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Saratoga Investment: Issues New Baby Bond

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NEWS

On June 17, 2020 Saratoga Investment (SAR) priced an underwritten public offering of $37.5 million in aggregate principal amount of 7.25% unsecured notes due 2025 (the “Notes”). 

The Notes will mature on June 30, 2025, and may be redeemed in whole or in part at any time or from time to time at SAR’s option on or after June 24, 2022.

Interest will be paid quarterly on February 28, May 31, August 31 and November 30 of each year, beginning August 31, 2020.

The offering is expected to close on June 24, 2020.

The Company has granted the underwriters an option to purchase up to an additional $5.625 million in aggregate principal amount of Notes.

The Notes are expected to be listed on the New York Stock Exchange and to trade thereon within 30 days of the original issue date under the trading symbol “SAC”.

The full press release is attached below and the full pricing term sheet.


ANALYSIS

Purpose

We will review how the new Baby Bond fits within SAR’s liability management and liquidity; and assess the impact on earnings that might follow.

Furthermore, we’ll seek to ascertain what the BDC’s unsecured debt raise might mean for the sector as a whole.

Balance Sheet

At March 31, 2020 all SAR’s outstanding debt was fixed rate and unsecured in nature.

The BDC’s SBIC subsidiary (SBIC LP) has $150mn in debentures outstanding, and $75mn in equity capital invested therein.

In addition, the BDC was recently approved for a new SBIC subsidiary (SBIC II).

Initially SAR has funded SBIC II with $50mn of equity capital, but has not yet issued any new debentures.

Eventually SBIC II will be allowed to issue $175mn of SBIC debentures in a phased progression.

Technically, only $100mn of debentures are issuable at this stage.

Private Debt

In addition, SAR has a $60mn  issue of Baby Bonds maturing in 2025, with a yield of 6.25%.

Finally, SAR has a $45.0 secured borrowing facility with Madison Capital.

At February 29, 2020 there were no outstandings under the secured revolver but the borrowing base was $35.6mn.

However, the availability is based on SAR’s 10-Q from the prior period.

As a result, the upcoming borrowing base may be substantially lower.

We estimate gross availability may be below $30mn.

Historically SAR – for whatever reason – has drawn on the secured Revolver , which dates back to 2010, very sparingly.

In The Till

The BDC had $25mn in unrestricted cash and $15mn in cash in reserve accounts at February 29, 2020.

Of this cash SAR revealed on its conference call that “we used $26.4 million to originate net new or follow-on investments since quarter end”.

Asset Coverage

Total debt outstanding was $210mn at fiscal year end, compared with total portfolio assets and cash of $526mn.

As a result “asset coverage” of debt was 250%.

Debt To Equity

Net assets were $304mn in this period, meaning that net debt to equity was 0.56x.

On a regulatory basis, debt to equity (leaving out cash) was only 0.20x.

The new unsecured notes – if the underwriters option is exercised – will be $43.1mn before costs and bring total regulatory debt to $103.1mn.

Regulatory debt to equity will be 0.34x, and net debt to equity on a GAAP basis will be 0.70x.

Clearly SAR will not be “highly leveraged” either on a regulatory or GAAP basis.

Liquidity

The new capital raised will initially sit as cash on the balance sheet as there is no Revolver outstanding to pay down.

At this stage we doubt any funds will be diverted to fund the rest of the equity commitment for SBIC II as the first round of debentures remains undrawn.

This suggests the proceeds will be used to fund additional advances to existing portfolio companies or for new investments.

It’s also possible the capital will be used to support the BDC’s CLO in some form.

In any case, this will be a boost for SAR’s liquidity, which we’ve only rated as FAIR until now.

Despite all that POTENTIAL ability to issue debentures under SBIC II, we’ve seen that SAR has used up most of its cash and unused availability under the Revolver is modest.

This additional $43mn is causing us to change our Liquidity Rating to GOOD.

See the BDC: Nav Change Table

Earnings

Given the expensive nature of the new unsecured debt – and that SAR’s portfolio yield averages 9.3% – we don’t expect any new assets to be accretive to EPS.

Any incremental investment assets – even if on richer spreads than before – will see any additional investment income eaten up with interest expense, management and incentive fees and costs.


VIEWS

Bravo 

It’s a notable achievement for SAR to be the first BDC to be able to tap the public fixed income market since the onset of Covid-19.

Moreover, the move definitely improves SAR’s liquidity position at a time when that is very important, and still leaves the BDC far from breaching any regulatory leverage limit.

No Gain

However, the high interest rate being charged the BDC will negatively impact earnings till the funds are deployed and provide no material increase in EPS in the medium term.

Hard To Determine

We wonder if the capital is being raised to allow SAR to be defensive and make up for projected shortfalls or to take advantage of the new investing environment.

Or, put another way, did SAR want to raise this capital or have to ?

Management has been very conservative since Covid-19 began about preparing for what might be coming down the road.

Controversially – and unlike most of its well performing peers – SAR suspended its dividend entirely.

Was that step – and this latest capital raise – an excess of caution and an attempt to take advantage of better investing conditions going forward ?

Or are there weaknesses in SAR’s investments which management fears could be highly destructive and these are protective measures.

We don’t know the answer but the Baby Bond issuance has not put those concerns to bed.

The release of the next quarter’s financial results (through the end of May) will be very revealing.

Big Picture

From a broader BDC perspective, SAR has shown that the market remains receptive to unsecured debt issues by smaller BDCs.

This will be encouraging news for the 30 BDCs with portfolio sizes under $1.0bn who have become the main issuers of public debt.

On the other hand, we are a long way from the beginning of the year when new unsecured debt for the lower tier BDCs was being raised at yields well below 6.0%.

Although both floating and fixed rates have dropped to record lows, the risk spreads for BDC debt remains very high.

Too high for many BDCs without any immediate need for the capital.

Nonetheless, we wouldn’t be surprised to see a trickle of new Baby Bond issuance in the weeks ahead.

For the moment, though, we’ll be adding SAC to the BDC Fixed Income Table: the 43rd public debt issue outstanding.

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