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BDC Preview: Week Of February 25 – March 1, 2019

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Earnings:  This is going to be a busy week for BDC earnings as the season rolls on.  We’re already blanching at the prospect, with 11 separate releases coming. Far and away the most important will be the report by FS KKR Capital (FSK). This will be the first time since the merger with Corporate Capital Trust (ex-CCT), and after a name and ticker change. More importantly, we’re going to hear more about the ever huger BDC’s credit status. Reviewing the filing and listening to the Conference Call should tell investors whether the ambitious folk at this unusual arrangement between a firm best known for raising capital and another for investing capital will be successful at lending capital. To be honest, our impression from reviewing the portfolios at both entities (CCT and FSK) for some time now is that management is going to be in turnaround mode for some time to come. Much of that – if we’re right – can be laid at the underwriting taken by FS Investment’s prior partner in leveraged lending GSO Blackstone, which was not shy about taking some very large positions on behalf of the shareholders of multiple FS Investment funds in what now appear to have been some dicey propositions. KKR – now in charge of day to day investment management – re-underwrote those assets when taking over and adding their initials to the door and will have to be responsible for the consequences, if not the original credit decisions. However, KKR will benefit from being in control of many of the debt tranches through the multiple funds now under their co-tutelage with FS Investment, which will aid any work out efforts (but also prolong the time it will take to determine the final outcome). Also worth mentioning – as Oaktree Specialty Lending did last week  (OCSL) when discussing their own escape from under two troubled portfolio companies – is that the LBO market remains flooded with private equity buyers with huge untapped resources; hungry lenders of all stripes and an economy which is humming along (despite all the “next recession is around the corner” talk). As OCSL’s management noted, with a little luck and those favorable conditions, FSK may be able to dig itself out of the hole dug by another party, but which they enthusiastically adopted.

Also interesting will be what FSK announces about two related items that will affect shareholders for years to come: the status of the dividend (currently $0.19 a quarter, after being reduced from $0.2275 in late 2017) and the policy on the Small Business Credit Availability Act (“SBCAA”). To date, FSK has not followed 37 other public BDCs in adopting the higher leverage/lower asset coverage standards allowed by the SBCAA. We wonder – and this involves a series of assumptions none of which may turn out to be correct – if FSK’s earnings are pressured by credit problems, if the managers will choose to “leverage up” with the SBCAA in order to boost earnings (albeit with greater risk) and “protect” the dividend ? To date, one of FSK’s concerns has been staying in the good graces of the major ratings groups, which has kept their finger off the higher leverage button. With Moody’s, S&P, Fitch and all the rest increasingly – and perplexingly – accommodative about maintaining investment grade ratings despite planned debt increases that range from 30%-100% – FSK may seek to finesse a troubled portfolio; an investment grade rating and higher leverage. This is no small matter as the new super-sized FSK is expected to have $8bn in assets, which could go well into double digits, so what happens here will have an outsized impact on the BDC sector as a whole.

At the other end of the size scale, we’ll also be hearing from newly “externally managed” KCAP Financial (KCAP). Less important than the quarterly results – which will be rife with non-recurring items – will be any light shed on what is going to happen in the quarters ahead now that BC Partners has almost literally purchased the helm from KCAP shareholders, in the form of a one time payment. Now that all the excitement about the big changes at KCAP is settling down – and that payoff is in the rear view mirror – shareholders will be asking themselves what returns to expect in the new packaging. More specifically, will the BDC really be able to maintain – under a new name,ticker, format and strategy – the $0.40 annual dividend that is the current running rate and which the new External Manager is protecting with fee waivers over the next 12 months. However, a year will go by in a flash and where will recurring earnings and distributions be then ? Our initial estimate has not been encouraging but the BDC Reporter is the first to admit there’s a lot we don’t yet know about the new KCAP and are eager to learn more. As with FSK – albeit for different reasons – we are concerned that future performance may be underwhelming, but we’re keeping an open mind and looking forward to whatever reveals there are in store.

Markets: As we’ve been noting on our Twitter feed daily – and often in real time – the BDC sector and individual stocks have been breaking various price records as the rally that began Christmas Eve rumbles on. This is no time to get complacent – which is easy to do nine weeks in and with little in jolting pullbacks to keep investors wary. Immersed as we might get in new BDC facts and figures, the BDC Reporter will be watching to see how the general level of the sector moves, using the Wells Fargo BDC Index (closed Friday at 2,681.53) and the UBS Exchange Traded Note with the ticker BDCS (closed Friday at $20.225) as our rough and ready guides. We’ll also be poring over our own multiple data points for the 45 public BDCs out there, which we discuss every week-end in our Market Recap, but which we also lean on day by day for a sense of market confidence and direction. Will we see new sector and individual highs, or some sort of plateau or some sort of meaningful drop (which we define as a sequential downward move on BDCS of at least 3.0%) ? Of course, we don’t know but after such a sharp upward spike in prices – and so broad based – investors have to be wary. By the way, what happens – or does not – at FSK is likely to play a large part in any short term sector movements. Size counts in an industry with many minnows and a relatively small number of heavyweights like FSK. A disproportionate number of those larger BDCs will be reporting this week: TCG BDC (CGBD), Bain Specialty Finance (BCSF); Main Street Capital (MAIN); Barings BDC (BBDC); New Mountain Finance (NMFC) and BlackRock TCP Capital  (TCPC).  For our part – and to keep readers apprised – we’ll be sharing our very first reactions on our Twitter feed (where we’re already getting tens of thousands of “impressions” a month)  as results are first printed. However, we’ve found that reading the regulatory filing and listening to the Conference Call – and doing some additional digging and analysis – can often change our initial view. Our Premium subscribers will be receiving our more considered views once all the data is in, if we can possibly keep up. A full fledged dissection of each BDC’s credit portfolio will take a little longer.

Capital Markets: In last week’s Preview, we led with the expectations that one or more BDCs would be tapping the debt or equity markets. Of course, all we heard was that OCSL would be repaying one of its 3 unsecured debt issues with its Revolver and planned to redeem another one later. We don’t have spies in the corridors of Wall Street so we can’t really tell when a BDC might come calling for more capital. However – after what we’ve heard on the Conference Calls this earnings season from BDC managers – we have no doubt that balance sheets will shortly be changing, absent one of those unexpected downturns the markets are so infamous for. Virtually all the BDCs out there have Big Plans – admittedly sometimes years out – thanks to the SBCAA and a still active secondary common stock and unsecured debt market. Then there’s the prospect – discussed on a couple of Conference Calls – of further changes in the regulatory environment (that lobbying of Washington may literally pay dividends) that might broaden the BDC shareholder base. This week we won’t predict any particular capital market activity, but if one or more do occur we’ll not be surprised and will still expect more. Those BDC models analysts and investors like to tweak constantly are likely to be changing some more.

Medley Group: We’ve had a few quiet days where the Medley Capital (MCC) merger into Sierra Income, along with Medley Management (MDLY) is concerned.  All the protagonists took a week off from public disputes, but nothing is resolved and nothing is for certain. As we complete this Preview a little later than we should, we notice that Institutional Shareholder Services (ISS) has weighed in again on the subject. So we can say with complete confidence in this regard that there will be more “sturm und drang” this week, with the shareholder vote two weeks away. We are keeping an eye – as always – on the stock price of MCC and MDLY as a guide to market expectations of this deal going through. We’ve also taken to reviewing the price of MDLY’s two Baby Bonds (MDLQ and MDLX). If those debt prices are headed down – which they have been for weeks – you can be pretty sure the market is not optimistic about the merger going through. And vice versa. See the chart below:

For our part, we believe there is an interesting opportunity for speculators in both these Baby Bonds even if the merger is nixed. The emphasis, though, is on speculation. That’s a subject for another time.

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