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TPG Specialty: Shareholders Approve Higher Leverage

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NEWS

On October 9, 2018 TPG Specialty (TSLX) reported the result of a special shareholders vote held the day before,

The only subject on the ballot was whether to approve adoption of the higher leverage standards allowed by the Small Business Credit Availability Act (“SBCAA”).

The vote was overwhelmingly in favor of the change.

The new standard will become effective from October 9, 2018.

See the Form 8-K attached.


ANALYSIS

Follow-Up

The BDC Reporter offered up a full analysis of the pros and cons of the shareholder proposal at the time of the filing of the Proxy.

See the article dated August 28, 2018, part of the BDC Reporter’s review of BDC corporate governance ands made available to all readers, our so-called BDC Shareholder series.

Given that TSLX has committed to maintaining leverage at 1.25x regulatory debt to equity, the likely maximum increase in assets is $470mn.

Impact On Balance Sheet

That will bring total investment assets from $1.955bn to $2.425bn, an increase of 24%.

Total debt will increase from $858mn at June 30, 2018 to $1.328bn, a 55% increase.

Impact On Earnings And Expenses

We had previously calculated that the likely increase in Net Investment Income Per Share will be $0.11, or 5.0% over the current level.

In absolute dollars, that’s incremental Net Investment Income of $7.1mn per annum.

TSLX has agreed to reduce its Management Fee to 1.0% on assets acquired with leverage over the 1.0 to 1.0 limit.

We estimate that $266mn of the $470mn of additional assets will benefit from the fee concession.

We estimate TSLX will generate $5.7mn of incremental Management Fees and an unknown amount of additional Incentive F ee as a result of the new policy, beginning from the IVQ 2018.

Context

By the BDC Reporter’s unofficial count, TSLX becomes the twelfth public BDC to receive shareholder approval of the new SBCAA limit.

Another six BDCs are in process of holding a vote and 14 have chosen only Board approval and the implementation of the rule twelve months out.

If all shareholders vote in favor when asked, the number of BDCs to adopt the new elective  SBCAA standard in some form will be 32.

We track all 45 public BDCs, and continue to estimate that over 40 will ultimately adopt the higher leverage, based on comments made on Conference Calls.


VIEWS

Not Kidding Ourselves

Although the BDC Reporter voted in favor of the Proxy proposal ( along with 98% of TSLX shareholders !) we continue to have few illusions about the risk-return calculation.

Given that TSLX intends to continue to operate as before the change, the increase in risk is equal to the likely increase in assets or 24%.

However, thanks to narrowing loan spreads due to competition; the high cost of debt borrowings and the modest fee concession made by the Investment Advisor; the corresponding return is low at 5.0%.

Latest Developments

Not helping the situation is that the cost of both unsecured and secured debt has risen since the issuance of the Proxy, and may have some more way to go.

Given that all incremental assets purchased will be funded with debt of one kind or another that may reduce pro-forma shareholder profits further.

On the other hand, the Management Fee to be earned is unaffected by the higher cost of capital although the Incentive Fee may be marginally lower.

Sticky

Shareholders are likely to stick around due to the BDC’s excellent credit performance since coming public in 2014.

Moreover, TSLX has paid an unchanged regular distribution of $0.39 for 16 quarters in a row, and a number of Special Distributions.

Potential Benefits

The adoption of the higher leverage may not result in a material – or any – increase in the standard distribution – butt may result in larger special pay-outs.

Moreover, the addition of greater asset firepower makes more likely – thanks to potential higher income – the maintaining of the regular distribution even in the face of future credit losses.

Plus, the big gap between the new regulatory limit and the self imposed leverage limit means TSLX is unlikely to be forced to sell assets during a crisis when asset values drop and impact asset coverage requirements that BDCs are bound by.

This was a major problem for BDCs in the Great Recession and was becoming a potential risk for TSLX as late as June 2018.

At that point debt to equity – with the then limit at 1.0 – was 0.89x.

With the new 1.25x limit  (and the regulatory limit at 2.0x) TSLX is insulated against even a very drastic reduction in asset values and unlikely to breach – even at the top of its “Target Leverage” – BDC asset coverage requirements.

Summed Up

As with many BDCs, the main benefit of adopting the SBCAA will be that current distribution levels are likely to be maintained for longer and with less risk of balance sheets being unwound in financial stress scenarios.

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