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Gladstone Capital: IIQ 2018 Portfolio Preview

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With Gladstone Capital’s (GLAD) IIQ 2018 earnings release just a few days away – on July 31, 2018 after the close – the BDC Reporter decided to have a look at what we know of the credit quality of the BDC’s portfolio, and which companies shareholders might want to look out for when the next 10-Q comes in.


BDC CREDIT REPORTER ANALYSIS

We review the portfolio list of most every BDC in the 46 public universe, including GLAD.

We utilize a 5 point scale, similar to the one adopted by many – but not all – BDCs.

We categorize each company as either Performing or Under-Performing, based on investment valuations and publicly available information.

Within those two broad categories, we break Performing companies into two sub-sets: i) performing as expected ii) performing above expectations.

These are titled Corporate Credit Rating 1 and Corporate Credit Rating 2, or CCR for short.

In the Under-Performing category, we divide the companies into 3 sub-sets: i) moderate under-performance; ii) serious under-performance likely to result in a default; and iii) non-performing.

These are given Corporate Credit Ratings of 3, 4 and 5 respectively.

In addition, we review each investment individually and apply a similar 1-5 rating scale.

Moreover, we calculate for every yielding investment with a Credit Rating of 4 the amount of investment income at risk should the borrower default and be re-rated as Non Performing (CCR 5).

Finally, we estimate – based on available information and common sense review – what ultimate realized capital losses might occur for all non performing assets, both already accounted for and not.

The goal is to evaluate what the likely book value might be after non-performing investments are restructured, closed, sold or revived.


BACKGROUND

At March 31, 2018, GLAD had a reported 50 companies in its portfolio, with a cost of $456.8mn and an FMV of $402.1mn.

According to the 10-Q, the five largest portfolio companies account for 29% of the total portfolio at fair value.

The average yield on the debt portfolio is 11.5%.

GLAD maintains a credit monitoring and risk rating system which we do not find useful. Readers can review the IQ 2018 numbers on pages 59-60 of the 10-Q.

GLAD: ANALYSIS

By our count – at March 31, 2018 – GLAD had 17 Watch List (under-performing and non-performing) companies in the 50 company portfolio.

CCR 5

Of those, two were Non Performing or CCR 5.

These are Alloy Die Casting and Sunshine Media Holdings.

Alloy: Backstory

The former has been on non-accrual since the IQ 2017, and principally consists of second lien debt and Preferred and common stock of $7.9mn at cost.

GLAD shares the exposure with sister BDC, Gladstone Investment (GAIN).

GLAD’s Preferred and common equity has been written down to zero, while the second lien debt is carried at a 25% discount to cost.

However, that’s up from as much as a 37% discount when the position was first lien two quarters ago.

On the last Conference Call, GLAD’s management was relatively optimistic about the medium term outlook for the company:

[Alloy Die Casting] is obviously a business that we are co-invested with GAIN in, so we have very good insights as to what’s going on. There has been a substantial management change, and there’s been a substantial buildup in liquidity of that business. We expect that business to move in the direction that you’ve alluded to, to become a performing asset, and that is something that we are expecting eminently.The final details have not yet been laid out, but the trajectory of that business is heading in that direction, and I don’t believe it will be too many quarters before we will be able to report that to you.

We have not found anything in the recent public record about this Californian privately-held company, which the Gladstone BDCs bought into in 2013, to change the outlook one way or the other.

We assume from the shift of GLAD and GAIN’s exposure from first lien to second lien that a new secured lender has been added to the lender group but that the Company’s performance does not yet allow any resumption of interest payments to the junior debt holders.

For our purposes – and taking a conservative position –  we assume that GLAD may yet have to write off all its exposure, resulting in a possible  $7.9mn Realized Loss, including a further drop in value of $4.4mn.

Sunshine Media: Backstory

The business-to-business publishing company, in which GLAD (the sole BDC lender) has invested $30mn –  which is also in a traditional combination of debt, Preferred and equity –  has been non-performing for some time.

In fact, the Company has had one debt tranche or another on non-accrual since 2012 !

All the junior capital has been written down to zero and the debt greatly discounted, leaving only $2.4mn of FMV in total.

For our purposes, we expect a full write-off of the investment resulting in a Realized Loss of $30mn, including a further drop in value of $2.4mn.

CCR 4

There are 14 companies in our “serious under-performance category”, which we often call our Worry List.

However, most of the names on this list only have non income producing Preferred or equity exposure.

Moreover, many of the investments are small even at cost, and thus non-material (anything valued below $1mn).

For example: Glad’s investment in Frontier Financial Group consists of $500,000 in Preferred and common, valued at zero.

Or, the junior capital has been greatly written down (which leads to their CCR 4 rating), but loans outstanding are carried at or close to par.

Nonetheless, we are not thrilled that well over a dozen individual Preferred investments have been greatly marked down, or marked to zero.

Focus

However, our most immediate concern are two CCR 4 companies with material income producing positions outstanding: healthcare company New Trident Holdcorp and oil services-focused Francis Drilling Fluids.

In a sign of the times, the greater concern is New Trident. Two years ago, the likelier candidate would have been Francis Drilling.

This is a large syndicated credit held by 4 different BDCs, which have positions in First Lien, Second Lien and Subordinated debt of the borrower.

The company has been under-performing for some time.

Moody’s wrote down the corporate rating  to Caa3 back in November 2017.

More recently – and based on the information available to us – a Limited Default designation has been added since June 2018.

To date, GLAD’s $4.2mn of first lien secured debt, priced at LIBOR + 10.0%, has remained current.

We are concerned that the loan has gone on non-accrual, which will cost $0.52mn in annual Investment Income.

The debt was already written down by (51%) as of March, and may drop further.

Positive

More encouraging – based on public data and the latest valuations – is the situation at Francis Drilling Fluids, to which GLAD has advanced $27mn in debt, Preferred and common.

Yes, the junior capital invested is written down to zero and the second lien debt is carried at a (35%) discount.

However, that discount has been reducing – presumably helped by better business conditions in the oil patch.

We expect that trend will continue in this quarter, which may result in Unrealized Appreciation and no impact on income.

Public record info is very sparse.

CCR 3

There are just two companies in the moderate under-performance category: Lignetics Inc.  and Meridian Rack & Pinion.

Based on the public information available, neither company seems to be in any additional stress.

Wood pellet company Lignetics Inc. made an acquisition in February of this year, which is encouraging, and continues a multi-year M&A trend.

No news on Meridian worth reporting.

CCR 1 

Although GLAD does hold a large number of Preferred and equity positions, there was no one company with outstanding junior capital valuations.

The BDC may be able to harvest some common stock stakes, but none for any material amount or for a worth-talking-about Realized Gain.


CONCLUSION

From the available information GLAD approaches the current earnings release with one major potential loss of income borrower: New Trident Holdcorp.

If that business fails, the impact will be half a million dollars of annual investment income.

That’s the equivalent – if all the income loss  drops out of the Net Investment line –  to about $0.02 a share.

That’s not a major hit, should such a set-back occur.

At the moment, we don’t anticipate any other material risk to income.

Of course, we remind readers that we have only patchy information.

Write-Downs

In terms of potential write-downs beyond the level of March 2018 – and assuming our Worst Case scenarios – for the two CCR 5 companies and New Trident, we estimate $11mn is at risk.

That’s a maximum of $0.41 per share of downside for the $8.62 per share book value, or 5%.

Of course, with Alloy Die Casting potentially getting turned around and potential Unrealized Appreciation at Francis Drilling Fluids, the net book value impact could be lower.

However, even in a Best Case, we don’t expect any material improvement in book value, if we leave out changes in undistributed income and other non-credit related factors.

Although we have circled a great number of Watch List names, only a handful are likely to have any impact and the effect on both income and book value is likely to be minimal.

Till Next Time

We’ll know more when the IIQ 2018 results are published and we renew our investment by investment review of GLAD.

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