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TCG BDC: Shareholders Approve Higher Leverage

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NEWS

In an 8-K filing, TCG BDC (CGBD) announced shareholders – amongst other issues – had voted for the increase in leverage allowed under the Small Business Credit Availability Act.

This allows the BDC to reduce asset coverage of liabilities from 200% to 150%.

Effectively, this allows – on a pro forma basis – CGBD to double its balance sheet leverage.

The vote on the subject was 3:1 in favor.

The new limit becomes effective immediately.

As disclosed above under Item 5.07, the Asset Coverage Ratio Proposal was approved by stockholders. As a result, pursuant to Section 61(a)(2) of the Investment Company Act of 1940, as amended, and subject to the satisfaction of certain ongoing disclosure requirements, effective June 7, 2018, the minimum asset coverage ratio applicable to the Company is 150%.

See 8-K attached. 


ANALYSIS

First In

CGBD is the first of eleven BDCs to request shareholder approval to decrease the minimum asset coverage, as allowed under the Act.

We discussed the BDC’s bold move in an earlier article, dating back to May 4, 2018.

Another 14 BDCs that we track (out of 46) have received only Board approval and are not – as yet – asking for shareholder endorsement.

To The Numbers

Currently, CGBD has $1.913bn in investment assets, $46mn in cash and $796mn in secured borrowings.

The BDC’s net assets were $1.131bn as of March 31, 2018.

Roughly speaking, the new law will theoretically allow CGBD to add $1.466bn in additional assets and debt.

That would increase investment assets to $3.379bn and debt to $2.262bn, or roughly 150% assets to debt coverage.

That’s also equivalent of debt to equity of 2:1, as effectively allowed by the new legislation.

Don’t Forget

Off balance sheet CGBD already has a highly leveraged Middle Market Credit Fund, which has $1.090bn in loan assets, in which the BDC has a 50% stake.

On a gross basis and on a purely pro-forma basis, CGBD could be responsible for $4.469bn of investment assets on a capital base of $1.131bn.

Target Level

However, for our analysis – in the absence of any material guidance from CGBD – we are assuming the BDC will max out leverage at 1.5X equity.

That would result in total debt of $1.697bn, or an increase of $901mn.

That extra debt will be used to purchase an equivalent amount of new investments, bringing total loan assets to $2.814 bn, an increase of 47% over the current level.

If we add in 50% of the Middle Market Credit Fund assets under management, CGBD will have effective assets of $3.359bn over $1.131bn of equity.

On And Off

For greater clarity, let’s break this down between on balance sheet and off:

On balance sheet investments (excluding the $200mn invested in the Middle Market Fund) would total $2.614 bn, the debt $1.697 bn and the capital at risk $0.931 bn.

Off balance sheet CGBD’s share of the Middle Market Credit Fund would result in investment assets of $545mn, third party debt of roughly $345mn and capital at risk of $200mn.

(Most of the capital invested by CGBD and its partner is in the form of loans, bearing interest at LIBOR + 9.00%).

Happy Days

From the Investment Advisor’s standpoint, the extra $901mn in investment assets will increase management fees (pegged at 1.5%) at $13.5mn annually.

It’s harder to evaluate what the Incentive Fee might be, so we’re assuming an additional amount equal to a third of the MF or $4.5mn.

In total, that’s $18.0mn of additional compensation to the manager.

To put that into context, the current annualized running rate for Carlyle’s compensation is $50mn.

The new arrangement could result in a 36% increase, or even more if we’ve been too conservative on the Incentive Fee which has no look-back feature.

Shareholders Turn

Far harder to evaluate is what incremental earnings to shareholders might be earned from these additional assets.

On balance sheet investments are yielding 9.2% as of March 2018.

(By the way, that’s substantially richer – and riskier – than in the JV whose corresponding portfolio yield is 7.1%).

If we assume a 9.0% gross yield going forward, we calculate the return that will drop down the waterfall of interest expense, operating costs and compensation will be 2.3%.

(We could tell you how we calculated that number but we’d be killing you with detail).

However, that’s based on a very big assumption: that CGBD is able to borrow all that extra debt capital at its current senior secured rate of LIBOR + 2.0% (or 4.01% all in at the moment based on 1 Month LIBOR).

If the markets are not so generous and CGBD has to borrow half the monies on an unsecured basis that will  reduce the net proceeds by 0.5% to 1.0%, bringing the incremental benefit to 1.3% to 1.8%.

Taking the most generous view (i.e. 1.8%) that COULD increase CGBD’s Net Investment Income by $16.2mn.

That’s $0.26 per share of extra Net Investment Income or a 16% jump over the current level.

All Together Now

Thus – on a pro forma and preliminary basis – we estimate this move by CGBD could generate $34.2mn of incremental net income after interest and other expenses but before compensation costs.

Those gains would be roughly split equally between the Investment Advisor and the shareholders.

Both Sides 

That’s the return part of the equation. Let’s look (briefly) at risk:

For the type of assets CGBD is booking on balance sheet we assume average annual write-offs will be 2.0% over a full cycle.

Over a 5 year time frame that’s 10%.

Credit Risk Discussion

This is a mid-risk BDC, as can be determined from the portfolio yield.

Moreover, 28% of the investment assets on the books are second lien or last out uni tranche first lien or equity investments.

These are obviously riskier assets, most of which are priced in double digits.

Supporting Evidence

Moreover, a review of the BDC’s own investment risk rating system shows that currently $303mn of investment assets are rated 3 or below.

That means the underlying companies are performing at least 10% below base case.

Under very favorable macro conditions 18% of CGBD’s portfolio is under-performing expectations.

That’s not an unusual level and the BDC has very little in the way of non-accruals.

No Exception To The Rule

Nonetheless, with ($51mn) in Realized and Unrealized Losses booked in its short history, CGBD is not immune to bad credits.

We assume – leaving out any evaluation of the highly leveraged JV – that if CGBD leverages itself up as assumed above, credit losses in the next 5 years could reach $261mn.

That’s multiplying the assumed annual credit loss by the on balance sheet portfolio size and 5 years.

Net of the Management Fee cost that would no longer be charged that would result by year 5 of $19.6mn in lower income to shareholders and $3.9mn to the Investment Advisor.

(For sake of these calculations we’re assuming the Incentive Fee remains unchanged).

In this scenario, within a few years shareholders will have lost all the incremental income generated by the new assets, and more.

The Investment Advisor will still be ahead by 75% over the current compensation rate.


VIEWS

We apologize for throwing so many numbers at our readers.

However,  it’s preferable than making unsubstantiated comments about the two edged nature of the new reality in the BDC universe.

We like to show how we come to our generally not very favorable conclusions about what the Act means for the BDC sector and its shareholders.

Moreover, we’re aware that the results above are based on a series of assumptions, each of which will be different in reality than what we can predict.

What this deep dive into the pro-forma metrics of CGBD does underline without a doubt, though, is that this is a very complex matter, with no easy money involved.

Structural Problems

Adding leveraged debt assets by borrowing is a tricky business, and is complicated by the fact that BDCs do not maintain loss reserves (or even estimate what they might be) and pay out all earnings.

Concluding

We have a few specific conclusions to draw about CGBD and the BDC universe more generally.

Starting with CGBD:

  1. The initial impact of leveraging up will certainly result in higher earnings as the BDC draws on inexpensive secured debt to grow its balance sheet and invests in loans earning 9.0% or higher.
  2. The growth in earnings will slow as leverage reaches its targeted maximum as the BDC will need to borrow on ever more expensive terms, presumably in the unsecured markets.
  3. As credit losses mount over time, earnings will erode and could eventually exceed any incremental benefit in process that will take several years to play out.
  4. Given high leverage both on the balance sheet and in the JV, the possibility of major credit and earnings shocks has increased by 40%.
  5. Both the Investment Advisor’s decision not to reduce its Management Fee or institute a look-back on the Incentive Fee is unfavorable for shareholders.

For BDCs generally:

  1. As we and the BDCs themselves have stated before, the risks and benefits of the new leverage rules will vary by fund.
  2. Not stated as often – but obvious in the CGBD example – that benefits for every BDC will vary over time given the economics of borrowing to invest.
  3. Most of the benefits to shareholders in terms of higher earnings per share – if any – of a BDC leveraging up will be front loaded due to a variety of factors.
  4. Over the medium term – assuming credit losses occur at a normal pace for leveraged debt – initial benefits will be eroded by lower book value and lower earnings.
  5. External managers benefits from the higher leverage will be much more stable over time, and will erode only marginally.
  6. Most of the time BDC Managers will share disproportionately in any incremental earnings benefit to be received from being allowed to grow portfolio assets over the prior level.

Market Reaction

What will be most interesting to see is how the market will react to BDCs growing by taking advantage of the Act and leveraging up.

Will investors come running to the initial higher earnings involved, even if the benefits are heavily weighted to the Investment Advisor ?

Or will investors – concerned about the undeniable greater risks involved – hold back ?

What’s more, at times of financial crisis generally or when individual BDCs report unexpected credit losses, will investors sell out faster and to a greater degree than in the past causing greater price volatility ?

(We actually try to track the range of low to high price for every BDC. The current average is 33% for the past 12 months. Will that become 50% or more as jumpy BDC shareholders try to get ahead of potential bad news ?)

Impact On The Pioneer

To date, CGBD’s stock price has moved up only marginally, and in line with the sector as a whole, suggesting the market is still undecided.

Here’s the YTD chart, which compares CGBD to BDCS:

Still, these are Early Days.

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