Email us with questions or comments: nmarshi.bdcreporter@gmail.com           α

Capitala Finance : Portfolio Company Sale & Repayment

BDCs:
Premium Free

NEWS

On January 23, 2017 Capitala Finance (CPTA) announced in a press release the repayment of its $7.2mn first lien loans to Brunswick Bowling Products. As previously reported by the BDC, a few weeks earlier CPTA booked a $2.5mn gain from the $6.2mn received for its equity stake in the bowling equipment and supplies company.


ANALYSIS

This is the second time CPTA has mentioned its equity gain on Brunswick. On January 3, 2018, the BDC issued a press release mentioning new deals booked in the IVQ of 2017 and the gain booked on Brunswick, without mentioning the company by name. See the Daily News Table.

We do not know if CPTA received any other loan repayments in the IVQ of 2017 or this year.

According to Advantage Data, there was $27mn of BDC exposure – in both debt and equity – to Brunswick.

In fact, the BDC with the largest position is/was Gladstone Investment (GAIN) with $16.2mn at cost in senior debt and Preferred/equity.

Both BDCs had already written up their equity stake (which is carried as a Preferred position in CPTA’s 10-Q, bearing an 8% income generating PIK). CPTA’s cost of $3.6mn was valued at $6.1mn, and the debt at par, suggesting no prepayment or other fees were received.

(GAIN had valued its $4.9mn Preferred investment – initially booked in 2015 before CPTA came on the scene- at $9.9mn, or a 100% mark-up. By contrast CPTA’s FMV gain was “only” 71%. That may due to the BDCs owning different securities in the PE-backed company, which was spun-off as a separate business only three years ago – or the result of different valuation techniques).

However, CPTA – based on the press release – appears to have received more or less the amount for the Preferred of the IIIQ 2017 valuation.

As a result, the BDC will book a Realized Gain (neatly achieved before the year end and before the debt was repaid) in the IVQ of 2017 financial statements, but no further increase in book value.

In the IIIQ of 2017, CPTA booked ($10.3mn) of Realized Losses, which this success will partly offset.

Income Loss

However, the Brunswick transactions will dent the BDC’s income going forward until the proceeds are re-deployed

For more than 2 years, one of CPTA’s two loans to Brunswick: a  $5.6mn First Lien has been generating a very, very high interest rate- even by CPTA standards: 16.25%.

That’s LIBOR + 14.25% and with a 2% floor.

A more normal $1.6mn other Senior Loan tranche was priced at LIBOR + 6% with a 2% floor for an 8% rate.

Finally, the $3.6mn of Preferred shares – as we’ve discussed – was also generating an 8.0% return.

That totals up to $1.33mn annually, or 2.7% of the latest Investment Income level and 7.4% of Net Investment Income.

If and when the $13.4mn proceeds from Brunswick are re-invested – and assuming the yield received is at the BDC’s new target level of around 10%, the income received should be a wash.


VIEWS

CPTA has been active of late issuing press releases about its investment activity.

The Brunswick transaction is certainly a success and in a relatively short period.

The payoff of the 16.25% First Lien loan and the PIK removes 2 questionable earnings items from the BDC’s portfolio.

Questionable

(The BDC Reporter looks at every CPTA investment individually and takes note of unusually high PIK income and/or loans yielding more than 12%).

Unfortunately CPTA, even after the Brunswick investments are removed CPTA still has over 20 different investments we find questionable and worry us about “earnings quality”.

We Illustrate

For example, CPTA has an $8mn loan to Vology Inc. – which is carried at close to par and is not on our Watch List – but bears a back breaking interest rate of 19% !

That’s a cash rate of LIBOR + 14% with a 2% floor and 4% PIK.

At a time when many leveraged loans are getting made at rates under 5% (which itself is mind boggling) and CPTA is saying new loans will be targeting 10%, a rate nearly twice as high suggests – whatever the valuation says- high credit risk.

Big Bucks

We count $215mn of investments that fall into our “questionable earnings quality” on CPTA’s $471mn investment portfolio.

If they’re both lucky and good CPTA’s management – if true to their ambition to reduce portfolio risk going forward – will have to jettison/ get repaid out of 16 different borrowers with these unusually high rates out of 46 in total.

Easier Said

However, the risk is that – unlike with Brunswick – more bad debts occur before that can be accomplished.

The BDC already has 4 loans on non-accrual, and 2 that were “restructured” last quarter but which were previously non-performing.

CPTA is far from being out of the woods from a credit perspective. See our prior analysis of the subject.

As we’ve pointed out, CPTA has 6 different companies on our Watch or Worry list, outside of the non-accrual names.

No Relief

Even if CPTA can run through the rain without getting wet (we love that expression, which we use too often) from a credit perspective and switch out its higher risk assets for loans bearing interest rates 20%-40% lower than they’re currently garnering in some cases, the impact will be eventually felt on the bottom line.

As we pointed out in our earlier article, CPTA’s Net Investment Income could drop substantially over the medium term from this change of strategic approach. Here’s what we wrote a few weeks ago:

Another phenomenon underway which should cause CPTA’s income to drop is the decision by the Investment Advisor (not unreasonably given the multiple dividend cuts and credit losses) to seek refuge in lower risk but lower yielding credits. This is not a process that happens overnight but the CEO of the BDC did indicate that “we will probably lose 150 to 250 basis points on yield. Using a midpoint of 200bps that suggests the portfolio yield could drop from 12.9% to 10.9% over the next three years or so. If we assume about $350mn in performing debt outstanding on CPTA’s balance sheet that could drop Investment Income by $7.0mn, all of which would also come out of Net Investment Income as well. That’s equivalent to 40% of the BDC’s current running rate, or $0.44 a share. Or in other words that could cut Net Investment Income Per Share from $1.12 to $0.68.

Rock + Hard Place

CPTA -the Brunswick transaction notwithstanding – remains in a cleft stick.

If they stick with their high risk-high return strategy, they face the possibility of incurring many more troublesome loans, and imperiling their new $1.0 a year distribution level.

If they switch over to more moderate risk-return (an approach many other BDCs have already adopted after facing similar credit difficulties including AINV, BKCC, TCRD, ABDC, OCSL, CMFN and MCC) their income will drop sharply and imperil their $1.0 a year distribution level.

Either way – and the actual performance is likely to be a mix of both – the BDC Reporter believes CPTA will be hard pressed to sustain their current distribution in 2018 or 2019.


DIVIDEND OUTLOOK: We affirm our AT RISK rating for CPTA. See the Dividend Outlook Table


INVESTMENT APPROACH: We had a position in CPTA’s common stock first booked before the disastrous IIIQ 2017 results were announced – and the cut in the distribution. We’ve held on since – and dollar cost averaged and collected some distributions along the way. Given we were at break even on a Total Return basis – and given the research undertaken since October 2017 – we have sold out of CPTA’s stock. We recognize that CPTA is already trading at a massive (45%) discount to book value and under 8x the current dividend level, suggesting the market is expecting another dividend cut (the yield is 12.9%). However – and given that the long term pressures on the BDC’s business model are just beginning – we have decided that exiting is the best approach. 

We remain Long in multiple portfolios in both CPTA’s Convertible and Baby Bonds (CPTAG and CPTAL). Ironically, the shift towards a safer portfolio which the Investment Advisor has recently adopted is a positive for CPTA debt holders. Moreover, with the Revolver currently paid down to zero, outside of $168mn in SBIC debentures – the unsecured debt can look to $52mn in cash and $471mn in portfolio assets on CPTA’s balance sheet for comfort and an ever lower dividend burden. CPTA would have to suffer catastrophic losses on a scale we cannot envisage notwithstanding recent performance before the full repayment of the BDC’s debt would be at risk. 

Already a Member? Log In

Register for the BDC Reporter

The BDC Reporter has been writing about the changing Business Development Company landscape for a decade. We’ve become the leading publication on the BDC industry, with several thousand readers every month. We offer a broad range of free articles like this one, brought to you by an industry veteran and professional investor with 30 years of leveraged finance experience. All you have to do is register, so we can learn a little more about you and your interests. Registration will take only a few seconds.

Sign Up