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Corporate Capital Trust And FS Investment To Merge

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NEWS

As reported initially in the BDC News Table on July 23, 2018 before the market open, a major merger of two BDCs was announced.

See the press release attached.

Corporate Capital Trust (CCT) will merge into FS Investment (FSIC), if both BDCs shareholders approve.

Shareholders of CCT – which will cease to exist after the transaction – will receive shares in FSIC equal to the proportion of their book value at the time of the combination.

In addition, CCT will distribute, just before the merger, any undistributed taxable income or capital gains.

The combined entity – which will continue to trade as FSIC – will have $8.3bn in total assets.

The new FSIC will be the second largest public BDC by asset size, second only to  Ares Capital at $12.7bn.

(The numbers from the attached Investor Presentation).

The transaction is expected to close in the IVQ 2018.


ANALYSIS

The BDC Reporter reviewed the press release, and the Investor Presentation and listened to the Conference Call where senior managers of both firms discussed the transaction and answered questions.

The intention of CCT and FSIC had been announced months ago when KKR was chosen to partner with FS Investment across the latter’s entire platform of funds.

Previously the parties had discussed merging all the various FS Investment funds in with CCT, creating the largest public BDC with a pro-forma $18bn in assets.

On the Conference management suggested that was still the ultimate goal with further combination of funds into FSIC to occur in 2019 and 2020, subject to market conditions and shareholder approvals.

Management argued that the immediate benefits of the CCT-FSIC combination would include the following:

  • A more diversified portfolio as there is only one overlapping portfolio company amidst the 221 companies on their books.
  • That will reduce the proportion of FSIC’s assets invested in its top ten issuers to drop from 35% to 19%.
  • Greater liquidity for the stock from the higher capital base and increased analyst coverage.
  • Reduce operating expenses as a percentage of assets. The “low estimate” of savings – which will take time to realize – was placed at $5mn-$7mn.

See page 2 of the Investor Presentation for a full list of likely benefits from the amalgamation.

Swings And Roundabouts

On the other hand – and without giving any number – management pointed out that there would be one-time costs associated with the merger.

Changing Business

From a strategic standpoint, the combined FSIC – management says – will be able to take greater advantage of the 30% “bucket” of non-qualifying assets that BDCs are allowed to invest in.

See page 8 of the Investor Presentation.

This will mean an even greater contribution to the current (or future) senior loan Joint Ventures, in which $303mn of capital has already been invested.

Also targeted is a greater emphasis on asset based lending.

Finally, FSIC is eyeing more lending abroad, using KKR’s global footprint.

In an Investor Presentation relatively light on hard numbers, the amount of spare capacity available to invest in these typically higher yielding-higher risk assets was listed at $540mn.

Potential Benefits

The Investor Presentation – and the manager comments – suggested that a bigger FSIC might be able to reduce its borrowing costs.

Very little in the way of specifics were given. Here is an example of how the subject was framed:

“Pro forma entity’s scale and diversification expected to improve funding costs over time”.

Currently  the “weighted average stated interest rate” at which the two BDCs borrow are very similar and average 4.5%.

(Of course, there are other costs associated with borrowing that are not included in that number and should not be taken as their starting point cost of debt capital).

What Was Not Discussed

Despite questions from analysts, FSIC/CCT were coy about future stock buyback plans.

Many of the bigger BDCs have created large scale buyback arrangements for supporting their stock price during downturns by automatic stock repurchase arrangements.

What FSIC will do in the future is not yet known.

Likewise, little was asked (except by National Securities’ Chris Testa) about the approach of FS Investments and KKR towards the higher leverage allowed by the Small Business Credit Availability Act.

(FSIC first adopted the new rules, then rescinded them but left the door open for future adoption in a flurry of contradictory activity in recent months).

Unspeakable

The joint Investment Advisors (FS Investment and KKR) did not offer up any change in the current compensation arrangements, either in the Management Fee or the Incentive.

FSIC will continue to charge a 1.5% Management Fee and a 20% Incentive Fee with a 7% threshold.

No change in the dividend policy was discussed.


VIEWS

Thumb Up

As far as the BDC Reporter can tell this is a favorable outcome for shareholders in CCT.

The stock has traded between $14.51 and $17.37 YTD, well off book value which ended up at $19.72 as of March 2018.

Moreover, shareholders will receive a Special Distribution of $30mn-$35mn of Taxable Earnings generated but not yet distributed just before the merger, or $0.24-$0.28 per share.

Plus – if all goes on schedule – two more regular distributions of $0.40 each or $0.80.

Then – using the March 31 2018 CCT book value (adjusted for previously distributed Taxable Earnings as mentioned above) – a book value of $19.43.

All that at a current stock price of $16.68.

Underperformed

That’s not bad for a BDC that has not covered itself with glory since going public in a reverse stock split in October 2017.

NAV as of September 2017 was $20.01, and has dropped subsequently to the current $19.72 level. Even more when non distributed Taxable Income is considered.

Our review of the latest portfolio identified 19 Watch List names in the 128 company portfolio.

From the 10-Q

Even the BDC’s own idiosyncratic portfolio asset quality grading system (A to E, with anything B and below representing performance below expectations) showed only 38% behaving as expected.

Admittedly, though,  both in the BDC’s own estimate and ours, the value of deeply troubled investments was low ($103mn of D and E) or 2.6% of the total.

Still, a not insubstantial 6 borrowers are on non accrual.

There was the real possibility that CCT’s stock might have cruising for a bruising had this transaction not occurred.

Bigger Picture. Longer Timeframe.

Longer term, determining whether an enlarged FSIC will be a Good Thing or not is very hard to do.

Not helping is that KKR is just now inheriting the FS Investment fund’s day to day management from GSO Blackstone.

How well the hand off of a portfolio goes between two arch rivals is anybody’s guess.

Then there’s FSIC’s own questionable investment quality.

At March 31, 2018 the BDC rated a fifth of its portfolio as under-performing versus expectations.

Add to that the questions that surround the economics and credit quality likely to flow from the increased emphasis on the JV, asset based lending and foreign activity.

Finally – and we’re leaving plenty else out – there’s the changes that will be wrought from the planned multi-step folding off other FS Investment non-traded funds into FSIC over the next two years.

Anyone who can safely project FSIC’s fortunes over the next several quarters in light of those variables is a better credit analyst than we are Gunga Din.

FSIC may be about to become the second largest BDC and shortly thereafter become the megalodon of the sector, but the BDC remains, for all the reasons listed above, a work-in-progress.


INVESTMENT DISCLOSURE

We have no position in FSIC.

Nor did we have any position in CCT before the day’s merger announcement.

However, we bought a position in CCT’s stock on hearing about the transaction with FSIC and following our initial review, much of which is reflected herein.

The market has not been excited about the merger, and CCT’s stock closed the day before the news at $16.63 and closed on the day after at $16.68.

Here is a link to the current price level.

Likewise FSIC’s stock barely moved on the news.

Perhaps the markets had already adjusted to the combination months ago when the first word of the intention to merge was made.

Nonetheless – and despite the markets cold reaction – we added CCT to our Special Situation portfolio.

All those questions going begging about what will happen to this expanding BDC over an extended time horizon makes investing for our Long Term Income strategy a non starter.

In the shorter run, we hope to benefit from the generous terms CCT shareholders are receiving for being absorbed into FSIC.

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