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TPG Specialty: Proxy Filed To Adopt Higher Leverage

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NEWS

On August 24, 2018 TPG Specialty (“TSLX”) filed a Schedule 14A – a Definitive Proxy Statement.

The sole item on the Proxy is to ask shareholders to ” allow the Company to increase leverage by approving the application to the Company of a minimum asset coverage ratio of 150%, pursuant to Section 61(a)(2) of the 1940 Act, to become effective the date after the Special Meeting, which would permit the Company to double the maximum amount of leverage that it is currently permitted to incur”.

The Special Meeting referenced is scheduled for October 8, 2018.

The Proxy – over two dozen or so pages – provides the principal arguments in favor of the proposal while detailing the risks involved.

The Proxy is attached as is a Shareholder Presentation slideshow presentation added the following day.


ANALYSIS

One Amongst Many

Two-thirds of BDCS have received Board approval to increase regulatory leverage from their Boards.

Some funds have also sought shareholder approval, while others are prepared for the one year hiatus envisaged under the law until the new regulation becomes effective.

Some BDCs have self imposed limitations more restrictive than those required by the Small Business Credit Availability Act.

Some Investment Advisors have offered compensation concessions. Some have not.

Multiple

In the case of TSLX, there are a number of variations.

First, the Board has approved the higher leverage which becomes effective on August 1, 2019 and will allow TSLX to double maximum allowable regulatory leverage. See page 6.

However, if shareholders vote in favor on October 7, 2018 the new rules will change immediately.

If shareholders do not approve the new rules, the higher leverage will still be effective as of August 1, 2019.

Second, the BDC has announced its intention to take only partial advantage of the new leverage limits:

Upon the effectiveness of the lower minimum asset coverage ratio requirement (either after the Special Meeting or on August 1, 2019), the Company would revise its financial policy to increase its target debt-to-equity range from 0.75x to 0.85x, to 0.90x to 1.25x. I

See page 7.

Third, the BDC’s Investment Advisor has agreed to a lower Management Fee on a portion of assets acquired with leverage:

“The Adviser intends to waive a portion of the Management Fee payable under the Company’s Investment Advisory Agreement by reducing the Management Fee on assets financed using leverage over 200% asset coverage (in other words, over 1.0x debt-to- equity). Currently, the Management Fee payable to the Adviser is an annual rate of 1.5%, based on the average value of the Company’s gross assets calculated using the values at the end of the two most recently completed calendar quarters, adjusted for any share issuances or repurchases during the period. Pursuant to the waiver, the Adviser intends to waive the portion of the Management Fee in excess of an annual rate of 1.0% (0.250% per quarter) on the average value of the Company’s gross assets as of the end of the two most recently completed calendar quarters that exceeds the product of (i) 200% and (ii) the average value of the Company’s net asset value at the end of the two most recently completed calendar quarters. The fee waiver will be permanent and will have the effect of reducing the Management Fee payable to the Adviser from 1.5% to 1.0% on assets financed using greater leverage than the Company currently is permitted to incur under the existing 200% asset coverage ratio”.

The Proxy contains a list of issues considered by the Board before granting approval. See pages 12-18.

In addition, the Proxy contains pro-forma calculations about the impact of leverage on the balance sheet, expense and debt levels and shareholder returns. See pages 8-11.

Insider Ownership

There is also information regarding the share ownership of TSLX by insiders and major investors.  See page 4 and 5 for all details. Here is a snapshot:

As the document shows, TSLX’s current balance sheet  – at June 30 2018 has assets of $1,978,479 and debt of $876,880.

Debt To Equity is 0.88x.

In the Proxy. the Investment Adviser made clear that no change in investment strategy was expected to occur following the adoption of higher leverage.


VIEWS

We should clarify from the outset that we are a shareholder in TSLX and that we will vote FOR the proposal.

Moreover, based on what has already occurred at other BDCs that have asked for shareholder approval and given TSLX’s excellent reputation for portfolio management, we expect the proposal to be overwhelmingly accepted.

The Above Notwithstanding.

However, there are a number of serious shortcomings in the Proxy and the compensation concessions are mediocre at best, as we shall review.

As always, BDC shareholders have very little in way of options and most of the choices are a matter of a choice between the devil and the deep blue sea.

More on that as well in a minute.

Thumb Up

However let’s begin with the positive elements of the proposal.

First, TSLX has demonstrated in its over four years as a public company an excellent credit track record and a business strategy that has generated stable earnings and distributions.

Whatever you may hear from BDC managers a good credit record is relatively rare in the BDC space.

We keep a list of all 46 BDCs which tracks how many have managed to maintain a positive book value since inception.

We count only 10 names (less than a quarter of the total), including TSLX.

Room For Maneuver

Second, we agree with the Proxy that the adoption of the higher leverage rule will almost completely innoculate TSLX from the risk of a very sharp drop in portfolio asset values.

We offer this extensive quote from page 13, with which we wholeheartedly agree. We also refer readers to page 5 of the Investor Presentation.

The Company believes lowering the minimum asset coverage requirement provides meaningful regulatory relief to the Company as it removes the most significant existential or outside risk that a BDC structure faces — the risk that broader market events and individual portfolio company specific credit issues puts downward pressure on the fair value of investments that could result in a breach of statutory asset coverage requirements. Such a breach could severely limit the ability of a BDC to operate, constraining further borrowings and, as a result, the ability to pay distributions to stockholders and interest to lenders. The relief provided through the lower asset coverage requirement increases the regulatory cushion, or room above the minimum asset coverage requirement, available to the Company, meaning that the amount of decline in the fair value of assets that can be absorbed before the asset coverage requirement is breached is significantly expanded. As a result, the Company believes the relief represents a positive development for stockholders.

Not Forgotten

The BDC Reporter was actively involved in the BDC sector during the 2008-2009 crisis, and witnessed first hand the damage inflicted on BDCs by having to mark portfolios to fair value.

The result – in many cases – was the breach or near breach of the regulatory asset coverage ratio – which caused many BDCs to suspend their distributions and/or undertake pricey Rights Offerings and/or sell off assets at the worst possible time.

Whatever else we think of the Small Business Credit Availability Act, the increasing of the limit – if not matched with an equal increase of actual leverage – should be an unalloyed benefit.

The likely result in the Next Crisis will be – for those BDCs like TSLX who aim to keep a wide margin between what is allowed and what is borrowed – a far greater degree of flexibility and much greater likelihood that dividends can be maintained at some level.

Moderate Appetite

Third, the target leverage which TSLX has chosen seems reasonable at 1.25X Debt to Equity, versus 2.0x allowed by the Act, and will allow total portfolio assets to grow by nearly a quarter.

(We note that the Proxy indicates that the rating groups -shown on page 6 of the Investor Presentation – have agreed to maintain TSLX’s investment grade rating even as debt outstanding will increase eventually by over 50% !).

Accretive

Fourth, the arbitrage between what TSLX receives from new investments and what the BDC will pay out in the form of compensation, interest expense and operating costs appears to be a positive number, even when a provision for bad debts is taken into account.

Here is what the Proxy suggests might be the incremental Return On Equity from recurring income (and before taking into account any bad debts) from boosting the size of the portfolio as envisaged:

…assuming a limited level of credit losses, if the Company were to operate at the top end of its target leverage range (1.25x debt-to-equity) under its revised financial policy, the additional leverage would add approximately 150-250 basis points of annual ROE, compared to operating at 0.75x debt-to-equity.

The BDC Reporter undertook its own calculations and came away with a higher pro-forma ROE (3.4%).

Net of expected credit losses for the type of assets in which TSLX invests (which we typically set at 2.0% per annum), the gain would be 140 basis points.

That amounts to about $0.11 per share on a net and very pro-forma basis.

Now For The Negatives

As we expressed at the top of this article not everything is bright and shiny about TSLX’s Proxy proposal.

First of all, we’re not delighted that even if shareholders vote the higher leverage down, the Board’s decision to leverage up will prevail in 2019 when the first anniversary comes along.

Unfortunately, this is another example of the Bizarro World of BDC corporate governance where the views of 3 “independent directors” – who own 2% of the shares of TSLX – are allowed to supercede the express opinion of the shareholders.

Of course, we don’t really lay this at the feet of the “independent” directors as is suggested by our constantly placing quotation marks around the word, but at those of the Investment Advisor (whose own ownership in TSLX is also modest) who are really in control.

If Wishes Were Horses

We would have preferred to see a commitment from the Investment Advisor not to proceed with the higher leverage should shareholders vote the proposal down.

Maybe we’ve missed a comment to that effect on a Conference Call, but we are not aware of such a commitment.

Plain Talking

Second, the Management Fee concession is un-generous.

As most readers will know GSBD reduced its entire Management Fee to 1.0% (but did not promise Target Leverage of 1.25X Debt to Equity).

Likewise, the newest entrant – Barings, LLC – has promised an initial 1.0% Management Fee on all assets as well.

We hear that GSO/Blackstone is preparing to launch a public BDC with a 1.0% Management Fee as well.

However TSLX has chosen to follow in the footsteps of Ares Capital (ARCC) and several other BDCs and only offer any concession to shareholders on assets acquired over the prior regulatory level.

This means that once the BDC is fully leveraged at its Target Level only one fifth of investment assets will receive the discounted Management Fee.

Numbers

In absolute dollars that suggests on $266mn of investments shareholders will receive a credit of $1.33mn a year.

By contrast TSLX will receive an incremental $2.66mn in Management Fees and as much as another $2.0mn of Incentive Fees under our assumptions of income and costs.

That will add to the $32.4mn in Management Fees already being earned and an approximate $35mn in Incentive Fees at Debt to Equity of 1 to 1.

We estimate that TSLX’s compensation in toto at 1.25x – which includes fees earned on amounts over the current asset level to the old regulatory limit and up to 1.25x Debt to Equity- could increase by nearly a quarter over the current running rate.

As we’ve seen above, shareholders may net $0.11 in higher NET earnings per share or a 5% increase over the current level.

Not Very Shareholder Friendly

This disproportionate allocation of the benefits of a bigger portfolio – which comes with a near 25% increase in associated credit risk because lending is a two edged sword – may be typical in the BDC sector but hardly cause for celebration.

However – as we said earlier – shareholders have little choice but to sign on.

If they say no, the higher leverage will kick in anyway in a year and it’s not clear if the lower offered Management Fee would apply at that time.

As they used to ask rhetorically on the Sopranos ” What are you going to do ?”

It’s the same here for would-be BDC shareholders.

If you want to invest with this particular BDC – and we and many others do – you have to accept a fee structure that while not as expensive as some (yes, we’re talking to you Prospect Capital) is far from a bargain.

Welcome to the world of BDC investing following the passage of the Small Business Credit Availability Act where every BDC’s mix of leverage and compensation is unique as Investment Advisors decide – with no visible pushback from BDC Boards – how big they want to grow and how much they want to charge.

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