BDCs

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OUR VIEW

Ares Capital (ARCC) is a granddaddy of the BDC sector – launched in 2004 – and the largest player in terms of assets under management, starting with a mere billion and now fourteen times as large. You don’t get so big for so long without doing most things right. Along the way the BDC acquired its two largest competitors  when they zigged into a ditch and ARCC zagged. Through the years the management; the business strategy and the liability management has been remarkably stable. Notably, ARCC pioneered joint venturing with moneyed partners – first GE and now an AIG affiliate – and has been very effective funding itself with an admixture of secured and unsecured debt. Given its size, the BDC necessarily lends into the upper middle or large cap borrower market, typically as lead lender and is able to syndicate out portions to third party lenders or to other Ares Management credit funds. There have been misfires or damp squids along the way. There was a push into venture debt and then a strategic retreat. Project finance has not amounted to much. Once in a while there are big individual credit losses. No one’s perfect in credit whatever you might hear. There was that painful break-up with GE…Through it all, the BDC has managed to maintain very stable earnings and distributions. There was a brief period during the Great Recession where the payout was reduced but that didn’t last long. In fact, the quarterly ARCC dividend today is not much different than in 2006. Nonetheless, the BDC – by its own admittance – is spooked by the ramifications of the Covid-19 crisis and has been quick to boost its liquidity and reset its strategic expectations. ARCC has plenty of cash and unused revolver availability – even if borrowing bases shrink in the months ahead – and the ability to sell assets to its IHAM subsidiary if need be. Leverage is moderate and access to the debt markets remains wide open. What we don’t know – and even ARCC itself is uncertain – is just how many of the hundreds of borrowers on the books will stumble or fail in 2020-2021. We don’t expect to see ARCC resuming its asset growth trajectory till that becomes clearer, but the BDC has the resources to play both defense and offense. For our part, we are currently assuming the distribution will drop by a tenth from the current level, similar to what happened the last time we had a recession. After all, there will be credit losses and there may not be a glorious acquisition or two as in the past to boost long term earnings. Nonetheless, we – and a good deal of individual and institutional investors – feel we’re in good hands with ARCC at this difficult and dangerous time in BDC history.

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OUR VIEW

Once upon a time PennantPark Investment (PNNT) was one of the most stable BDCs out there. Launched in 2007, PNNT worked its way through the Great Recession without cutting or suspending its dividend by keeping credit losses remarkably low, a fact which management mentions on every conference call to this day. Then the BDC made a major mis-step, investing heavily in energy loans which began to go sour in 2014 on. Rather than write those loans off and ride on, PPNT chose to convert debt to equity or get paid in PIK and advance more monies on the understandable hope that what goes down will eventually come up. Any reader will know that has not happened. Management sought to shift its investing generally to lower risk, lower return investments and reduce – even outside energy – its proportion of non income producing investments. That’s been partly successful but portfolios are hard to reset even over a period of years, and the new approach shaved down earnings. Market-wise, PNNT has found itself lending into very different segments: a few big energy investments; a slew of smaller companies financed by an SBIC license; middle market borrowers for those safer first lien loans and upper middle market borrowers for higher yielding but hopefully good risk second yield loans. That’s a bit of a potpourri and not everyone’s cup of tea. The BDC’s dividend paying capability – which used to be so solid – has taken it on the chin with two reductions since 2016 bringing the payout more than 50% down, most recently to $0.12 a quarter. Book value is down a third or more from the Good Old Days and debt to equity is one of the highest out of there when private and SBIC debt is totted up. Two-thirds of assets are financed with debt, but those assets are still dropping in value.  Management remains eternally optimistic, planning on a new SBIC license given that the SBA has already given a “Green Light” and planning some sort of off balance sheet joint venture just when many other BDCs are heading in the other direction.  Near-term, thanks to Covid-19 the BDC faces a host of challenges including renewed pressure on its equity and other investments;  tightened liquidity; very high leverage and a stock price trading at such a deep discount that even an equity raise below NAV would hardly help. We don’t have much hope that a new SBIC license or JV will happen any time soon and offer any earnings solace. Most likely, management will have to shrink the portfolio to keep liquidity OK and leverage within the rules and that will pressure earnings, as will any non accruals that might come along. The analysts are projecting earnings through the medium term sufficient to cover the new dividend level, but we’re less optimistic.  For our purposes, we’re assuming another one-third haircut of the dividend in 2021. Could matters get even worse ? Notwithstanding its august history and well regarded team, it’s not impossible. For the moment, though, we expect that PNNT will spend the next year just trying to survive, but won’t actually be at risk of going out of business or being bought out or liquidated. With all those uncertainties and despite a juicy dividend yield still being paid in cash, we’re staying away from PNNT. If we were halfway convinced that the drop in earnings and book value was over, or even that the current dividend was sustainable, we’d be buyers in a New York minute, but we’re not there.

Click here for Expected Return calculation.

(June 12,2020)

PROFILE

If Oxford Square was a cat, the BDC would be on its third life. After starting off as TICC Capital in 2003 as a technology lender and failing miserably just before the Great Recession; OXSQ took a hard right and began investing in CLO equity at just the right time, when everyone else was leaving the building. Then in 2015, the manager sought to sell off the investment advisory contract to another asset manager and ignited a firestorm that lasted till September 2016 when dissident shareholders failed to wrest the advisory contract away from the managers, but spiked the original sale. Management then doubled down on its CLO-centric investment strategy, only months after claiming the approach was not appropriate within a BDC wrapper. In 2018, even the name was changed- TICC was out and Oxford Square was in – eerily similar to its sister public closed end fund, which is 100% CLO focused, Oxford Lane Capital. Along the way, management appears to have lost analyst coverage, and Conference Calls tend to be defensive affairs. Instead OXSQ appears to be reaching out to the individual investor market, most recently switching to monthly distributions – popular with the retail crowd. Net asset value has also been lost over the years: more than half of par capital written down or written off. NAV Per Share has dropped three quarters in a row. That’s the price investors pay for the high current yields thrown off by CLO equity stakes. GAAP earnings run below the $0.80 annual distribution and have since the pay-out was cut back in 2016. Adopting the higher leverage levels allowed by the Small Business Credit Availability Act might help OXSQ dodge the prospect of cutting its dividend in the short run, but that greater portfolio and higher debt could result in even greater losses down the road as CLO price volatility remains very high – as a vehicle leveraged 10x-14x should be. Admittedly, this management team knows the CLO market inside and out, but is CLO-investing the square peg in the BDC format round hole ? All these years after the BDC made that hard right, the jury is still out.

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PROFILE

HISTORY

Incorporated in Delaware on April 13, 2005 and commenced operations with private funding on July 25, 2005, and completed initial public offering on July 2, 2007. Externally managed and elected to be regulated as a BDC under the 1940 Act.

LATEST

At September 30, 2018, portfolio of $780.6 million (at fair value) consisted of 28 portfolio companies and was invested 46% in senior secured loans, 21% in unsecured or subordinated debt securities, 30% in equity investments, and 3% in senior secured notes.The weighted average yield of the debt and income producing equity securities at fair value was 11.2%.

PORTFOLIO AND INVESTMENT ACTIVITY

IVQ 2017 Earnings Release:

“As of December 31, 2017, our portfolio totaled $739.4 million and consisted of $619.3 million of first lien secured debt, $39.9 million of second lien secured debt, $45.4 million of subordinated debt (of which $42.7 million was invested in PSSL) and $34.8 million of preferred and common equity (of which $19.1 million was invested in PSSL). Our debt portfolio consisted of 99% variable-rate investments (including 4% where London Interbank Offered Rate, or LIBOR, was below the floor) and 1% fixed-rate investments. As of December 31, 2017, we had one company on non-accrual, representing 0.4% and 0.2% of our overall portfolio on a cost and fair value basis, respectively. Overall, the portfolio had net unrealized appreciation of $5.6 million. Our overall portfolio consisted of 84 companies with an average investment size of $8.8 million, had a weighted average yield on debt investments of 8.3%, and was invested 84% in first lien secured debt, 5% in second lien secured debt, 6% in subordinated debt (of which 6% was invested in PSSL) and 5% in preferred and common equity (of which 3% was invested in PSSL). As of December 31, 2017, all of the investments held in PSSL were first lien secured debt”.

Horizon Technology Finance (HRZN) is one of three BDCs focused on the so-called venture debt market, alongside Hercules Technology (HTGC) and Triple Point Venture Growth (TPVG).  HRZN went public back in 2010, but had a hard time getting going for a number of years. Early on, the BDC was rejected for an SBIC license and has had to fund itself in the more expensive private debt markets ever since. At the end of 2017 total assets had not moved much – if at all – from the level of seven years before. Nor has the dividend fared well, cut from a $1.80 annual pace to $1.20 currently, a third down. Realized Losses of one kind or another have eroded equity capital raised by 25%. Net Asset Value was at $11.64 at year end 2018, down from $16.75 at the close of 2010. The stock price, which traded as high as $17.00 in the early days has dropped as low as $9.04. However, the BDC has been on a rebound for some time now; weeding out or writing off bad loans made; growing the portfolio size and increasing earnings to exceed the current dividend. A joint venture formed in mid-2018 with Arena Sunset SPV promises to add one more pocket in which loans can be dropped, along with the higher leverage allowed under the Small Business Credit Availability Act will allow balance sheet assets to grow a little further, on what is already a highly leveraged business. Outside of the JV, debt to equity is already close to 1:1. The market has taken note of late, allowing HRZN to raise fresh equity capital in March 2019 at $12.14 a share. Now the BDC’s challenge is to maintain this recent asset growth without absorbing material debt or equity losses. In fact, HRZN has to show that the many investments in equity and warrants in these technology and life sciences companies can generate some meaningful  capital gains over time and offset  loans that go bad. In this regard, HRZN’s track record has not been so great. Is the problem just the nature of the market for this type of asset that doesn’t allow for material net gains, or is it management’s fault – choosing the wrong horses to ride ? This could work out well for HRZN and its shareholders if all goes well. After all, the yields on these venture debt loans are the highest in the BDC sector. That might help to maintain or even increase the regular distribution down the road. On the other hand when you’re talking investment yields in the mid-teens above average risk – sooner or later – will follow. The BDC is highly leveraged and is going higher, so watch out below if the Indian Summer of HRZN should come to an end for any reason. Some investors will say “once bitten, twice shy”, others will be willing to give management the benefit of the doubt.

NEWS

8/5/2019: Prices On Balance Sheet CLO Financing.

We add to the Twitter feed.

7/30/2019: Files IIQ 2019 10-Q

• Net investment income of $5.0 million, or $0.37 per share. Total investment portfolio of $274.8 million as of June 30, 2019. Net asset value of $157.1 million, or $11.60 per share, as of June 30, 2019. Held portfolio of warrant and equity positions in 74 companies as of June 30, 2019. Subsequent to quarter end, declared monthly distributions of $0.10 per share.

NAV at 6-30-2016: $14.11