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BDC Preview: Week of January 7 – January 11, 2019

BDCs:
  • SAR (Lower Middle Market Lender/One CLO Investor/Manager)
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We’re back to writing a preview of the week ahead in the BDC sector after a two week holiday break when not much was happening except wild swings in BDC common stock and bond prices, neither of which do we pretend to have any definitive insights as to their short term behavior. With the new year, though, we’re eager to get back to penciling out what we might expect to be reading about in the days ahead, and what the BDC Reporter might need to tackle in greater depth. In our most recent BDC Common Stocks Market Recap we boldly stated to our Premium subscribers that 2019 promises to be “the most important for the BDC sector in the last 10 years”. Let’s see how that goes, starting right away.


Market Moving: As always – but especially in recent weeks – the BDC Reporter – and most everybody else, will be watching how both BDC common stocks and public debt fare price-wise. After one of the most vertiginous drops in the history of the BDC sector, we’ve been in a rally since Boxing Day. BDC common stocks – as reflected by the Exchange Traded Note sponsored by UBS, which contains most of the BDC common stocks and has the ticker BDCS – was as low as $16.83 Christmas Eve, but closed Friday at $18.40. (There’s much more discussed in the Market Recap) . BDC Fixed Income also plunged to historic lows in December when investors were adjusting portfolios in advance of year end even as the data – and interest rates – moved hither and thither. At January 4, 2019 the median price of the 41 public debt issues we track was at $24.81, but had been much lower just two weeks before.

Investors who are long will be wondering if the rallies represented a real renewal in investor confidence or just a temporary enthusiasm – as prices breached all-time lows both the the sector and for many, many individual issues. If optimism is the order of the day – and this week alone will not be long enough to draw any hard conclusions – there is plenty of room for both segments to move up and still be below the modest highs set in the summer when “everyone” seemed certain the economy was strong; credit (as reflected in expected default rates by the major agencies) was moving from very good to even better and every asset management firm with a shingle was hurrying to get into or expand their presence in leveraged lending. On the other hand – if investors decide the chances of a recession and an attendant recession in 2019 or early 2020 – are just too high to bear (pun intended), there’s plenty of room for prices to fall and fall, even without any tangible evidence of credit fails. If you’re going to get out before the herd – as many savvy investors seek to do – one has to push the button when the sun is still shining.

We’re guessing that there are many investors with capital to spend sitting on the sidelines. They , and investors already long, will have their running sneakers on. We’ll bring any major developments in either individual issues or the sector as a whole as soon as we can, but there’s no outrunning the markets who can move much faster than we can type. (Admittedly we are still pecking away with one finger after 40 years at the keyboard).

Earnings Release: Most BDC earnings won’t be published till February or March. New Mountain Finance (NMFC) and the two Solar BDCs (SUNS and SLRC) have fixed their revelations, which we’ve added to the BDC Earnings Calendar, found in the Tools section of the BDC Reporter’s website. However, this week we get the earnings release for the quarter through November 2018 of Saratoga Investment (SAR), the Iowa of the BDC sector. From a fundamentals perspective, this mid-sized BDC – which was left for dead during the Great Recession and brought back to life by the Saratoga organization – has been doing very well for multiple quarters. Assets, earnings and distributions have all been trending up inexorably. The dividend policy is as much about marketing as distributing earnings, with management deliberately increasing the pay-out by 1 cent a quarter for the past 3 years, and boasts “17 sequential increases” in all. The current dividend is $0.53. We don’t necessarily expect an announcement of the next quarter’s payout along with earnings, but we project another (1 cent) increase will be with us shortly.

For the quarter, we’ll be curious whether the big jumps in Net Investment Income Per Share that have featured in the last 3 quarters will continue. Last quarter Adjusted Net Investment Income Per Share was $0.69, up from $0.64 the quarter before. Total assets grew by 14% in three months. One-time events – both in income and expenses – can cause significant swings. For our part, we’ll be more swayed as to what is happening to credit quality, which management was extolling in the last Conference Call. (Our review was less elegiac, noting 8 under-performing companies in the 35 company portfolio). Just as important as potential credit problems will be how SAR’s big bet on Easy Ice, LLC has been performing. The BDC has invested $27.1mn and the investment is valued at $29.6mn. Leaving out the value of SAR’s CLO stake, Easy Ice represents 8% of investment assets and 17% of book value. Even a small drop in value could affect the era of good feelings at SAR, but a higher value could keep things going on.

Most of all, though, in this quarter’s earnings release and in the very detailed Conference Calls that typically follow we’ll be looking for as much information as possible about SAR’s recently expanded and extended CLO.  The CLO investment – which SAR manages and invests in the junior tranche of – has been a major feature of the portfolio since 2008, and was – till recently – a leading contributor to income. That had fallen off as SAR grew its balance sheet and the CLO grew long in the tooth but management doubled down with more capital invested and a rest on December 4 2018.  This will have an important impact on earnings and risk for many more years to come. We wonder if the recent crisis in leveraged loan market prices has boosted loan spreads which could help earnings going forward, especially if not followed by more credit losses than previously anticipated. We have an open mind, but confess to giving SAR’s management a greater than average benefit of the doubt. In any case, we’ll be summarizing the key findings in some form following the conference Call and a review of the earnings release and the 10-Q.

Merger Movement: Both Medley Capital (MCC) and KCAP Financial (KCAP) will be spending this week and a few more weeks to come seeking to convince their respective shareholders to agree to the proposed drastic changes in their corporate formats. We’ll be watching out as much as for what happens or does not happen. Will the previously self introduced MCC shareholders unhappy with the three way merger with Sierra Income and Medley Management (MDLY) speak out again, or take some other action ? Will any shareholder at KCAP put their hand up to contest the curious decision by management to sell off its internally managed status to an external manager for $0.67 a share, cash on the barrel ? To date, existing shareholders seem delighted with the switch, even though the new manager is hardly a household name in the world of credit, unlike the situation at prior BDC manager takeovers at Triangle Capital and Fifth Street Finance and Fifth Street Senior Floating and MCG Capital. Nonetheless, things can change as more and more information is dribbled out of KCAP,

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