This article begins as an up-to-date analysis of what Apollo Investment’s (AINV) balance sheet might look like when IQ 2020 results are published in light of the rapid drop in asset values brought on by Covid-19. Spoiler alert: the numbers and conclusions we came to are pretty dire. However, AINV is far from the worst BDC. In fact – as we wrote the article – we realized that the dark outlook we foresaw for AINV would apply not only to the BDC sector – our bread and butter – but to the leveraged lending industry as a whole. With that in mind, we segue in this article into suggesting some actions that Wall Street could employ to save us all from potentially devastating consequences. With the bit between our teeth, we have also outlined quite specifically how the Federal Reserve – increasingly playing an all-purpose role as the savior of the U.S. economy in the absence of good ideas out of Washington – could step in and save the day. We recognize the chutzpah of the BDC Reporter – with our few thousand subscribers – pontificating on this scale. We have no illusion that Chairman Powell or President Trump or even the leadership at the larger asset managers will be poring over our screed. However, we do have a large number of subscribers (you know who you are) sitting pretty high in the hierarchy of American finance. We offer this article up – like a message in a bottle set afloat from a deserted island on stormy seas- with the hope that some of the ideas herein might find their way to those in the corridors of power,  because there’s still time to save American business and finance from what could be a disaster.

First Step

We’re beginning to assess every public BDC in turn in light of the new conditions brought on by the Covid-19 virus.

As we wrote in a “thought piece” back on March 18, 2020,  everything that we’d taken for granted in the BDC sector for years has been up-ended and in a very short period by the new economic and market conditions that have no parallel in living memory.

At the BDC Reporter, we’ve begun the arduous and imperfect process of seeking to estimate how the disruption in the credit markets will play out on the books of the 45 BDCs we track.

We want to calculate how that will affect the key factors that every BDC observer is concerned about: earnings, book value, dividend, credit quality and so on.

Most immediately, with one a half weeks to go in the quarter and 6 weeks till the first results are reported, we’re seeking to project what might happen to portfolio and book value as of March 31, 2020 and the resulting consequences on each participant’s path forward into the unknown.

Begin At The Very Beginning

We begin alphabetically  –  with one of the oldest and larger BDCs – Apollo Investment (AINV :

Book Value

At 12/31/2019,  AINV had $3.0 bn portfolio assets at FMV. 78% were in the form of first lien debt, 14% in second lien and the remaining 8% in structured products; preferred, common and warrants.

We reviewed the entire portfolio – spot checking values of select loans against market prices or estimates on Advantage Data.

Moreover, we searched out the latest news development on select names.

However, in many cases, we had to use common sense and historical precedent to value individual assets.

We applied – based on market prices at 3/20/2020 – a 20% discount to first lien, 30% to second lien and 50% to the remainder.

Footnotes

Potential additional downside exists at Merx Financial – the aircraft leasing firm – to which AINV has lent $305mn in first lien debt – but which is structurally subordinated to secured loans against aircraft.

Should there be a broad industry-wide repossession of assets by secured lenders, Merx would be at risk of losing the first lien debt and the $58mn of equity at FMV in the company.

Clearly – and given that AINV is in control – the debt and equity could be marked much higher than our number, and only time will tell how that plays out. Given the size of the exposure, Merx deserves special mention.

However, we’ve not provided for any of that in our numbers.

Lack Of Energy

Also worth mentioning is AINV’s investment in oil explorer SHD Oil & Gas, which includes $87mn in senior debt, and two tranches of which are carried at par, while a third tranche was written down by two-thirds.

The entire $87mn in debt outstanding at FMV might be written down by more than the standard 20% being used in our calculations.

Bottom Lining

By applying the discounts mentioned above AINV’s overall portfolio fair market value is projected to drop ($710mn).

With 66.545mn shares outstanding, that’s ($10.7) per share, and would bring AINV’s NAV Per Share to $7.7.  

It goes without saying this is but an approximation to help us evaluate the knock-on impacts on the BDC from the decline in asset values.

Assuming a $($710mn) drop in portfolio assets at March 31, 2020, total portfolio assets would drop to  $2.3bn.

Debt – in this proforma calculation – remains at $1.8bn.

GAAP equity – which was $1.216bn- drops to $0.510mn. 

Consequences

Not to be preachy but this underscores the very great risks BDCs like AINV took “leveraging up” in recent quarters.

The BDC increased AUM 32% since March 2018 and debt by 126%.

Now, “asset coverage” of debt – that key metric which determines if a BDC is allowed to make distributions or borrow additional funds – will be reduced to 127%, well below the 150% requirement.

Debt to equity, thanks to the effect of FMV losses on both the asset and equity level because of the magic of fair market value accounting, rises to 3.5x.

At 12/31/2019 that metric was 1.43x.

Liquidity

At 12/31/2019 AINV had $36mn in cash on its balance sheet.

Coincidentally or otherwise, that’s equal to a quarter’s worth of the BDC’s expenses.

On paper AINV had $263mn of unused availability at year end 2019 under its only Revolver, and $1.44bn outstanding.

Tripped

Unfortunately, based on the drop in asset value and the covenants in the Revolver, AINV is likely to be in default under its loan agreement, and no draw may be allowed. 

The current effective advance rate in this pro-forma calculation of debt outstanding versus portfolio assets at FMV is 64%, so it’s unlikely lenders would be keen to make further advances, but we are speculating.

Of course – and very likely – AINV may have received some repayments either before the crisis or after and that those exceeded any new loans.

That might have improved debt to asset ratios but is unlikely to be material.

Back To The Conference Room

We’d surmise – and all the above is surmise and should be treated as such by readers who should draw their own conclusions – AINV will have to work closely with its lending group in the quarters ahead to renegotiate and restructure its Revolver.

The bankers will want to see debt to portfolio assets drop, which will stress the BDC’s liquidity as repayments or sales of assets will be likely applied to reduce borrowings and will not be available for re-drawing.

It’s at times like this that BDCs will wish to have funded themselves exclusively with unsecured debt.

On the other hand lenders have been flexible in the past and given BDC debt values time to bounce back – which most will  in most every possible big picture scenario.

The likely result is that lenders will require AINV distributions to be suspended or paid in the maximum amount of paper (i.e. additional shares ) as allowed by the BDC regulations.

That’s the path much smaller but equally constrained Great Elm Corporation (GECC) took this week when announcing its next distribution.

As a result, we expect a major cut in the amount and the form of AINV’s next distribution from the $0.45 announced for the IQ 2020.

That will save some cash from flowing out of the BDC.

Cost Cutting

Also AINV’s external manager may waive/defer some portion of its management fee, which cost $10.3mn in the IVQ 2019 but will amount to $8.5mn or so in the IQ 2020.

There is no Incentive Fee to suspend or waive as AINV was already not paying anything to its manager as of the IVQ 2019. 

Initially these measures will only marginally improve liquidity or the borrowing base default that we assume will have occurred with the Revolver, but will allow the BDC more readily to pay its remaining bills – interest and operating costs.

This week, AINV  suddenly announced the suspension of its vigorous stock buyback program, presumably in an early effort to conserve cash and (we’re guessing) please its lenders by not shipping funds out of the BDC.

Shifting

Given that these are extraordinary times, we’ll switch from our analytical mode to suggest how the liquidity and covenant crisis at AINV that we’re anticipating might be resolved in the short term, giving the market and the BDC to return to “normal”.

“Normal” is defined as a state where the outlook for economic conditions is  clearer – even if negative – and markets are able to evaluate the creditworthiness or otherwise of every loan with greater confidence than currently. 

The BDC Reporter would suggest that AINV’s eponymous external manager  -Apollo Global  – which has earned hundreds of millions of dollars in fees in the past from the management of its public and non-traded BDCs and hopes to in the future – step forward in a meaningful way.

That could include the guaranteeing of the Revolver debt: a little bit like when creditworthy parents co-sign on their less creditworthy children’s mortgage.

Or,  Apollo Global could lend- on  an unsecured basis and junior in the capital structure – a sufficient amount of new debt sufficient to bring Revolver advances reasonably within borrowing base standards.

Measures like those could happen quickly and bring back AINV to solvency and be removed when and if the situation resolves itself. 

Changing Times

In the past the sorts of assets that are sitting on the books of AINV and most other BDCs would have been owned by the major and regional banks.

Now that risk has been transferred to the non-bank sector to a large degree, and many of the large asset managers bear some responsibility for having strongly encouraged a short sighted Trump Administration and financially unsophisticated Congress to allow the passage – in the dead of night and with little public discourse –  of the Small Business Credit Availability Act (“SBCAA”).

That has removed most of the risk from the banking sector but has left BDC investors – both retail and institutional – holding a bag that has no Fed standing in the background to bail them out of, as would have been the case if the banks were involved.

Shoulder

That role should now shift to the huge asset managers,  who now own 80%-90% of all BDC assets and which earn somewhere between $2.0bn-$3.0bn in annual management fees, incentive fees, capital gain fees and overhead allocations from the public and non-traded BDC sector. 

Shareholders of AINV – and the many other BDCs that are in this position or worse – should at least put the question to their BDC senior managers, most of whom are some of the most highly placed executives at the asset management giants which control the BDCs. 

This is not a matter of altruism or patriotic duty (if that’s still a guiding element in Wall Street these days) but of long term self interest.

If BDCs – like AINV- are left to struggle for months or years digging itself out of this hole, or if bankruptcies occur in the sector to keep lenders from taking control of portfolio assets in an effort to limit their losses, the damage to the industry’s reputation – just as AUM was growing and BDCs were becoming mainstream – could be enormous.

AUM will drop; new capital raises will become very hard to come by; secured and unsecured lenders will walk away or raise the cost of capital and – most worrying of all for the asset managers – fee income will tumble. 

This is a business where manager compensation is closely tied to AUM and should that drop 30%-50% as BDCs sell off assets over time to stay solvent; pay dividends with more stock thus leaving shareholders with phantom income etc. the earnings power of the asset managers will drop profoundly if they cross their arms and refuse to assist the funds under their control.

In turn that could impact the earnings, stock price and reputation of the many, many asset management firms that have gone public in recent years.

Be Consistent

 If you’re going to tell investors that BDCs are an investment opportunity because they’re displacing banks in leveraged lending – the key elevator pitch in every BDC prospectus for the last several years – then someone has to play the role of the Fed when the system fails.

Clearly that role SHOULD be filled by the asset manager parents.

If they will not – or cannot (we’re not sufficiently versed in the parents financial standing to know if they have the capacity to stand up and be counted) – both investors and the Powers-That-Should-Be in government should rethink our current arrangements.

Next On The List

In the here and now, should there not be meaningful support from BDC managers (fee waivers do not count as sufficient to make the grade), we’ll be interested to see if the Fed itself – already taking actions way beyond its historical role, might step in.

There are very good reasons why they should.

Left to their own devices – and barring a sudden snapback in asset values – most every BDC will be a seller in a market with no buyers as virtually all credit groups except the lucky few sitting on cash will be in the same predicament.

Even willing lenders/buyers will be moving slowly to advance capital given the unprecedented uncertainty about the future of the global economy.

That will only cause assets to drop further in value across the private credit industry in line with the immutable laws of supply and demand. 

This is what a “credit crunch” looks like.

Downhill

Compound that with the likelihood that many borrowers will have a hard time making debt service payments as the months go by, a snowball of ever lower private and public company values and increasing defaults could occur.

That brings prolonged unemployment; a huge drop in GDP; disruptions in economic activity and – not to sound too much like a politician – threats to our national security as many companies in key industries (energy ; defense; healthcare; technology) begin to fail. 

There’s an eerie parallel here to the Covid-19 situation.

Act decisively early enough and a bad situation can be managed, mitigated and returned to normal state in a reasonable period.

Do nothing and we could face a downturn like nothing we’ve faced before.

Fair Point

We understand that like the airlines with their infamous stock buybacks that some readers may have little sympathy for highly leveraged companies funded by highly leveraged lenders.

There will be a time for a dialogue about that subject down the road.

In the here and now, though, Fed action – which would probably amount  to providing emergency lines of credit to the lenders rather than the companies themselves – could save America from a financial disaster.

Ironically – and compared with programs being implemented in Washington – the number of counterparties involved would be relatively small (probably a few thousand leveraged lenders, including the BDCs) and the amount not terribly huge. 

Getting Specific

We would suggest the Fed set up in very short order emergency lines of credit for any BDC that requests one and that would be secured by its assets.

That would allow the BDCs to draw down enough funds to pay off their secured lenders (which would protect the “favorite son” banking industry) and to have the ability to fund any borrowing requests that might occur as companies seek to refinance or expand.

That debt should be priced at a premium to market rates to give BDCs every incentive to return to borrowing unsecured or from the private sector once asset values and the economy stabilize.

In turn, BDCs should agree to distribute cash dividends sufficient only to pay taxes (50% ?) until governmental support is removed.

(Yes, we’re guided by our remembrance of how TARP worked).

We’d also suggest – but now we’re coming up against the power in Washington of Wall Street – that no external manager be allowed to charge an incentive fee until Fed monies are returned.

That would ensure – in that old fashioned wartime way – a degree of shared sacrifice between government; shareholders and managers. 

(You see kids,  a History degree is useful in finance after all).

Not So Long

Of course, we don’t know how long the economic crisis brought on by Covid-19 will last.

However, if Fed intervention occurs early enough to support leveraged lenders at this time of maximum stress, we’d expect that a program such as this could be wound up in a relatively short period, probably a year or two.

Very quickly the financial markets would take back their historic roles and business-as-usual could resume.

There’s no “moral hazard” here as this proposal will not save BDC shareholders from absorbing whatever credit losses their portfolios eventually contain (that’s the burden of investing in this area) but will keep other  deserving companies from failing unnecessarily because of a global liquidity crunch.

Not Done Yet

Then we can have a necessary dialogue about what is an appropriate amount of leverage to have at both the company and lender level and such wonky-items such as the deductibility of interest used for financings and the use of other forms of capital to finance M&A.

We’ve been intrigued for years about how preferred stock – with the ability to accrue rather than need to pay in cash at times of crisis – might be used to strengthen balance sheets.

Then there’s the question of whether fair market value accounting – where assets are ruthlessly and unrealistically written down at times like these – is the best methodology for valuing risk assets.

After all, if AINV’s portfolio assets were not carried at  FMV right now there would be no huge drop in value and no default.

Also, if all BDC debt on the books was currently unsecured, the danger of facing a default with the secured lender, and a debt acceleration would be removed.

Alternative Universe

We don’t really have to be in the dire condition that we are in, but we are.

Some lateral thinking and some good old fashioned American horse trading and we could avoid a repeat of this impending financial crisis in the future. 

CONCLUSION

On re-reading everything we’ve written and checking the AINV numbers we recognize that much of what is said flows from the premise that AINV’s book value – and most other BDCs – is going to be hammered when IQ 2020 results come out.

We accept that our numbers – and thus the severity of the crisis and the required response – may not be as severe as we presume. 

At our age we know well enough that things could go any number of ways.

Right now, the Powers-That-Be might be preparing a rescue package that will put the Marshall Plan to shame. 

Less spectacularly, maybe a bottom has been reached where asset values are concerned and the private markets will adjust enough to keep the system solvent and capital flowing appropriately.

We hope so for all our sakes.

However, if we are right – or if the situation turns even worse – the possible downside is so huge as to be unplumbable.

We’d argue that given that prospect,  waiting to see if the normal “braking system” of American capitalism will work might not be worth the risk.