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Gladstone Investment: Changes To Revolver

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PREAMBLE

Gladstone Investment is one of many BDCs that is “leveraging up” its portfolio to take advantage of the new law and has already been busy getting its liability management ducks in  row. However, the BDC Reporter has been looking at the BDC’s business model and cost of capital and come to the conclusion that what the Investment Advisor of the BDC wants may not be practical or even advantageous to shareholders. Admittedly, this does require looking into an unknown future and making a number of assumptions which only time will tell are reasonably accurate. Nonetheless, forewarned is forearmed. Anyone invested in GAIN’s common stock or fixed income should bear through this long analytical piece as we’re questioning the future risk-return balance of what has been a very successful BDC for several years. 


NEWS

On August 23, 2018 Gladstone Investment Corporation (GAIN) announced several amendments to its credit facility led by KeyBank.

Key changes included increasing the size of the facility from $165mn to $200mn.

Extending the “Revolving Period” when the BDC can draw and repay to August 2021 from November 2019.

Extending the final maturity date to August 2023.

Reducing the interest rate by 30 bps during the Revolving period. Higher rates apply thereafter.

Changing the unused line fees based on usage at different stages of the Revolver.

Reducing the minimum asset coverage ratio required to 150% from 200%.

See the press release attached.


ANALYSIS

Bigger Picture

The changes to the Revolver are part of  broader liability management changes associated with GAIN’s goal of taking advantage of the higher leverage allowed the the Small Business Credit Availability Act.

Earlier, the BDC redeemed two Term Preferreds with an aggregate balance of $82mn, which included a 200% asset coverage limit, with a new $75mn Term Preferred with a 150% asset coverage limit.

See the BDC Reporter’s Premium article of August 15, 2018: “Gladstone Investment Issues New Term Preferred”.

We expect GAIN will be issuing a new 150% coverage Term Preferred to refinance the remaining 200% asset coverage Series D Term Preferred on the books, with a face value of $57.5mn.

Only Some Of The Way

The above notwithstanding, these actions will only allow GAIN to make partial progress towards increasing leverage to its new target level, or even to the prior regulatory threshold.

With the increased facility size (and assuming a fully drawn Revolver) and the current configuration of Term Preferreds, total debt capability will be $333mn.

At June 30, 2018, total net worth was $380mn.

Next Milestone

In order for total debt to match book value, the next round of Term Preferred issuance will have to reach $104mn.

At that point, GAIN’s total debt capability would be split roughly fifty-fifty between secured and unsecured borrowings.

Total portfolio assets – currently $639mn – would increase by $138mn to $777mn.

A key problem GAIN will have in growing its balance sheet using the Revolver – which can yet be expanded to $300mn – is the low advance rate offered by its lenders.

By our calculation, using the June 2018 balance sheet and reading the footnotes in the 10-Q – gross availability under the Revolver amounts to 25% of portfolio assets.

Given that GAIN – like every secured borrower – does not fully utilize the facility, the effective secured debt advance rate on portfolio assets is closer to 20%, or even lower.

(At June 2018, Revolver outstandings as a percentage of portfolio assets was only 17%).

Preferred Route

This suggests that GAIN will need to finance – if the market is willing – its incremental portfolio expansion with unsecured borrowings such as Term Preferred.

Even if available in the quantities desired, that will increase the BDC’s cost of debt capital.

The most recent Term Preferred was priced – as we have seen – at 6.375% while the just amended secured Revolver is priced at 4.92%.

[Both types of debt have other associated costs: The Term Preferred includes a placement cost that runs about 0.5% per annum over the 7 year financing, plus hard to calculate professional and filing fees.

The Revolver includes front-end bank fees, amendment fees and the unused lines fees, which can add 0.25%-0.5% to the all in cost of financing].

Tight

Nor is there much excess capacity in the current borrowing base to allow GAIN to favor secured borrowing.

At June 30, 2018, the BDC had borrowed $103mn on a total borrowing base of $162mn, leaving availability of $59mn. That’s debt to availability of 64%.

For our purposes, we are assuming GAIN will seek to maintain a debt to availability of 75% at all times.

This suggests that the $777mn in total assets that GAIN will have when reaching 1:1 will be financed by $146mn by Revolver outstandings and $251mn by Preferred or unsecured debt.

Looking Forward

If we go further and assume GAIN seeks to go to 1.5x debt to equity, assets will grow another $190mn and will be financed by $36mn in Revolver and $154mn of unsecured debt.

In toto – and on a pro forma basis – GAIN’s debt financing $967mn of assets would consist of $182mn of Revolver borrowings and $404mn of Term Preferred or other unsecured debt.

Total debt would amount to $586mn on equity of $380mn.


VIEWS

The Reason Why

We’ve taken readers through this seemingly endless list of assumptions and calculations to suggest that GAIN’s ambitions to leverage up – understandable and not atypical – may prove difficult to finance.

Even for GAIN to reach debt to equity of 1:1 will be hard to achieve.

Nature Of the Assets

The key problem is that the BDC invests in higher risk loans (13.0% average yield) and a high proportion of non-income producing or junior capital investments which are not suitable for borrowing against.

At a time when some BDCs are able to receive advance rates of 70% against low coupon, highly liquid (till they’re not) syndicated loans to large sized borrowers, GAIN receives only a third as much advance rate.

This requires the BDC to rely ever more heavily on unsecured debt financing, currently in the form of Term Preferred.

However, unsecured lenders may eventually balk at bearing an ever higher proportion of the financing of the BDC.

They too will be worried about the value of the underlying assets.

Deconstruction

At June 30, 2018 one third of GAIN’s portfolio consisted of Preferred and common investments.

If that proportion continues if and when GAIN leverages up to 1.5x debt to equity, and assets reach $967mn, $330mn will be in the form of those junior capital investments  and $638mn in debt instruments.

That $638mn of income producing investments would support – as we pointed out above – $586mn of GAIN debt.

Will unsecured investors in GAIN’s Term Preferred  be prepared to take on such a thin amount of income producing asset coverage ?

Would GAIN even ask them to ?

We have our doubts.

Little Benefit

Then there’s the issue that we discussed in the prior article about the income accretiveness of the additional assets.

At June 30, 2018 investment income averaged 9.7% of GAIN’s assets.

If that number continues forward in the future on new assets acquired and we deduct out the cost of secured and unsecured borrowing (weighted all-in cost 6.6%), Management Fees (2.0%) and incremental operating cost (0.5%), and throw in the cost of the Incentive Fee, very, very little is left over that will hit the Net Investment Income line.

Before we even take into account any reduction in income that might come from spread compression and/or (heaven forbid !) bad debts, shareholders will be netting only 0.5% of that 9.7% of investment income.

Instead, both shareholders and Preferred investors will be relying very heavily on how the one third of GAIN’s assets invested in Preferred and equity fares.

Not All Change Is Good

If we’re right – and if GAIN is able to leverage up to 1.5X debt to equity – the risk profile that both common and Preferred investors have enjoyed will completely change.

At June 30, 2018 BDC common shareholders faced a debt to equity of 0.64 to 1.0. Obviously risks will greatly increase if that ratio rises to 1.5 to 1.0 but – as we’ve seen – earnings will barely budge – if at all.

Term Preferred shareholders can currently look to $531mn in net assets (net of secured borrowings) to secure their $136mn in capital invested in GAIN, or 390% coverage.

At the pro-forma 1.5x multiple, net assets after secured debt would be $785mn, covering $404mn of Term Preferred or 194%.  Of course many of those assets – as we’ve seen will be non income producing.

Rhetorical Device

Will unsecured debt investors be prepared – at any price – to double the risk they are taking ?

For our part – as a long time investor in both Gladstone BDCs Term Preferred –  the answer is a resounding no.

One More Thing

Finally – if yet another objection was needed – there’s the issue of investment production.

As the management is the first to admit (see the transcript of every Conference Call) finding the right transactions to invest in has been a perennial challenge for GAIN.

Here’s a typical example from the latest transcript:

Now I will say that we’re still operating in a buyout environment, where the competition for new investments is elevated, purchase price is being paid very high and frankly, this makes it very challenging for us to close new investments, given our conservative value approach and the expected financial returns. Now this may lead to an appearance of a low rate of investment production at any point in time, however, keep in mind that when we make investments, we’re striving for quality to build value in both the income and equity, and we’re not volume driven as it might be if we were building a portfolio of loans, where we would, say, be primarily sensitive to yield spreads. And it’s important to keep in mind that our process time line for any one acquisition is quite long. And from the time we’re introduced to a new potential buyout opportunity to actually closing on that transaction, it could be anywhere from 3 to 5 months. So it takes time, but we keep diligently working at this and building our portfolio.

We Have Questions. They Have ?

In an ever more crowded market for transactions, how will the BDC – without loosening its standards – vastly increase its investment production ?

Will there be a doubling of the professional staff ? Many more regional offices opened ?

None of this has yet been addressed by management.

On the latest Conference Call – which we re-read for this purpose – there was no discussion of the BDC’s plans, but much re-recital of its historic results.

Nor did analysts seem to care much.

There was only one questioner and two questions, none about the BDC’s plans to expand its debt and portfolio.

Doubts

The BDC Reporter – operating in the dark but looking at the business model – questions whether GAIN  – even if it wants to – can do much more than leverage up to a 1:1 debt to equity level.

Both problems with raising and deploying the capital may serve as a natural break on the BDC’s ambitions.

That may be the Good News.

Beware What You Wish For

However, if GAIN is successful at “leveraging up” – and this amendment to the Revolver is but a small step – the whole risk profile for both common and Preferred shareholders will change.

Dramatically.

Should that occur the BDC Reporter will be re-thinking its long held positive view on investing in GAIN, whether in the common (which has been fully valued for some time) or in the Term Preferred.

Silver Lining

In the interim – while we see what happens with new Term Preferred offerings and the size of the portfolio – shareholders will benefit from that lower Revolver interest rate.

We estimate the 0.3% rate cut will reduce interest expense by 1 cent a share on an annual basis.

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