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Year In Review: American Capital Senior Floating

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PREAMBLE

With little BDC news to write about and with 2017 coming to a close the BDC Reporter is reviewing many of the BDCs that we wrote about in a series we’ll unimaginatively call “Year In Review“. We aim – with the benefit of hindsight – to determine what we got right and got wrong on these pages, and project what the key challenges are for these BDCs in  2018. As we’ve done all year we’re also sharing with our readers how we invested our own capital and with what results to date. In this article we’re reviewing American Capital Senior Floating (ACSF) – which began the year strong but has been petering out for months. The BDC Reporter was cautious from the outset and appears to have made the right call, but there’s more than that to consider. 

YEAR IN REVIEW

Changes

2017 was a notable year for American Senior Floating (ACSF) which changed its Investment Advisor- but not its name –  when American Capital was acquired by Ares Capital (ARCC). An ARCC affiliate, Ivy Hill, became the new Investment Advisor in mid-December 2016. We wrote about the BDC more than a dozen times – sometimes in passing and occasionally in depth. Here are the highlights:

Nowhere To Go But…

On February 28, 2017 in Week 8 of the BDC Reporter’s Market Recap we noted that ACSF had hit a 52 Week High in price.

[Subsequently the BDC continued to move up further – along with a BDC Sector in full Bull Run mode – to a top of $14.10 in the last week of March 2017.

Coincidentally or otherwise, ACSF reached its highest level on the very same week as the BDC Sector- using BDCS as our measuring stick].

First Results

On May 10, 2017 we briefly commented on ACSF’s IQ 2017 earnings- the first full quarter under Oak Hill’s management.  One of the characteristic strategies of the new regime was already showing up: lower leverage – as measured by debt to equity – than in the past at 0.76x.

Still unclear at that time was how much the new Investment Advisor might subsidize ACSF to keep earnings up and sufficient to cover a distribution that has remained unchanged for years under ACAS.

The key issue here is the future relationship between the BDC and its Ares Capital owned Advisor Ivy Hill. The specific issue is who is going to pay the BDC’s operating costs, which were subsidized under American Capital ownership. ARCC, which is being subsidized by its Investment Advisor to the tune of tens of millions of fee waivers, seems less willing to pay all ACSF’s bills for much longer. A shareholder vote on a new Investment Advisory Agreement will settle the subject shortly.  However, keeping costs low is a critical component of the BDC’s business model. If, and we’re not saying this will happen, Ivy Hill did not waive a portion of operating costs this quarter, Net Investment Income Per Share would have been closer to $0.27 than the $0.31, and below the distribution of $0.29.

The BDC Reporter – for its own account – did not invest in ACSF at that point – or at any other time in 2017. At this stage, the BDC was too expensive for our taste and there were too many uncertainties – natural enough when a new hand is at the tiller – to cause us to pull the proverbial trigger. Here’s what we said at the time:

[ACSF is] expensive at 11.5x the distribution, or 8.7% yield for a BDC with little earnings upside; invested in a segment with rampant spread compression going on (a multi quarter process of getting squeezed) and an unsettled relationship with its Investment Advisor.

At the time ACSF traded at a $13.45 price.

Subsidy

A couple of weeks later the BDC Reporter – and we seem to be the only financial publication which tackles these nitty gritty issues – delved into the latest ACSF Proxy and the convoluted discussion of expense caps and waivers. In a nutshell, Ivy Hill agreed to absorb some of the BDC’s operating expenses – many of which had increased temporarily due to the transition- but would become less generous starting with the IVQ 2017.This is not an academic issue and the subsidy – as we saw above – was already the difference between “earning the dividend”, or not. Now that the issue of who would pay for what was resolved – albeit that the impact would not be felt for several quarters- the BDC Reporter remained unclear on what ARCC/Ivy Hill’s strategic plans were for ACSF, as we mentioned:

Now we will have to see how the new Investment Advisor manages the BDC and whether we get any change in strategy (more CLO ? less CLO ? higher earning loan assets ? lower earning loan assets ? etc) and in long term performance. Whatever American Capital’s other weaknesses, ACSF has performed relatively well since going public (albeit on a tiny scale). Will IHAM be able to claim as much in 3-5 years ? The BDC Reporter has no view. We are just innocently asking the question.

The stock price closed at $13.50.

Only Takes A Minute

By the summer – in a brief mention in the BDC Market Recap for the week ended August 11 – the stock price picture had drastically changed. By then, the bloom had gone off the BDC Sector rose and we were headed – but had not yet arrived at “Correction Mode” for BDCS.

For ACSF weaker second quarter earnings resulted in a (7%) tumble in its stock price. The stock closed August 11 at $11.85, down 16% from its high of a few months before, even though the monthly $0.097 monthly distribution was unchanged.

We would like to believe that the market was beginning to catch up from what the BDC Reporter had noted in the first quarter results – that earnings were already trailing the dividend when waivers are added-back. However, the price reaction was probably the result of weaker second quarter results; a still lower-than-before debt to equity and the impact of spread compression in both CLO and regular lending.

For the BDC Reporter’s own investing account, the price drop – then in its fifth month – validated our prior cautious approach towards ACSF. We added the BDC to our Watch List but decided – in this case at least – to leave the falling knife alone. This was partly also the result of having seen ACSF drop over (40%) in price – again with no change in the dividend- between February 2015 and February 2016. Given its exposure to CLO investments and its then above average leverage, the stock was even more volatile than the BDC Sector as a whole during that period. If we don’t learn from history (or from charts), we are condemned to repeat our prior mistakes, as George Santayana would have said if we had been a BDC investor.

Further Down

The next week, we noted in the BDC Market Recap that ACSF was down another (10%)…

By August 23, 2017 ACSF had dropped sufficiently that we were just beginning to wonder if the time might coming when we would be a buyer, rather than just standing and commenting on the sidelines. This is what we wrote :

Also keeping eyes on another BDC which has not cut its distribution but caused investors to worry: American Capital Senior Floating (ACSF). The Ares-led BDC is 20% off its YTD high and still dropping. Still ACSF – at $11.35 – has a long way to go to hit its al-time low back in 2016 of $8.11. Today’s price is about $2 a share below NAV, and the yield is just peeking over 10%. Based on our own Fair Market Value ACSF is still over-valued by 18%, but headed in the right direction for a buyer. Given we are believers in the Ares Management organization, which serves as Investment Advisor, and has already turned over half the portfolio since taking charge, we’re intrigued by the potential Buy opportunity. Will ACSF break below $10 ?

At Risk

When we next reviewed ACSF – following the IIIQ 2017 results – we used the opportunity to provide its Dividend Outlook – on November 13, 2017. Although earnings had perked up from the IIQ level, we were not convinced that the BDC would be generating enough recurring income to maintain the distribution at its historic unchanged level for much longer. In fact, we wondered aloud if Ivy Hill had come to the same conclusion and was preparing itself for a seemingly inevitable payout decrease, and was already looking ahead to defending whatever the new level might be.

We’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.

As to our Dividend Outlook, we rated ACSF AT RISK of a dividend cut in the twelve months ahead, even if the BDC had announced an unchanged payout through January 2018.

For the BDC Reporter’s own account by November – and when Oak Hill did not even bother to hold a quarterly Conference Call (as we mentioned in a post on November 20 ) – we were becoming even more conservative about when the ACSF price might be low enough for a purchase. We spelled out our investment view in this same article, which remains the same 6 weeks later:

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.

Update

Late in 2017, ACSF has been scraping along the bottom price-wise. The Lowest Low was on November 13 at $10.45, and intra-day the stock reached $10.30. At the close on December 27, ACSF traded only a notch above at $10.60. With book value at $13.12, ACSF is trading at a (20%) discount to book and at a yield of 11.0%.

Pretty, Pretty, Pretty Poor

If you bought the stock at the end of 2016 and held till today ACSF has been a mediocre investment on a Total Return Basis, with a price loss of ($1.30), not fully offset by distributions of ($1.164).  Not terrible, just not good enough. However, if an investor bought in the BDC Bull frenzy of March 2017, the stock price drop could be as high as ($3.50) a share and the offsetting distributions just $0.873. On a Total Return Basis that’s nearly a (20%) loss, which is pretty terrible.

Obviously, we’re gratified that we stayed away from ACSF as an investor in 2017. As the chart below shows, the opportunity to make even a short term gain existed only in the first few months of the year and may have said more about BDC investor semntiment generally than anything ACSF promised. Since then, the price trend has been down, down, down at a much faster pace than dividends could be harvested.

Up In The Air

Looking forward, both the BDC Reporter and the markets, are waiting for the other shoe to drop: i.e. a reduction in the dividend. All the signs point to a grudging drop by Oak Hill.  Typically, if a dividend reduction does occur -which in this case follows nearly 4 years of an unchanged payout – a price drop follows, notwithstanding months after month of sliding prices. Bottom fishers might want to wait for the Big Announcement.

Moreover, ARCC may have yet other changes in mind for what is a small, probably barely profitable BDC. Our guess is as good as yours as to what the Investment Advisor might undertake in 2018, but if we’re right that the insiders have been whiteboarding new ideas all year, that adds an extra element of uncertainty.


INVESTMENT APPROACH

Common Stock

For our own account, and notwithstanding an 11% dividend yield (which we expect will become a 7.5% yield if the dividend gets cut to $0.80) we like to know what business model we’re invested in even in a Special Situation speculative buy.

At the moment we don’t envisage investing in ACSF until the smoke clears. 

In any case, the BDC – despite its parentage – does not meet our Long Term Income strategy standards, so any purchase is likely to be short term in nature. 

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