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Saratoga Investment: To Issue New Baby Bond

BDCs:
  • SAR (Lower Middle Market Lender/One CLO Investor/Manager)
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NEWS

On August 21, 2018 Saratoga Investment Corporation (SAR) filed a preliminary prospectus supplement to its “shelf offering”.

See attached.

The BDC is preparing to issue new unsecured notes, due in 2025.

The amount to be raised, the interest rate and the early redemption date have not yet been fixed.

However the new “Baby Bond” will have the ticker symbol SAF.


ANALYSIS

Growth Capital

The new Baby Bond is not intended to refinance the existing public issue which trades under the ticker SAB.

SAB is not redeemable till December 2019 and matures in 2023.

The Prospectus indicates the capital raised will be used to invest in additional investment assets, including through the BDC’s SBIC subsidiary.

Election

Note that SAR’s Board approved the higher leverage allowed under the Small Business Credit Availability Act, which will become effective next year.

Along with a new round of equity capital raised a few weeks ago, and because SBA debentures are not counted in the calculation of debt, we calculate that SAR can -technically- borrow up to $270mn.

If we assume the BDC targets a debt to equity, net of SBIC debt, of 1.5X SAR could add $184mn of investment assets by increasing borrowings.

Snapshot

At May 2018, the BDC had total investment assets at fair market value of $343mn and total debt outstanding (including $138mn from the SBIC) of $212mn.

In the most recent Conference Call, management indicated that $12mn of undrawn SBIC debentures had been subsequently used, suggesting total debt could be marginally higher at $224mn.

On paper, SAR has the potential to increase portfolio assets by 52% (we’ve adjusted for the newer SBIC funded investments) and total debt by 82%.

Back Of An Envelope

At 1.5x debt to equity on a regulatory basis, total assets would reach $566mn, total debt $408mn and equity $172mn.

Debt to equity – without any exclusion of SBIC debentures – would be 2.4x.

As of May 2018 – and before the recent secondary – debt to equity was 1.4x.

Of the total assets on the balance sheet as of May and adjusting for the recent $12mn invested, SBIC assets account for $236mn.

Another $4mn is invested in SAR’s solo CLO.

That leaves $115mn in assets on the BDC’s balance sheet – as opposed to being in subsidiaries on which their is third party debt – financed by $74mn of unsecured debt (SAB).

Although SAR has a large Revolver with Madison Capital Funding, no balance was outstanding at May 31, 2018.


VIEWS

Meeting Expectations

SAR’s raising of new unsecured debt is not surprising given the equity capital just raised and the opportunity presented by the Act to “leverage up”.

As we’ve shown above, the loophole in the rules that allows a BDC not to count SBIC debentures as debt, works in SAR’s favor.

This is the third debt capital raise in a few days instigated – partly or fully – by the Act.

Gladstone Investment (GAIN) is refinancing all its Term Preferreds to take advantage of the lower asset coverage requirement from April 2019.

New Mountain Finance (NMFC) has raised $100mn by issuing yet another privately placed Convertible.

Both have been discussed on these pages.

Both the BDC Reporter – and our friends in the investment banking community who we talk to – expect a very busy new issue calendar going forward.

Perennial Question Mark 

From a SAR shareholder standpoint, questions remain about how much recurring earnings per share will benefit from the additional borrowings.

The BDC lends out at an average yield just over 11.0%, but one-tenth of investments are in non income producing equity stakes.

That means the likely yield – if past is prologue – from new assets added will be around 10.0%, invested in a mix of first lien, second lien and equity in lower middle market companies.

We don’t yet know the interest rate SAR will pay, but for these purposes we’ll assume an all-in cost for the new notes, including placement fees spread over 7 years, of 6.75%.

Add to that the Management Fee of 1.75%, and variable operating expenses of 1.0% of assets acquired.

Those expenses add up to 9.5%.

When we deduct out a 20% Incentive Fee, shareholders are likely to see only 0.4% of the income on the assets purchased.

Plus any capital gain that might be achieved on the tenth of the portfolio invested in equity, after the Investment Advisor receives a 20% fee on capital gains.

That Other Debt

Critical to SAR’s ROE, as well as its ability to take full advantage of the new leverage limits, will be how much and how cheaply secured debt can be arranged.

Typically that will reduce the cost of capital, increase firepower and boost shareholder returns.

However, in the case of SAR – whose loan assets are relatively concentrated, illiquid and in the less favored (from a collateral standpoint) lower middle market, this is a challenge.

The Madison facility is priced at LIBOR + 4.75%. 1 month LIBOR is at 2.1% and 3 month LIBOR at 2.3%.

That means the interest rate paid is as high as 7.0%.

Then there’s the cost of unused borrowings which is currently 0.5%, and 0.75% when the Revolver is less utilized.

Finally, there are the costs of renewing and amending the Revolver.

It seems cheaper for SAR to borrow unsecured than secured !

Unavailable

Another handicap is that the current borrowing base for Revolver borrowings – again reflecting the nature of the investments held as collateral.

As the 10-Q shows, the Madison Revolver has a cap of $45mn (see page 27) but a borrowing base of only $27mn on a pool of assets that we’ve estimated at over $100mn.

If these conditions continue SAR’s extra debt capacity will result in very little in the way of incremental recurring earnings and/or will require the funding to be in the form of unsecured debt.

Fluid

However, we expect SAR’s Investment Advisor – which has very carefully rebuilt the BDC since its almost complete collapse in the Great Recession – will be seeking to ameliorate the situation.

We’ll be very interested in both the rate on the new Baby Bond and to see how SAR handles its secured borrowings going forward.

Elephant In The Room

However and whatever happens to the BDC’s cost of capital and shareholder ROE, there is no doubt SAR shareholders face greater credit risks going forward.

Assuming no change in the type of asset in which SAR has successfully invested in, SAR will see credit risks increase from all the new assets added by “leveraging up”.

If you increase total assets by 50%, risk increases correspondingly.

Other Stakeholders

Nor are the future holders of the BDC’s unsecured debt – SAB and SAF and issues that might follow – without reasons to pay attention to the creditworthiness of their unsecured debt investments.

As the 10-Q itself points out, the unsecured debt SAR has raised – and will raise – is structurally subordinated to $150mn of SBIC debentures and any future draws under secured financings and to the debt in the CLO.

Even as of May 2018, the unpledged asset coverage of SAR was already only 157%.

That’s $116mn of assets not pledged to a third party over the current unsecured notes of $74mn.

Of course, if the SBIC subsidiary and CLO were to be liquidated, any net proceeds would inure to the benefit of shareholders.

However, in a recession or financial crisis such an unwinding would take too long and is too unreliable to be counted on.

We’ll be interested to see what the unpledged asset coverage of SAR looks like when all the dust clears, which should show up initially when the next 10-Q is filed.

Conclusion

We’ve been very impressed with how SAR has been managed over the years so this “leveraging up” of an already highly leveraged BDC does not ring any immediate alarm bells.

Nonetheless, there are valid questions to be asked about risk and return.

We’ll be updating this article as some of those issues come into focus.

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