FS Investment: Calculating The Impact Of the New BDC Leverage RulesPremium Free
On March 30 2018, FS Investment (FSIC) filed an SEC filing indicating that its Board had voted to approve the new leverage rules.
” As a result, the Company’s asset coverage requirements for senior securities will be changed from 200% to 150%, effective as of March 29, 2019.”
Subsequently other BDCS have followed suit including Prospect Capital (PSEC) and Ares Capital (ARCC).
Furthermore, on its Conference Call Harvest Capital (HCAP) indicated interest in taking advantage of the new rules.
Previously Newtek Business Services (NEWT) has expressed similar sentiments on Conference Calls and in public meetings.
The BDCs that have adopted the new rules will – technically – be allowed to double their leverage and only maintain asset coverage of debt of 150%.
This could – technically – result in tens of billions of dollars of new debt being issued in order to allow a similar amount of new asset purchases.
The BDC Reporter has said in the past that the new rules will affect each BDC differently, and the impact will vary from accretive to non-accretive, depending on the circumstances.
In this case, we’ve decided to review the pro-forma impact on the balance sheet and earnings of the first mover: FSIC.
We’ll be reviewing all the other BDCs that are taking this momentous – and poorly understood – step in the future.
Drawn From The Filing
In the case of FSIC we are relying heavily for our analysis on the BDC’s recently published 10-K.
At 12-31-2017, FSIC had $3,926bn of investment assets, $134mn in cash and total debt of $1.712bn.
Net of Cash Debt To Equity was 0.69x, close to FSIC’s prior target.
The asset coverage number – adding in the cash – was 237%.
In theory, FSIC could increase debt on its balance sheet to $3.414bn while still achieving Congress-approved coverage of 1.65x.
Total investment assets would increase to $5.638bn.
Theoretical asset and debt growth would be even greater but even the most adventurous BDC is unlikely to go THAT far.
Under our scenario, debt to equity reaches 1.5x, more than twice the current number.
Let’s review the likely impact on FSIC’s earnings in both the short term and long term if FSIC proceeds to take advantage of what the Board has now approved.
First, all the monies will have to be borrowed..
Currently FSIC has two sources of debt capital: secured debt in the form of three facilities. See page 138 of the 10-K.
In addition, FSIC has raised over the years three Unsecured Notes from institutional investors.
All the Unsecured Notes are medium term in nature and are priced at rates between 4.0% and 4.75%.
The most recent Unsecured Note Offering was issued in 2015, had a 7 year maturity and was charged at 4.75%.
FSIC itself invests in a mix of investments, predominantly First Lien loans (65%), but also non-income producing equity (10% of the portfolio at cost). See page 68 of the 10-K.
However, newer investments have been more highly skewed to First Lien (74%) and only 4% in common equity.
(Over time, as certain transactions don’t work out as expected, debt is converted to equity, affecting the portfolio mix).
For our purposes we’re sticking with the latest portfolio split.
The most recent yield of investments booked is 8.6%, but 9.3% on the yield producing portions. See page 70.
On the cost side, we can quibble about which mix of secured and unsecured debt FSIC might use.
We expect 25% Revolver and 75% Unsecured, with the former having a substantial undrawn element.
Currently the debt mix is 37% Secured and 63% Unsecured.
However – whether secured or unsecured- a flattening yield curve means there is little difference between the two types of financing.
Using the so-called Hamilton Street Revolver as our guide, FSIC borrows at LIBOR + 2.50%.
That means the current interest rate – with 3 month LIBOR at 2.3% – is 4.8%.
If the Fed goes through with 0.75% of rate increases – and LIBOR follows- that could raise the cost to 5.55% by the end of 2018.
That’s when the new capital might be partly or fully deployed.
Besides the cost of borrowing there are amortized arrangement fees and fees on un-utilized borrowings.
That comes in at 0.5% when the facility is heavily drawn.
These other costs mean the effective cost of debt capital is currently north of 5.00% and will be 5.75% or higher by year’s end.
The Unsecured Note, plus the high costs of arranging and placing, is running at approximately 5.0% all -in.
We are making the as-yet unproven assumption that new issues of Unsecured Debt will require a higher coupon (5.0%-5.25%).
When associated expenses are thrown in we assume new Unsecured Debt will cost 5.5% or higher on an All-In basis.
In this pro-forma, we’ll be using an average cost of new debt capital of 5.5% per annum.
Paying The Piper
New assets also result in new Management Fees.
FSIC’s permanent MF is 1.75% of assets but 1.50% is being charged through September 2018. See page 122 of the 10-K.
We’re going with the higher MF until we hear otherwise.
Then there are incremental operating expenses (valuation, audit, travel, etc) from the addition of new loans.
FSIC is relatively inexpensive by this metric. We are using 0.25% on every dollar of new investments made.
Pluses And Minuses
Here’s the first stage of the math on a pro-forma basis:
New income is generated at a yield of 8.6%, which will boost Investment Income.
Offsetting will be the cost of debt at 5.5%.
Plus, 1.75% in Management Fees.
Plus 0.25% in Operating Costs.
That’s total of 7.5%, and results in a net yield before Incentive Fees of 1.1%.
Then there are those Incentive Fees that equal 20%, or (0.22%).
Net-net that leaves FSIC investors receiving 0.9% or a tenth of the income booked.
Nothing Is Straightforward
However, there’s more to consider, both positive and negative.
As we said, 4% of investments made are in equity form.
Some of these investments could be worth something in the future.
Unfortunately FSIC does not have much of a track record in this area.
Much of what passes for equity investments on its books currently are former loan that have been exchanged into common or Preferred.
On the negative side, note that FSIC books a portion of its Investment Income in non-cash form.
That accounted for a substantial 10% of Investment Income in 2017. See page 71 of the 10-K.
That’s equal to 20% of Net Investment Income.
Deduct that unreliable and long term paper income (sometimes as far as 7 years out) from the 8.6% yield earned equals (0.9%).
Net of that number FSIC investors are receiving a Cash return on the new assets of exactly 0% under our stated assumptions.
Don’t Worry. Be Happy.
By contrast, the Investment Advisor will earn – initially at least – of 2.0% (1.75% + 0.2%).
On our wholly theoretical increase in assets of $1.712bn that’s an extra $34mn a year.
That would add to the $123mn currently being earned to reach $157mn , a 28% increase.
The Elephant In The Portfolio
Unfortunately, we are not done.
Left out in all these calculations is any impact from bad debts.
Managers, analysts and even some investors sometimes act as if loan write-offs do not exist and have no impact on earnings and valuation.
We agree that estimating likely credit losses is as hard as predicting who’ll end up in the Final Four but along with death and taxes they are an inevitability.
We only have to look at FSIC’s own track record, which is middle-of-the-pack for a BDC.
The BDC has raised $2.272bn in equity capital and booked Realized Losses of ($245mn).
($141mn of those losses came in this year alone).
We’ll just cut to the chase and offer up that we expect annual credit losses for the Risk Profile of FSIC to be 2.0% per annum.
We’re assuming that through a full economic cycle, and with plenty of second lien and other riskier assets (including some CLOs) losses will be material, even if concentrated in whatever Bad Year(s) is up ahead.
Add that prospective loss and the contribution to long term shareholders earnings is negative, even if FSIC collects all its PIK income.
Of course, the downside from a credit standpoint could be much greater (see what’s happening at ABDC, CPTA, HCAP, TCAP and has already happened at OCSL, OHAI and AINV, BKCC, etc.).
Little To Look Forward To
On the other hand, the upside from higher yields or the occasional equity gain is much more modest.
Nor are these pro-forma economics necessarily as Bad As It Gets.
Spread compression in the future could push down investment yields, while higher cost of debt could squeeze the spread between lending and borrowing even further while Management Fees remain unchanged and unforgiving.
In 2017, FSIC’s Net Investment Income to net assets ( a standard – if flawed- Return On Equity metric) was 8.8% with debt to equity at 0.7x.
Wth debt to equity up to 1.5X as we’ve calculated, ROE could be barely any higher in the short term and drop in the long term as credit losses erode recurring net investment income. (Management and Incentive Fees will be only modestly affected).
However, the risk to investors from more than doubling the amount of debt on every dollar of equity will have grown astronomically.
Our numbers speak for themselves, at least to us.
Readers and BDC Managers may quibble with any or all our individual assumptions, which they are welcome to.
However, we believe the economics of growing the balance sheet and earnings by using leverage are not favorable where FSIC is concerned.
(That’s British under-statement).
At best investors will receive little or no benefit for taking on much more credit risk or could actually end up losing on a per share basis.
We will not presuppose that the numbers do not work in every case but this exercise where FSIC was concerned left us unconvinced that shareholders will incur any material benefit and will face heightened risk of loss of book value and a much lowered dividend down the road.
Not a good start for BDC 2.0.
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