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Great Elm Corporation: Issuing New Unsecured Notes- CORRECTED VERSION

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Corrections: January 16, 2018: We made a couple of mistakes in the earlier version of this article, which were kindly pointed out to us by GECC. Both have been now corrected in the text below:

  1. We incorrectly stated the quarterly dividend income was $0.32. The correct number is $0.25 (or $0.083 a month).
  2. We incorrectly suggested the new potential $30mn at Avanti in allowed indebtedness could be ahead of GECC in the capital structure. In fact, the debt – if drawn – would be pari passu or below.

We apologize for the mistakes. Our only excuse is that we seek to write about BDC developments very shortly after the news breaks, which causes occasional mis-statements.

However, neither correction changes our conclusions.


PREAMBLE

The first publicly traded Baby Bond new issue of 2018 (sorry ARCC- your institutionally placed Unsecured Notes don’t count) is coming from one of the smallest BDCs: Great Elm Corporation (GECC). Moreover, GECC has already retired one Baby Bond issue and launched another just in the past few weeks. Here are the bare facts of the new issue; as well as analysis into a major change occurring at GECC which will affect both the common shareholders and its Baby Bond holders. We discuss our own investment approach and why we pulled the trigger in the middle of a big shift in GECC’s business.


NEWS

Great Elm Corporation (GECC) has announced its pricing of $43mn by issuing Unsecured Notes.

The maturity of the Unsecured Notes will be 2025 and the coupon 6.75%. Interest will be paid quarterly.

The Unsecured Notes will be redeemable from January 2021 on.

The ticker symbol will be GECCM.

For full details, see the press release.


ANALYSIS

Stranger Things

Unusually for such a small BDC (assets $218mn at 9/30/2017), GECC will now have two Unsecured Notes outstanding.

The BDC already has a $33mn Unsecured Note due 2022 (ticker GECCL) , and with the expected underwriters option being filled, will end up with approximately $80mn of Unsecured Notes in aggregate.

This latest Unsecured Note has a longer maturity (2025 versus 2022) and a marginally higher yield (6.75% versus 6.5%) than GECCL.

The Big News

The Prospectus contains up to date disclosure – at the very top of the document – regarding the current status of GECC’s largest investment; Avanti Communications. Here is the summary:

Our investment in Avanti Communications Group plc (“Avanti”), which represented approximately 24% of our investment portfolio (excluding cash and short-term investments) as of September 30, 2017 and 36% of our total investment income for the nine months ended September 30, 2017, has resulted in significant payment-in-kind (“PIK”) interest, which exposes us to significant risks. PIK interest represents interest added to the debt balance and due at the end of the instrument’s term in the case of loans, or issued as additional notes in the case of bonds. Instruments bearing PIK interest typically carry higher interest rates as a result of their payment deferral and increased credit risk. When we recognize income in connection with PIK interest, there is a risk that such income may become uncollectable if the borrower defaults or our investment is converted to equity.  Our investment in Avanti is paying PIK interest because its financial situation does not allow it to pay cash interest on a current basis. For the nine months ended September 30, 2017, PIK interest represented approximately 46% of our total investment income. In December 2017, we agreed to convert our entire investment in Avanti third lien senior secured notes into Avanti common shares.  At September 30, 2017, the $49.2 million in principal amount of these notes represented approximately 7.3% of our net asset value, and, after the restructuring, we expect to own approximately 9.1% of Avanti’s common shares. The conversion of our Avanti third lien senior secured notes to Avanti common shares, if ultimately consummated, could result in a significant decrease in our net asset value if the market value of the Avanti common shares were to decrease following the restructuring, a significant decrease in our total investment income and an increase in the risk of investing in the Notes.

Favorite Subject

The BDC Reporter has been highlighting the risks associated with the Avanti investment for years, beginning back in July 2016.

For a BDC Reporter article about the debt restructuring of  January 2017 that was just converted into a debt for equity swap, click here.  Also, click here for a discussion of another amendment, in June 2017.

For the origins of the Avanti transaction and how GECC came to have the investment on its books, click here.


VIEWS

Blow

For GECC common shareholders the news about Avanti – that we’ve been aware of for a few weeks – is a definite set-back.

With the conversion of the third lien (!) debt to equity $$49.759mn at par and $40.438mn at cost is going to cease to generate income (12.00% or as much as 17.5% if PIK toggle chosen).

That will hit the BDC’s investment income hard. Very hard

Plus, the Second Lien PIK Toggle Notes  ($32.5mn at par, $27.8mn at cost) sees its interest rate cut from 10.0% to 9.00% and “and the PIK interest rate will be reduced from 15% to 9% on the PIK Toggle Notes, the maturity date will be extended by one year to October 1, 2022 and Avanti will be permitted to issue up to $30 million of indebtedness that ranks equal with or junior to the PIK Toggle Notes and will be provided with relaxed financial covenants, including the elimination of certain financial maintenance covenants”.

Or, in other words, lower pricing, longer term and potentially more debt ahead pari passu with the Second Lien in the capital structure.

Expect the nominal Avanti income to drop by as much as 80%.

Not There Yet

Avanti is hardly out of the woods and it’s unlikely this will be the last restructuring. A new CEO has been brought on and time will tell.

Ironically – on a cash basis – the reshuffling of Avanti will make no difference as no cash was being being on either loan facility in 2017, if we understand the disclosure mentioned above.

Live In The Truth

The only good news is that the Avanti investment – at least in part – properly reflects its real status: an equity stake in a troubled company that could be worth something. Or nothing.

The remaining debt -though – remains in question as to its collectibility and the yield does not reflect the risk involved, even with the restructuring completed.

This will also mean Taxable Income is likely to drop in 2018 on, no longer artificially boosted by non-cash income recorded as revenue.

Down the road, there is still the possibility that the entire stake in Avanti will get written off. That’s $68.2mn at cost and still $36.7mn at FMV as of September, or 27.8% of NAV.

If that happens – and all else is equal – NAV Per Share would drop to $8.94. As the Company’s own disclosure says the portfolio would be reduced by a quarter.

Doubling Down

No wonder, then, that the Investment Advisor is seeking out new capital to diversify and expand GECC’s portfolio.

The $50mn of new debt and another $52mn  sitting in a Money Market fund would allow total investment assets – net of Avanti – to increase from $169mn as of September to $271mn, once fully invested.

Expensive Money

However, you have to ask yourself how much of the income from $102mn of new investments – assuming an 11.0% yield – will drop to the bottom line.

GECC will have to pay 6.75% to the new Note Holders and 6.5% to the other Note. Then there’s the incremental 1.5% Management Fees and 0.5% plus in incremental operating costs.

Plus the Incentive Fee, which will vary.

A back of the envelope calculation suggests the $50mn in new assets to be acquired with the  capital from  the new Notes will generate 1.5%-2.5% per annum, before we account for future bad debts.

That’s about $250,000 a quarter in a BDC whose Net Investment Income last quarter – before the change in economics hit – was $3.6mn.

Perplexed In Pasadena

Frankly, we don’t understand why the stock price is trading north of $10.00. We accept that we might be missing something. Or investors could be boundlessly optimistic.


DIVIDEND OUTLOOK

Given the Avanti news, and the increased interest cost that will be impacting GECC from the IQ 2018 on, the BDC Reporter is changing its Dividend Outlook from UNCHANGED to DECREASE, skipping right over AT RISK.

We expect a dividend cut – which may be substantial – to occur within 2018, especially as GECC has already distributed prior year excess Taxable Income in a recent distribution.

The market – as reflected in the current 9.6% yield – expects the dividend to remain UNCHANGED at $0.25 a quarter or $1.00 annually.

We are either ahead of the market or we’re wrong as the next 12 months will clarify.

See the Dividend Outlook Table for the change in our rating. 


INVESTMENT APPROACH

Common Stock

We have no position in GECC’s common stock, nor have any intention of buying any.

Fixed Income

We have a position in GECCL and just initiated a position in the new Notes in the grey market.

An investment in the debt of GECC appears to be a reasonable investment, notwithstanding all the above.

Our Analysis Revealed

We calculate that among the $169mn of investments on the books at September 30, 2017 roughly $128mn are in Performing investments – principally in debt instruments.

Add to that the $100mn in Money Market funds and coming from the new issue (net of fees and expenses), GECC will have $228mn in “good assets”.

Furthermore, given the likely dividend cut, less in distributions will be going out of the BDC to shareholders.

Moreover, the new capital will allow GECC to build a more diversified – and liquid – portfolio than in the past. (We only count 9 material Performing investments at September 30, 2017).

Testing, Testing

Even when we Stress Test the pro-forma portfolio and assume a 30% haircut in value – while giving no value to Avanti and several other questionable investments – the net value of these assets is $160mn.

That represents a 200% coverage of the $80mn in Unsecured Notes, or a 50% advance rate on the net value of these Good Assets and 35% on a face value basis.

Moreover, virtually all the existing and to-be-purchased investment assets are likely to be cash yield producing. 

Eyes Wide Open

Longer term the risk is that the Investment Advisor – master of finance – may borrow more at the unsecured level. Or – worse – arrange senior financing that will rank above the Unsecured Notes.

And/or there is always the risk that these high yield investments picked by the Investment Advisor will “go bad” in great numbers and eat into the value of the portfolio that supports the Unsecured Notes.

However, given the wide margin of safety discussed above and the background and experience of the principals those are acceptable risks.

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