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TCG BDC : Approach To New Leverage Limits

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PREAMBLE

The BDC Reporter has been saying ever since the Small Business Credit Availability Act was enacted that the approach of every Business Development Company out there would be different. In recent weeks – and especially since BDC earnings season began on Tuesday May 1, 2018 – we’ve been learning more and more about how different Investment Advisors and their Boards are tackling the opportunities and the risks involved in the new legislation. Here we have excerpted from TCG BDC’s (CGBD) Conference Call transcript, dated May 4, comments made about this thorny subject. The headlines are ours, but the rest of the text is taken from the transcript. The BDC Reporter adds its commentary after each quote. We wrap up below with a couple of key  conclusions.


Surprised 

“This is obviously a significant event for our industry. And while a potential change in leverage has been discussed for years, the manner in which it was passed and the timing was a bit of a surprise with a narrower version of the reform bill being included in the recent omnibus spending bill and signed into law on March 29”.

BDC Reporter adds: We’ve certainly received the impression from CGBD and other BDCs that the in-the-dead-of-night passage of the Act came as a surprise, which is reflected in the still inchoate responses of many BDCs. CGBD, despite having much to say, is no exception.

Shareholder Involvement

“In evaluating the provisions of the bill and the potential impact not only on our business, but on the industry as a whole, we concluded as the management team that the correct path and the right thing to do was to seek the approval of both our board and our shareholders. It’s a decision that we feel is too important not to have those two constituencies weigh in. At a meeting held on April 9, our Board of Directors unanimously approved the adoption of the new BDC leverage bill, as being in the best interest of the company and its shareholders.

And as a result, the two to one leverage ratio will become effective on April 9, 2019. Additionally, since that time, we’ve worked closely with our legal counsel and the SEC in developing a proxy statement that we feel provides our shareholders with a complete and transparent perspective on the benefits as well of the potential risks associated with the new legislation.

That proxy statement was filed with the SEC and mailed to our shareholders on April 27, 2018 for their consideration in advance of our annual shareholders meeting on June 6. We would encourage you to review the proxy statement, which is now available on EDGAR as we feel it provides a very comprehensive look at the many factors that we considered in light of the new regulation.

For many years, as a private company, we were able to effectively manage our leverage at or near one to one due to the call structure of our equity commitments. And while no decision has been made as to whether or not to increase leverage, we believe that the outer boundary for our business would be in the area of 1.3 to 1.4 to 1, which we believe to be a prudent level, given the overall risk in our portfolio today”.

BDC Reporter adds: We’ll be reviewing the Proxy statement carefully shortly. To their credit – unlike many other BDC players – CGBD is giving shareholders a vote on this critical decision that could transform risk and return (especially the former) if taken to the limit. Moreover, this approach means the impact on the BDC could be felt sooner -if shareholders vote Yea – and affect results as early as the third of fourth quarter of 2018 so investors will want to pay attention.

A Borrower Be 

“With respect to the availability of increased credit, where we need to choose to increase leverage, we’re confident that incremental credit would be available to us, holding current market conditions constant. We believe the adoption of the new leverage guidelines represents a further opportunity to deliver increased returns to shareholders, however, we also believe the opportunity will be differentiated by manager”.

BDC Reporter adds: Like us CGBD believes how each manager approaches the new law could affect returns – for good or ill – differently. There’s no size fits all for how to approach the new rules. However, CGBD is confident – and we have no reason to contradict them – that new debt facilities will become available if sought. We often talk about the dog-eat-dog environment for BDC lending, but there’s also much competition from banks to provide secured financing (not so much on the unsecured side) to the BDCs themselves. CGBD will enjoy being on the other side in this case.

Good To Have In A Storm

“And that differentiation will be a function of the quality and composition of the portfolio, the breadth of the origination platform and the track record around the prudent use of leverage. However, even if we did not choose to increase leverage, approval of the reduced asset coverage ratio by the shareholders would provide an immediate operational flexibility and additional cushion which would be invaluable in the event of more volatile markets”.

BDC Reporter: This is a theme that we’re seeing elsewhere and which seems correct. The new lower asset coverage limits reduces the risks of BDCs tripping asset coverage requirements during the Next Crisis and being forced to sell off assets, and/or suspend cash distributions until coverage returns within regulatory limits. This will save BDCs who’ve not pushed leverage/coverage up to the new limits more flexibility in a crisis, and not cause sale of assets at the bottom of the next downturn. We’ve been a vocal critic of most aspects of the new law, but this is an undeniable benefit and takes away some of the sting of quarterly mark-to-market valuations which wreaked so much havoc in 2008-2009. Of course, BDCs who leverage up to the new limits will not have that extra margin for error AND will be subject to the risk of much higher credit losses than before.

Much Yet Unknown

“Many aspects of the new build impact will play out over time and many of the decisions to be made in the future will be market dependent. What is certain from our vantage point is that we’ll focus on being as thoughtful in our approach to this strategic decision, as we have in managing and and investing on behalf of our shareholders since the company’s inception”.

BDC Reporter: We refer you back to the first extract, which showed that CGBD was surprised by the enacting of the new law. The managers still have much work to do talking to debt sources, modeling assumptions and determining likely results under a variety of circumstances. This is a Work In Process. This also means that investors should take with a grain of salt any projections analysts might throw out there about future earnings with some much unknown, even by the principals”.

Stick To Our Knitting

“Unidentified Analyst

[indiscernible] for Jonathan this morning. Thanks for taking our question. Congratulations on the quarter and I appreciate the in depth proxy put out here in detail. Involves just one follow up question on the leverage matter. Could you give us a sense of the incremental assets? Would they be — would it look similar to your current ROE profile in terms of assets on boarded and leverage utilized? You’re already — you already have very low cost leverage facilities in place. Would you be going more upmarket, lower risk or continuing sort of core CGBD assets?

Michael Hart

Good morning and thanks for the question. The bill itself has provided a lot of flexibility to the industry. It really gives participants a lot of options. It gives them the ability to hold steady and enjoy the benefit of any increased regulatory cushion. It also provides the opportunity for companies to rotate out of their asset mix and perhaps improve the overall quality and that seems to be the recurring theme that you hear a lot about from industry players and what you’re trying to accomplish. Quite frankly, we don’t see a great need to reposition the company with respect to risk profile.

Today, I think our portfolio composition with 77% of our assets in first lien, we feel good about the non-cyclical nature of that. So from a quality standpoint, we don’t think that’s going to be a significant move. I hesitate to say, you can never be too stronger, or a too safer portfolio, but we feel good about that in that respect. And the major rotation and change in asset focus will not, would, in all likelihood, not be a major impact or major initiative around this new provision for us in anyway”.

BDC Reporter: Many BDCs are talking about loading up on lower risk-lower return assets that are not typically what they’ve invested in in the past. The BDC Reporter has been – and remains – skeptical that the numbers work absent fee concessions from the managers. In this case, CGBD appears to be leading towards adding “more of the same” in terms of assets financed by the new rules.  Management is very confident of its credit skills. We’ve looked at the portfolio since the BDC went public last year and are a little more doubtful. The BDC has been in constant flux in recent quarters, with huge amounts of assets added very recently. The Carlyle brand name is very powerful with many investors but we’d prefer to see credit performance play out over a longer period.

Baby Bond ? Or Not.

“Rick Shane

Hey, guys. Thanks for taking my question this morning. I just want to talk a little bit about the funding strategy in terms of the idea of potentially terming out some of your financing in the unsecured market, whether that makes sense where we are in terms of the rate cycle and also as you consider the possibility of increasing leverage.

Tom Hennigan

Hey, Rick. It’s Tom. I’ll take that. Good morning. Based on our asset mix, we have quite a bit of flexibility in our funding strategy. We’ve got multiple credit facilities, we anticipate continuing to grow those over time and we also have successful CLO and I think that we can, with some changes in risk retention recently, that market has now reopened to us.

In terms of the unsecured market, we’re certainly also investigating that market as well, whether it be a traditional bond offering, S&P is making that a little bit difficult, based on their view on the leverage legislation as well as convertible offerings. So we have all the options on the table and we’re investigating all those simultaneously here and getting the right longer term capital structure here.

Rick Shane

It is interesting when you think about the different constituencies that you need to satisfy related to the higher leverage limits, whether it’s shareholders or your bank lenders and the rating agencies, it does seem like the rating agencies thus far have the biggest gaining this year?

Tom Hennigan

I’d say, they’re – it’s simply in terms of the unsecured bond market, but I think that we’ve got the flexibility, if we need to, to maintain our capital structure or grow up — continue to grow the business without that market.

Michael Hart

Rick, this is Mike. And the only thing I would add to that is that I would agree with you, a little surprised in the position that S&P took, particularly in providing really new differentiation. But we do benefit greatly from the sort of where we sit today in terms of the source of liability of funding that we have are sort of non-rating dependent, but our hopes clearly over time have been that rating agencies would take a different view for the benefit of all the constituencies, because it’s hard to imagine that all should be created equal or all should be treated equally and the analysis that can be quite specific in this”.

BDC Reporter adds: There has been a chorus of criticism by analysts and managers ever since S&P warned that any BDC with an investment grade rating  which adopted the new rules would be downgraded. The rating group followed through with Apollo Investment (AINV) to make clear that they were serious.  That has kept Ares Capital (ARCC), Prospect Capital (PSEC), Hercules Technology (HTGC) and FS Investments (FSIC) on the fence. Fitch Ratings has offered up a more vague response, rightly or wrongly. We’re of the opinion that the major BDCs will wear down S&P’s resolve before long and find a way to maintain investment grade status while taking advantage of the new borrowing powers. In the case of CGBD the message seems to be that the manager will seek out other forms of financing. In this “hot” capital market there will be sources of debt capital willing to step in.

Senior Secured Lenders Playing Ball

“Ryan Lynch

Good morning and thank you for taking my questions. The first one has to do with the covenants on your credit facilities. I believe you guys boast a bunch of credit facilities on your balance sheet, have a one to one debt to equity limitation. One, I guess, is that correct? And then two, have you guys had any sort of preliminary discussions with your credit facility providers on whether they would be comfortable in those facilities, if this two to one does pass your shareholder vote?

Tom Hennigan

Good morning, Ryan. Yes. Correct. Both our credit facilities do have one to one leverage covenants and we have been in very active and positive dialog with our lenders to date. So, we anticipate a positive outcome there”.

BDC Reporter adds: Again, bank lenders are likely to bend to the will of BDCs seeking to adopt higher leverage. We expect very few individual banks will walk away when negotiations occur. Nonetheless, it’s very likely that a junior form of debt will have to be raised for CGBD or any other BDC trying to take full advantage of the new rules. How much will need to come from that source will depend on how flexible the secured bank lenders are willing to be for facilities priced at anywhere from LIBOR + 1.75% to 3.50%.  We expect the secured lenders won’t say No, but we don’t expect any material changes in advance rates or other borrowing base covenants. That will make the cost of the junior debt to be raised critical to whether leveraging up will prove accretive or not. The BDC Reporter will wait till we’ve reviewed CGBD’s 10-Q before opining on whether the numbers work.


CONCLUSION

Kudos for CGBD for involving its shareholders in the “shall we ? shan’t we  ?” leverage up decision and for providing a reasonably good idea of what the strategic approach is likely to be.

Less impressive – especially after having heard from New Mountain Finance (NMFC) and Goldman Sachs BDC (GSBD) – is that the manager did not offer any fee concessions to shareholders while setting themselves up for a major increase in compensation.

Maybe there’s more to that subject in the Proxy.

In the short term, the market does not seem to have been convinced that the new law will help CGBD’s return to shareholders. The stock price remains in the same price range as it’s been for most of 2018, as this chart shows:

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