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BDC Wrap-Up: January 10, 2018

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There has been a mountain of BDC news in the last couple of days since we last posted. The BDC Reporter has been very busy just keeping up reading the press releases and SEC filings and undertaking additional analysis. We’ve been updating the Investment Disclosure, Fixed Income Table, Dividend Outlook Table and Earnings Calendar. Here are three stories about 5 BDCs that require additional color and commentary drawn from January 10 alone.  We’ll be updating the subsequent Big Stories shortly. 

Dividends Announced: Gladstone Investment (GAIN) and Gladstone Capital (GLAD)

The two Gladstone BDC siblings announced distributions for each month of the calendar quarter, for both their common stock and Preferred issues. As expected, the distribution level was unchanged. GAIN recently increased its distribution modestly and GLAD has been paying out the $0.07 a month payment for a record in BDC-land of 36 quarters. While the performance of both BDCs has left something to be desired over the years (although not as much recently), the Investment Advisor has cottoned on to what many investors seek in a BDC investment: a sense of certainty about the distribution. Both BDCs are trading close to their 52 Week and multi year highs and both are priced at an 11% premium to book.

The BDC Reporter’s Dividend Outlook – and that of the market judging by the stock price and implicit yield – is UNCHANGED for the rest of 2018. Nonetheless, we’d be remiss if we didn’t mention that risks remain at both BDCs. We count numerous Watch List names at both BDCs, which is not surprising given the higher risk loans which they focus on. GAIN has a yield of 12.8% on its loan book. As management likes to point out – to contrast itself with certain other BDCs whose accounting treatment is more aggressive – if success fees were accrued into income, the yield would be 14.0%. You don’t make 14% loans without breaking some eggs, and GAIN has 3 on non-accrual at the moment. The risk and losses therefrom has been obscured in the last couple of years by a series of Realized Gains (and a few written off duds) and valuation increases which have boosted book value. Nonetheless, the BDC Reporter – more concerned about the downside than the upside on two BDCs which are already highly valued – remembers that the stable earnings and dividends achieved at GAIN and GLAD are largely achieved by the Investment Advisor waiving fees to “make” the target number. There’s no reason to believe – given what we know – that’s going to change in the year ahead, but both BDCs remain more vulnerable than most of their peers to credit issues, given that equity investments (the most volatile type of investment) are a substantial portion of their portfolio (especially GAIN) and many loans are in junior positions on the balance sheet of smaller – and typically more vulnerable – portfolio companies.

Investment Disclosure: We have no position in either GLAD or GAIN’s common stock but are Long all 4 Term Preferred issues. 

IVQ 2017 Results Previewed: Solar Capital (SLRC) and Solar Senior Capital (SUNS). 

A few BDCs like to provide investors with an early reading of key results in advance of the actual earnings release.  Those other BDC twins: SLRC and SUNS were in the news with these semi-revelatory announcements. Judging by the press releases alone – always a dangerous game – both BDCs appear to have had a solid fourth quarter and are performing as expected. SLRC continues to be relatively “under-leveraged” (which is a bit of a mirage as we’ll explain later); NAV is flat compared to the IIIQ; there are no loans on non-accrual and recurring earnings per share are up even though investment activity was overtaken by investment repayments. Both the BDC Reporter and the market have a Dividend Outlook of UNCHANGED. However, investors -whose enthusiasm for SLRC seem to wane as the  year chart below shows – have priced the stock at a (11%) discount to book.

Performance has been excellent of late and allowed SLRC to maintain the same distribution of $0.40 a quarter for 18 quarters in a row and an increase to $0.41 for the first quarter of 2018. However, investors believing that the BDC has a huge amount of undrawn borrowing capacity will be disappointed.  The fact is that the strategy of the BDC is to lean heavily on acquiring and controlling third party financial companies by investing in their equity and using the distributions therefrom to fund a good portion of its dividend. Just last quarter another portfolio finance company was added. With so much of its capital invested in these entities – which have their own third party senior financing – SLRC has less latitude than most BDCs to leverage up by borrowing against its assets. Nonetheless, we remain relatively optimistic about the BDC’s prospects for both the IVQ and the current quarter, but we’ve not undertaken a deal-by-deal review in the past few weeks.

Over at SUNS – although a very different BDC – the results seem to be the same: steady. NAV is flat to up, earnings are improving and leverage is low. The BDC has paid an unchanged distribution for 23 quarters in a row. Again, both the BDC Reporter and the market have an UNCHANGED rating for the 2018 distribution. In this case, the market is more enthusiastic for SUNS than SLRC, with the former trading at a premium to book and a yield of 7.9% versus 8.1% for its sibling. That seems fair enough given the risk profiles of the two BDCs. SUNS lends to less risky borrowers on average and- unlike SLRC – has never reduced its distribution since coming public.

Investment Disclosure: We are Long SLRC, which we purchased  for $20.13 12/20/2017 when the BDC’s stock price was close to its $19.90 (intra-day) 52 Week Low. 

We have no position in SUNS. 

Executive Changes And Portfolio Update Announced: Alcentra Capital (ABDC) 

ABDC is one of the walking wounded from 2017, with major credit losses and write-downs booked; reeling from a huge drop in its stock price and a cut in its distribution. As a result – and as we mention below – because we are invested in the BDC, the BDC Reporter follows the stock more carefully than others. Wouldn’t you walk more carefully if you were carrying gelignite ? Anyway, there have been a flurry of developments. First, Paul Echausse, who led the BDC in its glory days after going public and managed to pull-back and hand over the reins to the current CEO David Scopelliti just before all credit hell broke loose is now resigning completely. He had been appointed to be the Chairman of the Board recently, but  “resigned to devote his time to a new initiative within a non-profit that focuses on charitable endeavors”. The BDC Reporter noted that Mr Echausse was selling shares at the height of the ABDC price meltdown on November 14, 2017, even as other officers were buying. He sold a portion of his stock at $7.45, not far above the 52 week low, and well off the current price of $8.65. Still, ABDC “came out” at $15.00 a share. Now he is gone for good Paul Hatfield – who had been kicked upstairs to the status of Chairman Emeritus in 2017 to leave Mr Echausse become Chairman – has stepped back into his old role which he held when ABDC went public in 2014.

Furthermore, Mr Echausse has been replaced on the investment committee and ABDC has set up – years after going public – the role of “lead independent director” on the Board. That’s supposed to give shareholders some confidence that the independent directors will operate in the best interests of the shareholders at a difficult time for the BDC. We remain ever hopeful but only time might tell.

Even more importantly, ABDC provided some color on portfolio activity during the just ended quarter. Unlike SUNS and SLRC no earnings or NAV numbers were given. However, we were told what happened to several portfolio loans. 3 were repaid at par; two new advances were made and a Watch List company – Conisus LLC– was restructured with second lien debt owed to ABDC being transformed into Preferred equity. That news – and their own financial model – was enough for Raymond James to upgrade ABDC’s stock from Underperform to Market Perform. That boosted the stock, which  jumped from $8.39 at the January 10 close to reach as high as $8.80 on January 11.

While we wish we could share the burst of enthusiasm, our reading of the situation is more pessimistic. The failure of Conisus- marked down only (15%) in the IIIQ 2017 and still carried at par in mid 2016 – will be a blow to earnings. We don’t know if any portion of the $11.8mn at cost of the loan will be written off and what might be the income to be received on the “Preferred Equity”. We will assume for our purposes that no cash income will be derived from Conisus till we learn more. That will reduce ABDC’s investment income by as much as $1.2mn, equal to $0.09 a share. That still leaves 7 other portfolio companies on our Watch List. Admittedly 4 are already on non-accrual and not much is expected from them in the short run, either in income or value improvement.

However, there are two names on our Worry List – where we estimate that the likelihood of eventual loss of some sort is higher than full recovery to par- which are the wild cards here. XPress Global Systems ($7.8mn invested- mostly in second lien) has just recruited a new CEO last November. Unfortunately for a company which has been written down in value that’s a troubling sign and suggests a change was needed at the top. The valuation of Xpress went up last quarter, reducing the discount on the debt from (56%) to (36%). Nonetheless, there is no guarantee that Xpress is out of the woods. Then, there’s a for profit educational business ( a warning in and of itself): Southern Technical Institute. Here the recent valuation trends are down, with the second lien debt of ABDC written down (16%) in September and its equity stake written down (100%). Just two quarters before STI’s debt  was trading at par and even the equity had some value. If these two Worry List names should move from Performing to Non Performing (i.e. non accrual), the income lost would be ($1.6mn) or $0.12 a share.

Otherwise we continue to track My Alarm Center – which was just restructured but does not generate any income. Restructuring a company by in and of itself does not mean the underlying business has been fixed, and we’ll continue to monitor developments there where ABDC remains low on the totem pole from a capital priority standpoint.

Just today we’ve added a fully Performing company – Palmetto Moon– to our ABDC Watch List. Our research turned up that the retailer’s CEO has just stepped down “to spend more time with his family” and a new chief executive brought in, according to a news report. The shortness of the CEO’s tenure (he only joined the company last year)  and the fact that ABDC’s equity investment in the company – and that of Fidus Investment (FDUS) who is also involved – has been sharply written down in the last two quarters. It’s early to be getting panicky but there is another $5.7mn of investment at risk and $0.6mn of investment income to be thinking about.

Besides credit, there are other uncertainties to take into consideration:

What will the Investment do, or not do, to support the BDC ?  Last quarter, the Advisor waived $1.2mn of fees to ensure ABDC hit $0.34 of Net Investment Income, equal to its then dividend. That was worth $0.09 a share and suggested the “real earnings” were closer to $0.25. Will the Investment Advisor continue to waive management fees (no Incentive Fee was earned) or Pontius Pilate-like wash its hands of the issue ? In the latest press release, there was a hint that the focus of stock support was buying back stock, but even $5mn of repurchases will hardly move the needle in a BDC with a net book value of $175mn.

Nor do we get the impression – based on this latest news – that ABDC is growing its loan portfolio or selling any equity investments (easier to talk about than do) that would help grow investment income. From the latest press release and the Subsequent Developments included the IIIQ 2017 results, we calculate the ABDC investment portfolio will have modestly shrunk in the IVQ 2017 versus the IIIQ 2017. Of course deals can’t be booked out of thin air but in the short term, this will pressure earnings and raise investor doubts.

If everything that we know about that could go wrong – and does – and if the Investment Advisor does not step in to subsidize the earnings with more waivers, we calculate (very roughly and please do not take as gospel) that recurring earnings per share could drop to $0.80 from $1,36 in the IIIQ 2017 annualized. That’s before earnings get eroded by the new CEO’s “safety first” strategy… Of course, these are only possibilities but the BDC Reporter believes that the risks at ABDC are greater than before what we’ve learned from the Company and our portfolio company research. As we’ve said before about ABDC and other BDCs with questionable credits : things could turn out fine. These are possibilities rather than certainties. In fact – looking back on our prior posts we said as much back on May 18, 2017. Here’s a brief extract:

Investors who’ve read this far have a clear choice that they can make. There are no certainties involved on either side, but given that ABDC is trading at a high price (just before the equity sale ABDC was at the highest level since July 2014)  the possible downside is substantial, while the upside (barring multiple expansion) is probably limited to continuing to capture the 10.0% yield, and a march up in the price towards the $15.00 all-time high.

The BDC Reporter does not know enough about each investors individual risk-return parameters; their tax situation; the availability of other investment alternatives, etc. to be bold enough to suggest what anyone should do. We see our role as providing News, Views And Analysis. Pushing the Buy, Sell or Hold  button is up to you. We hope we’ve given our readers food for thought at the very least.”

The stock closed that day at $13.51. On January 11, ABDC closed at $8.64. Getting these decisions wrong can have harsh consequences.

Dividend Outlook

The BDC Reporter has a rating of DECREASE where the sustainability of ABDC’s current $1.0 dividend is concerned. The market – based on the 11.6% yield – seems to be more undecided. We maintain our more pessimistic view.

Investment Disclosure: We are Long ABDC’s common stock and Unsecured Notes. We bought into the stock before the IIIQ 2017 results came out believing the worst was over. We were surprised by new, fast moving developments including the complete collapse of  GST Autoleather, which went from being valued at par in March 2017 to a modest discount in June to non accrual and 100% write-off in September. Moreover, we had not anticipated the change in strategy to a lower yielding, lower risk portfolio which was announced on the IIIQ 2017 Conference Call. We decided to hold onto our investment – and bought more at the much lower price – in an effort to be paid out over time. However, with the risk of another major step down greater than the market currently seems to anticipate, we may take our loss and have set a Stop Price.  

The Unsecured Notes continue to be creditworthy and may be in a better position – all else equal – with the implementation of the new, lower risk, strategy.

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