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Great Elm Capital: IVQ 2017 Results Released

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NEWS

On March 12, 2018, Great Elm Capital (GECC) announced IVQ 2017 and full year results, as well as publishing its 10-K and hosting a Conference Call. See above. Highlights:

  • Net investment income (“NII”) for the quarter ended December 31, 2017 was approximately $6.4 million, or $0.60 per share.
  • Net investment income for the year ended December 31, 2017 was approximately $17.6 million, or $1.52 per share.
  • Net asset value (“NAV”) per share on December 31, 2017 was $12.42, as compared to $12.38 per share on September 30, 2017 and $13.52 on December 31, 2016.

ANALYSIS

The BDC had an especially high Net Investment Income in the fourth quarter of 2017 due to its largest portfolio company – Avanti Communications – electing to pay by PIK in the period at a higher rate than in cash.

This so-called PIK Toggle option added $2.5mn of investment income, or $0.19 per share in the IVQ.

(Those facts were explained only in answer to a question on the Conference Call and not in the press release).

The BDC booked Realized Gains of $0.213mn in the IVQ 2017, and $3.633mn for the year.

However, Unrealized Depreciation was greater thanks to write-downs at several portfolio companies totalling ($1.580mn) and ($23.962mn) for the quarter and the year respectively.

As noted above, Net Asset Value Per Share dropped (8%) in 2017 and Net Assets dropped by ($2.754mn), notwithstanding the unusually high IVQ 2017 Investment Income.

Credit

The BDC does not provide a portfolio investment review calculation.

GECC reported ending the year with 19 portfolio companies in 24 different investments and overseeing more than 100% portfolio turnover in the last 12 months.

16 investments were “monetized” in whole or in part and 11 new investments made to both existing and new companies.

“As of December 31, 2017, the weighted average current yield on our debt portfolio was approximately 15.3%”.

By Our Count

The BDC Reporter’s internal portfolio evaluation counts 6 Watch List companies out of the 19 at year-end.

3 companies were on non-accrual : OPS Acquisitions Limited, which has been non-performing for three quarters in a row.

The Company was written down again, with the debt carried at a 58% discount to cost, up from 41% last quarter and par a year ago.

Luling Lodging LLC – which appears to be also in litigation – remains on non-accrual for the fourth quarter in a row but is carried at a slight premium to cost.

However, the value of the investment is non-material by our standards at $1.6mn.

Finally, there’s the Selling Source – non performing for 5 quarters – but which continues to be carried at a premium, valued at $4.659mn.

At the other end of our Watch List, there are two companies where we remain hopeful about, but which we track:

The first lien loan loan to Commercial Barge Line Company is performing but is valued at a (30%) discount to cost.

(Another BDC with exposure in the same tranche has a 38% discount booked).

Unfortunately, the valuation trend is down in the quarter and over the last 6 months when the debt was carried almost at par.

Potentially at risk is Investment Income of about $1.0mn.

We also have the PEAKS-Trust 2009-1 vehicle on our Watch List due to its being slightly de-valued in the quarter.

However, with a value of just $0.878mn this is not material either from an NAV or Investment Income standpoint.

Piece De Resistance

The key credit that remains to discuss is Avanti Communications.

The BDC Reporter has been updating readers regularly on this key holding of GECC since the launch of the new BDC, which represents 26% of the portfolio, not including cash.

The 10-K is very instructive about the risks involved and in a manner we’ve never seen before in a BDC filing for a single company exposure.

The 10-K devotes 3 pages to discussing the risks inherent in just the Avanti investment but we could not find any mention in the press release.

Follow Along

We refer readers to page 19 to 22 of the 10-K for the Full Monty.

The disclosure begins with a very direct heading: “We may lose all of of our investment in Avanti.

We cannot reproduce here all the discussion contained in the filing, but will summarize in this way:

Avanti has a new CEO – coming on board in April – and the promise of new capital.

Existing debt holders – including GECC – are being asked to convert some of their debt outstanding into a 92% equity stake, and reducing the interest burden on the rest.

Impact

For GECC that would mean converting second lien debt into 9.1% of the diluted equity of the satellite operator.

At December 31, 2017, the cost of this tranche was $30.4mn and the carrying value $28.8mn.

Obviously, if the debt-for-equity scheme was to go through, GECC would no longer benefit from $4.4mn of annual investment income from the current debt, which bears a yield of 12.5%.

Furthermore, the plan under offer envisages the PIK Toggle Notes – which Avanti has $45mn at cost of – will have their cash interest rate reduced from 10% to 9%.

More importantly – given that the non cash option is the more likely to be adopted – PIK interest if Avanti “toggles” will be reduced from 15% to 9%.

That will cut investment income by another $2.7mn annually.

The maturity of the PIK Toggle Notes gets extended from 2021 to 2022.

More Details

There are other provisions besides which will probably weaken the valuation of the PIK Toggle Notes.

The Company is being permitted to issue $30mn of pari passu indebtedness and covenants will be loosened.

In Doubt 

Unfortunately, there is uncertainty about whether this last ditch attempt to avoid bankruptcy will succeed.

After all, existing shareholders are essentially being wiped out – or at least greatly diminished – by the conversion of debt to equity.

Shareholders and bondholders have to concur and so does a “United Kingdom court”.

All this is happening this month with the court meeting scheduled for March 26, and Avanti shareholders gathering in April.

Explicit

This is where the 10-K filing is so important to shareholders and just relying on the press release and what is said on the Conference Call inadequate.

The filing is very explicit about the risks Avanti – and its creditors – face. Here is a long quote. The emphasis is ours.

“Avanti is highly leveraged. All or a portion of our investment in Avanti and our PIK income received from Avanti may be converted into equity securities as part of one or more restructurings of Avanti’s balance sheet, including the restructuring agreed to in December 2017 or replacement or further restructurings. If there is an event of default under the indentures governing the PIK Toggle Notes or the Existing Notes and the obligations under the PIK Toggle Notes and/or the Existing Notes are accelerated, Avanti likely will not have sufficient liquidity to pay the obligations under the PIK Toggle Notes or the Existing Notes, as the case may be. Under such circumstances, Avanti may consider other restructuring options, such as entering into an insolvency procedure under English law or by filing for Chapter 11 protection under the United States Bankruptcy Code, the consequences of which could include a reduction in the value of the assets available to satisfy the PIK Toggle Notes and/or the Existing Notes and the imposition of costs and other additional risks on holders of the PIK Toggle Notes and the Existing Notes, including a material reduction in the value of the PIK Toggle Notes and the Existing Notes and their potential conversion to equity interests in Avanti, which may not be on the terms of the December 2017 restructuring agreement should the transactions contemplated thereby not be completed, including as a result of not obtaining the required votes. In such an event, we may lose all or part of our investment in Avanti.  The long-term impact of this refinancing transaction on Avanti’s financial condition is uncertain and cannot be predicted. The refinancing transaction did not materially change Avanti’s long term capital structure and it is unclear whether the refinancing transaction address the longer term sustainability of Avanti’s business model. We may sell at a loss all or a portion of our investment in Avanti from time to time in order to meet diversification requirements under the Code or as part of our portfolio management strategy”.

In Other Business…

In happier news, in 2017 GECC made some headway with several other troubled credits.

Bankrupt Optima Specialty Steel – after much drama – was repaid at par.

Still on the books, but off our Watch List, is PR Wireless after the Puerto Rican cellular company was acquired.

The debt is now carried at a premium to par as opposed to close to cost, but warrants held in the prior JV had to be written off.

Overall, GECC has done a very good job of managing and exiting the dire Full Circle Capital investment portfolio inherited in 2016:

“In the year plus since the merger closed, we have exited 21 of the legacy Full Circle positions across 15 portfolio companies and in aggregate we have exited those positions at a net gain of approximately $1.775 million”.


VIEWS

As has been the case since GECC arrived on the public scene, the Elephant In The Room is what happens to Avanti Communications.

Everything else is secondary.

Admittedly, multiple write-downs have reduced the value of the investment as a proportion of the entire portfolio, but the income therefrom has remained a big part of what the BDC earns.

If the current debt for equity proposal goes through – and as we’ve noted in our prior article on GECC –  the impact on Investment Income and Net Investment Income will be significant.

However that’s a Good Case scenario at this point.

From our perspective – and given the returns available at GECC – the Avanti investment is essentially all “equity risk” at this point, and on the high end of the spectrum to boot.

How Bad Could It Get ?

In all our own analysis we assume – as the SEC filing warns – that the entire investment may be lost.

That accounts for a third of GECC’s NAV, as shown on its page F-7 disclosure.

Throw in for good measure full write-offs at the two non-performing companies, as well as Commercial Barge Line and Peaks Trust and total losses could amount to 43% of book value.

Moreover, the impact on income between Avanti – if the whole investment crashes and burns – and the investment in other performing Watch List loans also go south could be about $14mn a year, if we’ve counted right.

In 2017 GECC’s Total Investment Income was just shy of $30mn and Net Investment Income was $17.6mn.

Hold On To What You’ve Got

By our count, the BDC has just over $107mn of decently performing investments at fair value and under $20mn in short term liquid investments which could be redeployed into debt or equity investments.

If we assume average assets of approximately $125mn and a gross yield of 11.5% (consistent with the investments booked in 2017) annual investment income pencils out at $14.4mn when we leave out the questionable assets.

That’s half the level achieved in 2017.

Bottom Line Impact

Likewise one would expect that Net Investment Income to be impacted by either a Best Case or Worst Case situation.

Using the back of an envelope we had at hand we estimate Net Investment Income could drop to $4.0mn on a Worst Case basis as lower income meet higher debt expenses for the $79mn in Unsecured Notes on the books and unchanged operating costs.

That would amount – and we admit it’s a very rough estimate – of $0.38 per share compared to $1.52 in 2017 and NAV Per Share of $7.11 versus $12.52 currently.

Mr Market’s View

Judging by the jump in GECC’s stock price after the earnings announcement to $9.7 from $9.1, many investors do not share the BDC Reporter’s view.

Investors may be more optimistic than we are about how Avanti plays out.

Or the market has not yet dug into all the numbers and is responding to the very high quarterly result although that will never be duplicatable again once the Avanti deal restructures.

A Sense Of Proportion

To be clear, we don’t deny that GECC (as well as TCP Capital and other investors/lenders to Avanti) might yet get themselves out of this ever deepening credit hole.

We’ve seen the twists and turns at Optima Specialty Steel and the disposition of the Full Circle portfolio in a short time and been impressed that the BDC can make things happen.

However, we don’t believe in taking that degree of risk for a relatively modest return.

As always with investing, this is a matter of proportionate risk taking given that no one knows what the future holds.

Time will tell if we’re being overly conservative where Avanti and GECC are concerned.

We may not have that long to wait if the satellite operator fails to convince shareholders and creditors of its current proposal.

Even if that passes, Avanti’s cash needs may trigger another crisis before the year is out.

Whatever happens – and this Our View after all – we will have no regrets for staying away and wish both the BDC and its shareholders the best of luck.

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