KCAP Financial: First Impressions Following IVQ 2018 Earnings.
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Today, we’re beginning by republishing what we just wrote in the newsletter about KCAP Financial (KCAP) following its fourth quarter 2018 earnings release:
Own KCAP Baby Bond: Multiple portfolios
After reading KCAP Financial’s (KCAP) IVQ 2018 earnings press release, and making a first pass through the 10-K on my iPhone !) and reading the Conference Call transcript, came away under-impressed. After all, this earnings release follows the almost completed switch from an internal management structure to an external one (BC Partners making their bow); a major asset divestment (KCAP’s asset managers) and promises to maintain – for a year at least – the $0.10 a quarter distribution.
Management, though, was not able to articulate much of a vision for the soon to be renamed and rebranded KCAP. Much of what was learned about the type of assets the BDC will be booking in the future ( a few which have already been added to the portfolio) came only in response to a very fair question from KBW on the CC. We also learned in a similar fashion – but framed very vaguely – that BC Partners will be reducing CLO exposure over time. A little later this was followed by this classic quote from KCAP CEO Dayl Pearson ten years after the BDC bet most of its future on CLO investments: “We actually like the CLO business, we like CLO equities. [We] don’t think it’s necessarily the right structure to have them into [in a ?] BDC”. Management also ducked and weaved when asked about future target leverage or target returns such as ROE.
No mention was made of the future dividend policy or how KCAP is going to maintain that $0.10 quarterly payout. Admittedly, this was not a normal quarter (i.e. earnings were lower than might be expected) but Net Investment Income Per Share was $0.06, 40% below the dividend. Taxable Income Per Share seems to have been only $0.01 per share for the quarter and $0.25 for the whole year. With lower CLO income; higher one time transaction costs already noted in the IQ 2019 and the big expense of the planned redemption of KCAP’s Baby Bond in the fourth quarter of this year, not to mention increased bad debts (5 loans on non accrual) it’s hard to see how earnings can come close to covering the dividend.
Nor is leveraging up the balance sheet likely to help that much. With senior and secured debt capital costing KCAP 6.0%-7.0% all in; along with a 1.5% Management Fee and the associated operating expenses (which could be 1.0%-2.0% of assets purchased), very little in way of earnings will trickle down to KCAP shareholders. What’s more, BDC Partners have not agreed to a “look-back” provision in their compensation so if KCAP should be taking realized and unrealized losses in the future (not unlikely given that’s been the trend for several years) the Incentive Fee will still be paid. Again, that leaves less for shareholders.
Of course, this is a BDC in transition – although to what we can’t really discern – and we could be proven wrong. Our job, though, is to assess the odds and those don’t look good for short term earnings or maintaining the dividend (except by returning shareholders own capital but anybody can do that). We’ll be staying away while still holding onto our position in the Baby Bond (KCAPL), which is likely to get repaid after its “don’t redeem” date passes on September 30, 2019. Or we might sell out and take our (modest) profit and run. The market, which has been running up the price for weeks – excited about that one time payment for the management rights coming later in the quarter – seems to be having its first doubts too. The stock price is down (2.58%) intra-day at time of writing to $3.56. Till we get better transparency (the 10-K does not even include the portfolio listing for the JV) and a clearer picture of the upside – if any – we’ll stay on the sidelines. That was the same conclusion last time we dug into KCAP.
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