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CM Finance: Issues First Baby Bond

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NEWS

On June 27, 2018 CM Finance (CMFN) announced its intention to issue unsecured notes due 2023.

See attached press release.

The unsecured notes will be publicly traded under the ticker CMFNL. 

The initial press release indicated the proceeds would be used initially to repay outstandings under the BDC’s Revolver, which currently totals $17.8mn.

(At March 31, 2018, CMFN’s Revolver balance was $23.4mn).

On June 28, 2018, CMFN followed up with the pricing and amount of CMFNL.

See the second press release, also attached.

The BDC raised $30,000,000 and may raise another $4.5mn from the underwriters over-allotment.

The unsecured notes will bear an interest rate of 6.125% and pay quarterly.

The unsecured notes are subject to optional early redemption from July 1, 2020 and matures July 2023.

The new Baby Bonds begins accruing July 2, 2018.

CMFNL received a BBB rating from Egan-Jones.


ANALYSIS

A First

This is the first unsecured debt offering by CMFN.

To date, the BDC has funded itself with a secured Term Loan and Revolver, provided by UBS.

Complex

For full details on the complicated arrangement by which CMFN borrows we recommend reading the latest 10-Q on pages 24-25.

At March 31, 2018 the special purpose debt financing vehicle had $250mn in pledged portfolio assets of CMFN’s total portfolio value of $297mn.

Total secured outstandings were $125mn between the Term Loan and Revolver, compared with net assets of $172mn.

Pricing on the secured debt facilities is as follows, according to the 10-Q:

Borrowings under the Term Financing bear interest (i) at a rate per annum equal to one-month London Interbank Offered Rate (“LIBOR”) plus 2.75% through December 4, 2018, and (ii) at a rate per annum equal to one-month LIBOR plus 2.55% from December 5, 2018 through December 5, 2020 (the “Term Financing Rate”). The Company also incurs an annual fee of approximately 1% of the outstanding borrowings under the Term Financing.

…Borrowings under the 2017 UBS Revolving Financing generally bear interest at a rate per annum equal to one-month LIBOR plus 3.55% (the “Revolver Financing Rate”). The Company pays a fee on any undrawn amounts of 2.50% per annum; provided that if 50% or less of the 2017 UBS Revolving Financing is drawn, the fee will be 2.75% per annum.

For the quarter ended March 31, 2018 “the weighted average stated interest rate under the Financing Facilities” was 4.35%.

(We are supposing the above number does not include any unused line fees or the 1% annual fee due under the Term Financing mentioned above).

At the end of March 2018 unused availability under the Revolver was $26mn.

New Frontiers

On May 2, 2018 the Board of Directors approved the lower asset coverage requirements allowed under the Small Business Credit Availability Act.

The new rules, which allows a BDC to increase its debt to equity to a maximum ratio of 2.0 to 1.0 from 1.0 to 1.0, will become effective May 2, 2019.

At March 31, 2018 debt to equity was 0.7 to 1.0.

CMFN is not asking for shareholder approval of the new asset coverage/leverage limitations.

Looking Forward

On its most recent Conference Call, in reaction to a direct question, management indicated that its new leverage target would depend on multiple factors.

Here is a key extract from a Q&A with analyst Robert Dodd with CMFN’s CEO Michael Mauer:

Robert Dodd

… So framework wise obviously I mean do you’ve and I realize it’s a year out before it can happen, there’s a lot of discussion that can go on between now and then but can you give any color about what you think your target leverage ratio could be. Obviously you’ve got one right 0.8, where could you — do you think 1.5 is the ballpark, I would say that loud I hope its not 1.8 or is it lower than that?

Michael Mauer

Well its not 1.8, 1.5 could be in the ballpark, it could be 1.2, it really comes back the — it also comes back, Robert what people are not talking enough about is what is the availability and what are the types of assets as well as for any [indiscernible] that’s out there because those are two critical things. I think the one premise that a lot of people have around this is that its going to be a more competitive market out there because its going to be more leverage and so it’s going to drive yields tighter on the less risky and more liquid. That might be true because if you think about pure math that should be the direction.

The flip side of that is also true that if everybody starts going to the [indiscernible] liquid lower risk then the stuff we’re doing today for the same risk we’ve got we should be able to get wires spread and better pricing and better structure and maybe we don’t have to increase leverage as much taking increase ROE because everybody else is going away from the stuff that we do very, very well today. So it really is going to be a market dependent but the leverage is dependent upon the type of risk we’re taking but in any scenario that should translate into better ROE for the shareholder.


VIEWS

Important

From a Big Picture standpoint, this is an important milestone in the unfolding reshaping of BDC balance sheets following the new rules established by the Act.

Investors in both the common stock and debt of CMFN are getting a first look at how the balance sheet and economics of a smaller sized BDC might fare from next year.

Moreover, the fact that CMFN is raising publicly traded unsecured notes for the first time confirms our oft repeated contention on these pages that the BDC Fixed Income segment is poised for growth in both number of issues and dollars outstanding.

The fact that a tiny BDC (relative to peers such as Ares Capital, FS Investment, Prospect Capital etc.) can successfully raise unsecured debt is itself notable.

Come One. Come All

This suggests that virtually any BDC can aspire – at the right price and structure – to raise unsecured debt in the higher leverage format allowed under the Act.

The 5 year maturity of CMFNL, the relatively short no redemption period and the just north of 6.0% rate the BDC will pay suggests a still receptive investor market.

CMFN will only be paying marginally more for its unsecured debt at 6.125% than the 5.65% (1 Month LIBOR at 2.1% + 3.55% margin) being charged on the secured (and much safer from a credit standpoint) Revolver.

If the Fed keeps raising short term rates, by this time next year the unsecured debt on CMFN’s balance sheet could be “cheaper” than its secured Revolver !

Projecting

Let’s also have a look at what this might mean from CMFN’s balance sheet leverage going forward.

(We are assuming the underwriters will exercise their over-allotment and CMFN will raise $35mn from the Baby Bond).

With the proceeds (and ignoring front end costs for the moment), total debt will initially move from $120mn currently ($102mn Term Loan and $18mn Revolver outstandings) to $137mn ($102mn Term Loan and $35mn Baby Bond).

Cash available to invest will increase by $17mn as CMFN cannot readily temporarily repay the Term Loan.

There will also be $50mn available under the existing Revolver.

If and when the cash is deployed and the Revolver drawn, total assets will increase by $67mn, taking total assets from $297mn to $364mn.

Ever More

Furthermore, CMFN will be in a position to borrow more on a secured basis thanks to those additional assets.

Historically the BDC – much to our surprise – has been able to borrow as much as 60 cents on the dollar for every dollar of pledged assets.

On $67mn of potential new assets, CMFN could expand its secured debt by another $40mn.

Technically that could further grow portfolio assets to $404mn, and total borrowings to $177mn.

At that point on this journey asset coverage of debt would be 228%. Debt to equity would be just over 1.0x.

Second Stage

If CMFN can continue to raise unsecured debt and secured lenders remain prepared to lend as in the past, the portfolio (and the debt)could grow even larger.

Based on March 31 2018 book value of $172mn, a target Debt To Equity of 1.5x (as discussed by CEO Mauer above) would raise debt to $258mn (from $123mn at March 2018) and the portfolio to $432mn.

On paper, that’s a potential 45% increase in portfolio size while still being “conservative” about leverage (albeit doubled in size from the current level) for a BDC that was – till the new rules were announced- reaching its ceiling.

And without needing to raise a red cent of new equity capital.

Good Times

For the Investment Advisor, the potential increase in Management Fees is substantial:

Increasing portfolio size from $297mn to $432mn would add $2.4mn a year in those fees.

That’s a 45% increase.

Of course, Incentive Fees would have the potential to pop as well, but the calculation is harder and requires a set of assumptions.

To keep this simple, let’s assume that Incentive Fees continue to be 43% of total fees as of the last quarter.

That will increase Incentive Fees paid out by another $1.0mn a year.

In total, CMFN’s Investment Advisor (which has not offered any concession to shareholders as part of the adoption of the Act) could earn $3.4mn a year in additional compensation on a pro-forma basis.

That’s to go with the $11.2mn annual compensation running rate as of the last quarter.

Key Question

So much for the managers. How will shareholders fare ?

Right away we have to hedge ourselves  because the BDC itself has been vague as to how its investment strategy might play out with all the new firepower.

Will CMFN invest incremental dollars in “safer”, lower yielding assets or shift its entire portfolio in that direction ?

Or will the Investment Advisor stick to its current higher yield, higher risk approach ?

Even CMFN itself does not seem to know, as admitted on its Conference Call.

Can’t Help Ourselves

Still, we wouldn’t be doing our job if we didn’t have a stab at estimating what the economics might look like.

If CMFN focuses its efforts going forward on lower risk-lower yield assets (much beloved by the secured lenders to BDCs), the yield on those extra loans (we’re assuming no non income assets) will be 9.0%.

We would assume that CMFN could borrow on a secured basis at LIBOR + 2.50% and on an unsecured basis at 6.5% (including all transaction costs) in the 60/40 proportion.

That results in a blended cost of 5.4%.

Add to that the Management Fee of 1.75% and incremental operating costs of 0.3% and taking into account the Incentive Fee, we calculate shareholders net return will be 1.2%.

Bottom Line

In hard dollars on $135mn of PRO FORMA in new assets that’s $1.7mn of higher Net Investment Income.

Or $0.12 a share.

As of last quarter CMFN was earning on an annualized basis $1.08.

This would represent an 11% potential increase in Net Investment Income Per Share.

One For You And Two For Us

If we’re right – and please feel free to check our math – the Investment Advisor could earn $3.4mn from the bigger portfolio and shareholders $1.7mn.

We’ll let those numbers speak for themselves…

Almost Forgotten

However we’d be remiss if we didn’t discuss the higher credit risks that come with increasing the size of the portfolio by 45%, even if the incremental assets are in somewhat less “risky” borrowers than in the past.

By our very rough and ready estimate, the risk of credit loss would increase by 30% on a weighted basis.

Over time as credit losses occurred (and we’re assuming only 1%-2% annual losses) Net Investment Income would get eroded.

On the plus side, CMFN’s portfolio would become more diversified, a critical need in a small BDC with only 24 borrowers and still heavily involved in energy.

More Likely

However, we expect CMFN will not change its investment approach and will stick with investing at average yields between 10%-12%.

Initially – even if secured borrowing costs may be higher and the Incentive Fees meatier- the percentage return inuring to the BDC’s shareholders will be higher.

We won’t bore you with all our calculations except to say that the net percentage return could be as high as 2.4% (twice the level of the “safer” approach).

However, the credit risk to both shareholders and Note Holders increases substantially.

That may cause the Investment Advisor to target a lower leverage level and thus – in absolute dollars – pretty much the same benefit to shareholders and the same increase in credit risk.

Concluding Remarks

The BDC sector is at the beginning of a journey that promises to change its risk and return (more the former than the latter) drastically.

With CMFN’s latest Baby Bond offering we’ve received an insight into what the future might look like.

If our numbers are right, the BDC Reporter’s misgivings about funding asset growth with more debt continue to be valid.

In a nutshell shareholders, are likely to receive only a modest increase in earnings while taking on much more substantial credit risk.

Moreover, what initial benefits might occur in earnings are disproportionately weighted towards the Investment Advisor.

The key flaw in CMFN’s plans – and those of every other BDC to date to tread this path except for Goldman Sachs BDC (GSBD) – is to maintain its already high compensation structure in the new environment.

However, we understand  that there are huge dollars in play and it’s very hard for any Investment Advisor (CMFN is neither the first or the last) to walk away from such a large potential payday.

Once again the uneven balance of power between shareholders and insiders expresses itself in dollar and cents terms.

More power to the External Manager for being able to increase their profits by nearly 50% without needing to raise any new equity.

It’s a great business to be in.

For BDC shareholders and debt holders , though, more caution than ever is warranted given the divergence in interests between those who supply the capital and those who manage it.

 

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