BDC Earnings Season Recap: At The One-Third MarkPremium Free
PECULIAR RATHER THAN AMUSING
A funny thing happened to the BDC Reporter one third of the way through BDC earnings season. We had spent most of the week-end desperately seeking to read and chronicle the 73 different developments listed on the BDC Daily News Table, which includes thirteen different earnings releases, and an equal number of Conference Call transcripts and 10-Q filings. The week ended November 3 – as we wrote in the BDC Market Recap over the weekend – was colored darkly both by a continuing weakness in BDC common stock prices and the “credit implosion” at TCAP, which we reported on early and in great detail. Here’s the funny part: by week’s end BDC Sector performance did not seem too bad. In fact – judging from the roughly first third of the 46 BDCs to report – results can be described as “pretty good”.
By the way, given the large number of BDCs we’re going to reference, we’re using the tickers only. If you don’t know the name that goes with the ticker, just check out our BDC Disclosure List, which gives both – as well as our exposure thereto.
We’re not talking about whether a BDC met or didn’t meet by one cent or two the consensus of quarterly earnings or investment income you’ll see popping up as a headline on the financial news sites whenever results are received. Those comparisons are meaningless and misleading. Results could be “up” because portfolio companies are performing badly and have had to pay onerous investment fees or a much higher rate of interest; or fortuitously a couple of deals closed in the last few days of the quarter – which boosted fee income – but could as easily have been pushed into the next quarter, or management decided to waive some portion of its compensation to make the numbers work; or debt had been pre-paid which will provide long term benefits but the quarter was weighed down by the acceleration of the prior debt’s amortized costs and the front end costs of the new facility.
What was “pretty good” were the underlying fundamentals at most all of the reporting companies, generally meeting our expectations, and those of many of the analysts as we’ll illustrate in a minute. True, “spread compression” brought on by intense lender competition continues to be a factor across the BDC sector, but that’s a well known problem which no one assumes is going away soon. Most of the BDCs have had multiple quarters to take evasive or palliative action, and have done so. For example, ARCC prematurely wound down its joint venture with GE Capital (the “SSLP”) because the structure was resulting in lower yields than necessary. In addition, the BDC giant has been systematically selling off lower yielding American Capital assets and redeploying the monies (including Realized Gains) into higher coupon deals. The bottom line was spelled out by CEO Kip deVeer on the ARCC Conference Call:
Despite these [difficult] market conditions, we are able to improve our portfolio yields by approximately 30 basis points at the end of the third quarter when compared to the end of the second quarter.
Other BDCs have adopted different strategies to contend with the tightening spread environment. The two Solar BDCs reported in the week : SLRC and SUNS, and both revealed major new, higher yielding investments. In the case of these two BDCS, the Investment Advisor is following a strategy of acquiring controlling interests in reportedly lower risk financial companies where market competition is less frenetic. SUNS acquired an asset based lender North Mill Capital. Here is what the earnings release said (with many more details later given in the Conference Call):
“The acquisition of North Mill Capital LLC (“North Mill” or “NMC”), a leading commercial finance company that provides asset-backed financings, is a compelling addition of an established business with a management team that has consistently delivered strong performance. This sourcing channel operates in a less competitive market and expands Solar Senior’s ability to originate investments across multiple business lines in order to find attractive senior secured loans while also increasing the earnings power of the Company’s portfolio.”
A similar acquisition was made at sister BDC SLRC as explained by CEO Michael Gross:
Consistent with this approach in the third quarter we continue to execute on our strategy of buying and building speciality finance vehicles and less competitive and low correlated lending niches within the middle market by acquiring Nations Equipment Finance at approximately $327 million equipment finance platform.
OFF THE RESERVATION
In a similar – but not identical vein- AINV’s “new” management team – installed since June 2016 – has been investing much of its capital in off balance sheet entities which are supposed to be involved in “safer” lending, with a greater degree of collateral and in a more senior position in the balance sheet. Thanks to being able to “leverage up” these safer streams of loan income, the entities (which include an aircraft leasing business and an asset based lender) generate or will generate higher yields than on balance sheet loans.
By the way, ARCC also admitted to having similar ideas in its “lab”. This was interesting in a quarter in which the BDC divested itself of $125mn of venture loans to HTGC. (The BDC Reporter had never been a fan of ARCC – or any BDC- moving out of its area of expertise to invest in a highly specialized segment of the market. So this retreat from venture lending we see as a positive for all concerned, except that $40mn of those type of loans remains on ARCC’s balance sheet). Anyway – like SUNS and AINV and other BDCs – ARCC is reportedly intrigued by new ways to deploy its capital, using the room in its 30% basket. Here’s an extensive quote from the Conference Call, which speaks for itself:
So, we would like to bring some of the things that we are particularly good out here at Ares that may not have made their way into the BDC perhaps into the BDC. So, couple of examples of that, things that we think that we do well here that could be suitable for the company, our investments into an asset-based lending franchise. We have a very high-quality one here that we have developed privately and we are hopeful that we may find an ability to access that opportunity. Another interesting business that we have been building here at Ares is around the private ABS and securitization market, where quite a lot of capital is left banks and bank trading desks and are coming to alternative credit firms like Ares. Much like our core sponsor and non-sponsored lending businesses, it’s relying on origination, it’s relying on finding new deal flow, but it’s a bit of a twist on what we have done historically, but again we want to pursue higher return opportunities only where we are really investing in things that we know that we understand that we have our arms around and feel manageable, but exciting for the company.
YET ANOTHER APPROACH
In yet a different vein, NEWT reported yet another acquisition to add to its suite of technology/software based companies acquired to fill out its offerings to would-be borrowers. Here’s what CEO Barry Sloane said about the move:
On July 23..we completed our investment in Premier Payments that’s a payment processor. That’s been an important acquisition for the Company in addition to buying attractive inexpensive cash flows, the Company was also able to move major resources of its payment processing business to its new Lake Success facility where we’ve got the majority of our staff currently in the payment processing space.
CUTS BOTH WAYS
There are also more prosaic reasons many BDCs are still able to keep portfolio yields up even as many new plain vanilla leveraged deals are getting refinanced at ever lower rates. The first is that the increase in LIBOR – and the passing of the LIBOR floor thresholds – is boosting income on remaining loans even as many other credits get called in. Second, many BDCs are continuing -in an episodic fashion – to take advantage of the very “frothy” environment which is pressing their income by reducing their cost of debt capital. One or two BDCs reported negotiating lower rates on their bank Revolvers during the quarter. More widespread – as anybody who’s been reading the BDC Reporter and/or following the markets of late will know – many BDCs are paying off some of their high cost unsecured debt, either with more, less expensive unsecured debt or from other sources. Bad for existing BDC Note holders but good for BDC common shareholders, who have been burdened by these non-accretive debt arrangements for years. Now with BDC managers scratching around for any saving possible what was previously billed as indispensable long term debt capital has suddenly become dispensable.
Of the BDCS that have reported all the following have been tinkering with their debt liabilities: ARCC, AINV, HRZN, HTGC, SLRC and TICC.
Coming up, we would not be surprised if TCAP axed one or both its Baby Bonds (TCCA and TCCB) or that NEWT might not call in Baby Bond NEWTL. Readers should keep an eye on our BDC Fixed Income Table, where we’re beginning to add brief commentary about redemption possibilities.
After witnessing the not-unexpected but still shocking 33% drop in TCAP’s pay-out, it was refreshing that there was good news where other BDCs were concerned. Of course, most BDCs are still grimly holding on to their previously set dividend level. In this category are: AINV, ARCC, HRZN, SUNS and TICC. In most of these cases the integrity of the distribution was maintained largely by the manager choosing to waive a portion of its fees to keep earnings in and payments out in sync. A number of other BDCs did not change their distribution but appear to have the wind at their back from an earnings point of view or have cleverly set their distribution so low that there is no immediate threat such as GSBD, HTGC, FDUS and NEWT. In these cases, waivers are not necessary.
Remarkably, 3 BDCs (4, if you include SAR which reported August 2017 earnings a few weeks back) had Good News to report to shareholders where distributions were concerned. Everybody’s favorite dividend increaser, MAIN increased its monthly payout as of January 2018. That may have not have been a great surprise given the BDC’s track record and history of masterfully managing the art of the pay-out to its mostly retail investor base (expect a capital raise at a massive premium to book very soon), but still deserves mention. GAIN increased its monthly payout as well, and promised (in a very MAIN-like way) potential additional “special” distributions.
Also notable is that SLRC – despite recording earnings barely in line with its $0.40 quarterly distribution- upped its pay-out from next year to $0.41. That will be partly funded by the Investment Advisor’s voluntary (nobody even pretends the Board negotiates these matters) reduction in its Management Fee from 2.0% of assets to 1.75%. Here’s what the CEO said:
The new level will go into fact on January 1st, 2018. This amendment which is a permanent amendment to our management agreement continued our history of shareholder friendly actions which has included voluntary fee waivers to ensure that our net investment income has covered our dividend as well our restraint in raising equity capital and increasing leverage which would have necessitated lowering our underwriting standards to invest in a [indiscernible] market just to earn higher fees.
RIGHT THING TO DO
The BDC Reporter – putting on its dusty BDC Activist hat for a minute – cheers the voluntary reduction ( so rare) but does point out that over a third of the BDC’s capital and 60% of its income is derived from off balance entities where the day-to-day business of lending is performed by subsidiary companies, rather than by the principals at the Investment Advisor. Of course, the lender’s, staff, managers and landlords of those entities are all getting paid for their services before SLRC’s shareholders. While the BDC Reporter is positive about the business model being developed, there’s no doubt that the Investment Advisor’s role is much more passive on a great deal of the BDC’s capital than in your “normal” BDC. Thus, this fee reduction seems to reflect the changing economics of the business. We have a thumbs up, but a reduction in the management fee to 1.5% – and the maintenance of the not inexpensive Incentive Fee – would have caused us to give a two thumbs up salute.
Notwithstanding the better-than-might-have been expected results in the IIIQ, the BDC Reporter’s Dividend Outlook for the 15 BDCs that have reported so far has not changed much. We expect distributions to at least be maintained at eleven names. We project a DECREASE (our lowest rating) for TICC to have been announced by this time next year. Continuing pressure on CLO equity tranche yields is likely to be the culprit for a BDC whose GAAP quarterly recurring earnings are already at $0.13, while the distribution is at $0.20.
AT RISK of a dividend cut are HRZN (which we used to have in the DECREASE category) and TCAP (notwithstanding the most recent slashing) and AINV (whose earnings – if adjusted for waived fees and questionable non-cash PIK income from “Legacy” investments – are well below the current distribution level even as portfolio yields remain under pressure from its re-positioning strategy).
The most edifying – and surprising – development we’ve noted in this one-third-of-the-way-through stage of BDC earnings season is that overall credit quality of the portfolios APPEARS to have held up well in the quarter. We say APPEARED in block letters because we’ve not had the time to systematically dig into every portfolio. Where’s we have looked – though – the results have been pretty good. ARCC only had 1 new non-accrual to report. TICC – despite booking riskier loans all the time to boost earnings – still has zero non-accruals. AINV has the same list of under-performers as before. SUNS and SLRC remain virtually serious problem free. FDUS and OFS have 1 or 2 troubled credits, and the same Watch List names as we’ve noticed before. GAIN continues to have an admixture of upside and downside possibilities in its increasing book value. HRZN – to our surprise – has managed to keep its credit quality under control, with the 3 troublesome names from the IIQ unchanged in the IIIQ, except for an already weakening at Interleukin. HTGC has made some progress in this areas as well.
After the TCAP report, investors could have legitimately been concerned that all this loose money and weaker covenants and higher leverage in the loan markets might be causing a systemic deterioration in credit. Of course, that would be the kiss of death for the BDC Sector – where only a few bad loans can gut returns. The BDC Reporter is the first to be worried about credit quality – after all we were there in 2008 when so many seemingly “quality” credit portfolios turned to mush in a matter of months – but there is no obvious “red flag” in the results of all the BDCs that have reported that don’t have Triangle in their name.
What the rest of BDC earnings season, and the months ahead will bring, we cannot say.
ANALYST CHANGE OF HEART
“One swallow does not a summer make”, but the less-terrible-than expected BDC results is already causing a re-think amongst analysts.
We’ve noted a couple of new analyst ratings in BDC Daily News about the BDCs that have reported.
Ladenburg Thalmann has upped TICC to Buy from Neutral. (That may not mean the analyst is not concerned about a dividend reduction but may believe the big stock price drop that has occurred of late may be overblown. We wouyl;dn’t disagree but we are likely to stay away. TICC is a proven heart breaker for investors, and it’s economics are amongst the most opaque of all the BDCs).
Ladenburg has also raised SLRC to Buy.(Everybody loves a winner, even if trading at 13.5x recurring earnings).
Compass Point has raised AINV from Neutral to Buy.
Keep up with the BDC Daily News Table for any additional chopping and changing from our analyst friends.
So far, the TCAP disaster has proven to be more the exception than the rule where BDC fundamental performance is concerned. In fact, outside of TCAP, no reporting BDC has performed – looking at matters with a long term perspective – much outside of what we might have expected.Already a Member? Log In
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