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American Capital Senior Floating: Dividend Outlook

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INTRODUCTION

Following the IIIQ 2017 earnings releases, BDC Reporter is periodically reviewing our Dividend Outlook assessments for the next 12 months, through November 2018. We begin with American Capital Senior Floating (ACSF):

PRIOR OUTLOOK

For several months, we’ve rated ACSF’s distribution to be At Risk. We have been concerned about lower spreads on first lien and second lien loans and smaller profits (and cash distributions) on the nearly one fifth of investments in CLO equity tranches. Moreover, expenses are increasing due to higher LIBOR upping interest expense on the only source of debt funding for ACSF, it’s Revolver. Moreover, we question whether ARCC ultimately will subsidise as much of the operating costs of the BDC as did American Capital once the honeymoon period following the buy-out ends.

In the IIQ 2017, those concerns increased with results which saw Net Investment Income Per Share drop to $0.24 from $0.31 the quarter before. Much of the drop in recurring earnings per share came from lower CLO yields. After losses were incurred on selling some CLOs, Net Income Per Share (which takes into account both Investment Income and Realized and Unrealized Gains/Losses) dropped to $0.04.

LATEST RESULTS

Ironically, yields and thus Net Investment Income Per Share improved moderately in the IIIQ of 2017. See press release attached. CLO and loan yields stabilized, which helped. Net Investment Income Per Share increased to $0.26, a two cent increase ! However, that remains well below the distribution that ACSF has paid religiously since going public of $0.097 a month, or $0.29 a quarter. (Note, though, that actual cash received from CLO investments were higher due to the strange economics of this type of investment where GAAP income booked is very different from Taxable Income and Cash Income).

ACSF booked further Realized Losses that were not offset by Unrealized Gains, causing Net Income to drop to exactly $0.00 a share. Realized Losses, which were only at ($3.3mn) at year end 2016 have now tripled under the management of new Ares Capital-controlled Ivy Hill. What’s not clear is those losses were essentially inherited from American Capital or are the result of poor decisions by the new Investment Advisor, now in place for 9 months. Certainly Ivy Hill has been re-making ACSF to its own view of what a low yield-lower risk loan portfolio and CLO equity collection should look like. In 9 months portfolio turnover has been 47%. At this pace by mid 2018 just about every investment inherited from American Capital will have been replaced.

VIEWS

The Investment Advisor – despite a stable market for these type of assets in the IIIQ 2017 – has not fully leveraged up ACSF  since taking over. Debt To Equity has dropped to 0.74x from 0.93x at year end 2015.  This reduction may be temporary as Ivy Hill repositions the portfolio or a new approach. Whatever the reason this has been the biggest factor impacting the very well diversified BDC’s recurring earnings. If this lower level of leverage continues, there is little to no chance ACSF will be able to earn enough GAAP income to “cover” its dividend.

However, we can’t help noticing – on reviewing the 10-Q that as recently as this last quarter- ACSF is still booking an excise tax provision which typically occurs when Taxable Income exceeds the distribution. Indirectly this appears to imply that when the unusual tax attributes of CLOs are taken into account ACSF’s Taxable Income is materially higher than its GAAP Income.

W’re wondering aloud if the Investment Advisor might be prepared to allow the running rate of ACSF to drop – and eventually its distribution to follow – in order to have a more “defensible” pay-out level this late in the economic cycle. Given the economics of the compensation of the BDC a drop in recurring earnings has no impact on the Investment Advisor,  that might not be an unreasonable approach.

MARKET 

Since the spring of 2017 – when the BDC Sector as a whole was reaching its apogee – ACSF has been on an ineluctable decline: (23%) according to this top to current bottom chart.  The stock now trades at a 20% discount to book value. Clearly Mr Market does not have much confidence the dividend – currently yielding 11.0% – will be sustained at the current level.

DIVIDEND OUTLOOK

Based on all the above, we are re-iterating our view that ACSF is At Risk of a dividend reduction, probably in the first half of 2018.  That’s our mid-way rating between our confident view that no cut is coming (“Unchanged“) and our equal confidence that a cut is almost inevitable (“Decrease“). Note, though, that the BDC has announced an unchanged distribution of $0.097 through January 2018.


INVESTMENT APPROACH

Common Stock

We have had ACSF on our Special Situation Watch List for weeks given the long standing uncertainty about the distribution. We are leaving the BDC there, but have no immediate intention to stick our hand out to catch this falling knife. After all, ACSF – while never reducing its distribution – has been as low as $8.13. If the dividend were to be reduced – say to $0.96. That could cause – depending on circumstances and the future outlook – ACSF’ stock price drop as low as $7 a share. (Unfortunately, the high proportion of income derived from CLOs – one third of the IIIQ total – makes for a more volatile income stream that “normal” loans).

Although there is a chance the Investment Advisor will defend the current dividend level by rebuilding the size of the portfolio and/or the tax characteristics of the income will support the pay-out even if GAAP Net Investment Income remains low – and a juicy yield will be available – the odds are too high in the opposite direction. However, we’ll continue to track what happens to ACSF’s price. If we get a panic, we might be a buyer, but it’s too early to know.

While we are intrigued by ACSF’s unique model , and have the highest regard for Ares Capital and Oak Hill, ACSF is not on our Prospect List for a Long Term Income investment either. The BDC’s business model – in order to make the numbers work -relies too heavily on CLO assets. In a crisis, there is a risk that could cause – given how these structures work – some or all the income therefrom to be cut off. That would – at least for an indeterminate period – cause a huge drop in income and in the value of the stock. That’s a risk too far for a Long Term Income investment that one underwrites to hold through thick and thin.

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