’s stock price continued. The stock price closed at $8.30 on Thursday November 7th only to drop to a new record low of $7.49 intra-day on November 8. Since hitting a high of $14.50 as recently as May 8, 2017 ABDC has lost half its value.

Clearly investors have been expecting Bad News for months. The BDC Reporter, which has been reviewing the BDC’s performance all along, is “diving in” to the latest ABDC 10-Q and the Conference Call that followed to determine what is causing the market to run as far as investors metaphorical legs can take them.

HEADLINE RESULTS

On the surface – in a relative sense – ABDC’s IIIQ 2017 results did not seem too awful. Most of all, the BDC reported Net Investment Income Per Share of $0.34, in line with the already announced distribution for the period. Net Asset Value Per Share did drop from $12.73 to $12.27, but other BDCs have seen similar reductions without stirring up the drama that ABDC has. Likewise, the distribution was reduced from $0.34 quarterly to $0.25, but that had been expected and priced in to the stock price months ago.

The number of non-accrual loans on the books increased to 3 at the end of the September quarter, up from 1 at the close of the IIQ. Moreover, in answer to the last question on the Conference Call, new ABDC CEO David Scopelliti indicated that outside of the 3 non-accruals, there were only two other companies on the BDC’s Watch List, both of which were there last quarter.  Again – in a relative sense – 3 non-accruals and 5 Watch List names in a 30 company portfolio is usually a blow, but not an earthquake.

Furthermore, ABDC appeared to say and do all the right things in the face of this credit deterioration. No incentive fee was due thanks to the losses, but the Investment Advisor waived an additional $1,160,896 in management fees for the quarter (essentially all the compensation earned) in order to ensure Net Investment Income Per Share would line up with the dividend.(This has become a popular manager technique of late, with such disparate BDCs as Apollo Investment, Monroe Capital and Gladstone Capital – amongst others – making similar concessions for the purpose of aligning the quarter’s earnings with the dividend).

ABDC also announced a $2.5mn stock buy-back program, to last through the next 12 months. Other soothing information mentioned in the press release was the intention of the BDC to modulate its prior focus on second lien lending in the face of the latest results and market conditions while making clear ABDC was in a “business as usual” mode, with numerous new deals booked in the quarter and 1 new transaction post-September end.

10-Q TELL ALL ?

All this has fallen on deaf ears even though the credit problems that ABDC fessed up to APPEAR to be far more modest than the recent slip-ups by the former Fifth Street Finance (now OCSI);  Apollo Investment (AINV) in 2016 and – of course- TCAP a week ago. Intrigued by the market’s reaction, we looked at the 10-Q, and at each portfolio company mentioned, for insights into this unforgiving reaction by investors only a few months after many funded a common stock secondary at $13.68.

ALARMING

Let’s turn first to the big loss on the quarter to My Alarm Center – a sponsor backed, fast growing security company- which stumbled a few weeks ago and was rescued by groups associated with Oaktree Capital and some of its senior lenders. This was a credit owned by multiple BDCs, but those at the more junior levels of the capital structure had to write-off a good portion of their exposure and settle for Preferred and equity positions in the “new” My Alarm Center. We know this item was already on the cards weeks ago because we wrote an article on the subject back in July 2017.

ABDC was a junior lender, recorded a Realized Loss of ($10.4mn), and is now left with a non-income producing Preferred investment. However, last quarter My Alarm Center was almost completely written down.

NON PERFORMERS

Then there are the 3 non-performing loans on the books, two of which are new in the quarter. The surprise to ABDC – and its investors – was the very rapid collapse of GST Autoleather. In June, the now bankrupt company was valued at par by its 3 BDC lenders. Now the $8.5mn ABDC advanced to GST – not unreasonably from what we’ve read about how Chapter 11 is proceeding –  is written down to a solitary $1. Income, too, at 13.00% on the debt, has suffered irreparably.

Media Storm has gone from being valued at its $2.5mn par in June to $1.5mn in September and also gone on non-accrual for $150,000 annual income lost.

Show Media is also on non-accrual. However, the company’s $4.2mn in debt  has been non-performing since IVQ 2016.

NEVER TOO LATE

We know – from ABDC’s just instituted Portfolio Risk snapshot (3.5 years after becoming a public company) – that there are four other names in the portfolio which bear watching. To see the slides with this information, go to Seeking Alpha.  ABDC does not mention which names go with the numbers mentioned, but we’ve inferred that the two Category 4 companies mentioned are  Southern Technical Institute and the restructured debt to oil services company Black Diamond Rentals. The first is negotiating a “debt to equity conversion”, which would give the opportunity for the company to “build back its customer base”.  The second is still performing, but being watched carefully.

THE REST

ABDC has 2 further names in its Category 3 rating (“the investment is performing below expectations”) and we have 3 names. We don’t know who ABDC is tagging in this way, but we have XPress Global Systems (logistics company), Conisus LLC (media) and the restructured My Alarm Center on the BDC Credit Reporter’s Watch List.

These total up to $39mn at remaining FMV, or $2.74 a share. If every dollar of those assets were written off, NAV would drop to $9.52. That’s unlikely to be the case – GST Autoleather notwithstanding – but give a sense of the size of the hole ABDC is in.

EARNINGS IMPACT

What we prefer to do – rather than speculate about NAV – is estimate the impact on Net Investment Income from potential future bad debts. As far as we can tell, the impact of the My Alarm Center write-off and the 3 existing non-performing loans is already not counted in the IIIQ 2017 results, when Net Investment Income before fee waivers was $14.7mn annualized. Coincidentally or otherwise, that amounts to $1.03 per share, very close to the newly reset $1.00 annual dividend level.

HANDICAPPING

So what are the odds of new names being added to the non-accrual list and what might be the impact ? First is Xpress Global.  This long standing debt and equity investment in a floor covering moving trucking company seems to have been restructured earlier in 2017, but the biggest tranche was increased in value in the IIIQ 2017 from a discount of (56%) to (36%). Another second lien tranche is valued at par. That’s mildly encouraging, but if Xpress did fail to perform, the impact would be $0.5mn of income lost.

Then there’s Black Diamonds Rentals. If the current restructuring does not work (ABDC was very vague on the call) the impact on interest income because only one of the three tranches of debt to the company is currently “income producing”.  We estimate the potential loss of income at $0.375mn a year.

Far less likely to default in the near future are Conisus ($1.2mn of income at risk) or the restructured My Alarm Center (no income at risk because exposure in equity).

If we are take a moderate position and assumes something could go wrong with both Black Diamond and Xpress Global Systems, Net Investment Income could drop another ($0.875mn) or ($0.06 a share). That would take ABDC’s pro-forma Net Investment Income annualized down to $0.97 a share. Obviously that’s quite a drop from the IIIQ 2016 results – before all these troubles started popping up – when the annualized Net Investment Income Per Share was $1.40.

CONSERVATIVE APPROACH

If we assume the very worst from what we know about the portfolio today and add every Watch List name, Net Investment Income Per Share would go to $0.91.

PLUS…

Another factor presumably worrying the markets is the change of strategy which the new CEO is touting along with the flurry of bad debts. While investors may cheer a reasonable but belated embracing of a lower risk strategy, they recognize that the impact will be a lower portfolio yield. (By the way, there are half a dozen BDCs singing the same tune of late. ABDC is late to the party, but really has no choice).

The current portfolio yield is already down to 11.5%, down from 12.2% at the IPO (although most of that is probably due to spread compression). We’d guess the portfolio yield – given a mix of first lien, second lien and now uni-tranche loans- could drop to 10.5%, or lower. A 1% drop in portfolio income could cost ABDC roughly $3mn a year in lower Investment Income and presumably in lower Net Investment Income. That’s a potential ($0.21) of lower Net Investment Income, and with all the bad debts figured in gives us a Worst Case Net Investment Income Per Share of $0.70.

UPSIDE OPPORTUNITIES

There are a few factors on the plus side of the equation for ABDC and its shareholders – who must be in shock, especially those who bought more stock in May at $13.68 while the insiders were selling. The Investment Advisor could continue to make management and fee concessions- temporary (always the favorite option) or permanent. No promises have been made beyond the IIIQ, so we won’t speculate as to the impact.

ABDC was not overly-leveraged before this credit fiasco happened, and should still have liquidity available under its Revolver – once the credit situation stabilizes – to make incremental new loans. We estimate $25mn -$30mn of new debt capital might be accessible. However, after interest expense, all fees, operating costs etc. the impact will be minor. We estimate about $1mn a year in incremental Net Investment Income or $0.07 a share.

Then there is the hope and prayer that the BDC will be able to sell some of its equity positions. We’ve looked at all the different equity positions owned – which aggregate about $25mn- and there are a few prospects for sale and ultimate re-conversion into yield bearing instruments. If just half were to be thus transmuted, the gain to Net Investment Income Per Share would also be about $0.07.

Another form of hidden gold – from a BDC’s perspective – is any recovery made of current or anticipated non-performing loans and investments. That capital – which has become non income generating – can be re-directed into new loans once an investment is sold  or liquidated in some form.

ABDC – if we count up the cost of every non-performing and Watch List company – has $70mn “tied up” in this way. However, it’s impossible to assess how much of that capital will get recaptured and re-depliyed. Every reader must make their own assessment.

CONCLUSION

A lot has gone wrong at Alcentra Capital and a lot more could still be coming. Only time will tell if the 5 companies we have on our own Watch List, beyond the 3 non-accruals- will be added to the ranks of the non-performers. Moreover, the very actions to be taken to ensure “this never happens again” are likely contributing to the drop in the stock price as investors doubt that the $1.0 a year distribution can be maintained for long. (By the way, management addressed directly the long term sustainability of the new distribution level and made a case that the chosen level was very defensible. Obviously Mr Market does not agree). A glass half empty investor can make a case for an even bigger dividend reduction coming not so slowly down the pike. A glass half full investor will hope that the worst of the write-offs is past and ABDC’s fee waivers and additional capital will be sufficient fingers in the proverbial dike.


INVESTMENT APPROACH

Common Stock

We are Long ABDC, which we bought a few weeks ago when the stock had dropped to what was then an all-time low, in advance of the IIIQ earnings. Our premise – based on our earlier review of the portfolio – was that the dividend cut would be less drastic than some investors expected, and the credit picture poor but not dire. We didn’t take into account a potential change in strategy. We were mostly right on the dividend cut, but wrong about the credit and strategy switch. 

We invested a small amount in our Special Situations strategy (which is always the case because buying these falling knife scenarios is always fraught with risk). Our initial premise -which we are sticking to – is that if we were wrong, our way out is to hold onto the investment for a (much) longer period than expected in anticipation of dividend income ultimately offsetting our price loss. That’s how we’re proceeding, with the expectation that we might have to wait up to 5 years to get back to break-even. We did add a small amount yesterday to dollar cost average our position and may add to that if the price is right.

As we’ve said before- even when we were right – investing is hard.

Fixed Income

We have a Long position in ABDC’s Inter Notes, and we will continue to hold. We undertook some post IIIQ 2017 analysis. Using ABDC’s Portfolio Risk Snapshot, we assumed all 7 companies ranked 3,4 and 5 have no value. That leaves 87% of the portfolio ranked 1 or 2, or just under $250mn in value.  As we always do we haircut the value of those remaining assets – in this case by 30%- which gives a pro-forma Stress Test valuation of roughly $175mn.  From there we deduct the $60mn owed to the BDC’s senior lender. That leaves $115mn worth of assets – spread over 23 companies – to cover ABDC’s $55mn obligations to its unsecured note holders or 200% coverage. That’s in the middle of the pack for BDC Fixed Income issues that we’ve put through our Stress Test analysis.

Moreover, as a note holder, the shift towards so-called “safer”, lower yielding investments is a positive factor which will improve creditworthiness and our “asset coverage” percentage over time. 

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