BDCs Behaving Badly: Part 2

The following information is from the recent MRCC Pricing and Projections report previously provided to subscribers of Premium BDC Reports along with target prices, dividend coverage and risk profile rankings, earnings/dividend projections, quality of management, fee agreements, and my personal positions for all Business Development Companies (“BDCs”).

Please see “BDCs Behaving Badly: Part 1” which discussed FSK and FSKR.


 


Monroe Capital (MRCC) Update

  • During Q4 2020, there was a meaningful increase in the amount of PIK income from 12.8% to 33.4% of interest income.
  • This is typically a sign that portfolio companies are not able to pay interest expense in cash and could imply potential credit issues over the coming quarters.
  • Q4 2020 earnings would have been around $0.196 per share without the benefit of fee waivers covering 79% of the quarterly dividend which is down from 85% in Q3 2020.
  • Dividend coverage should improve as the company benefits from a full quarter of interest income from new investments and reduced borrowing costs due to the redemption of its Baby Bond (MRCCL).
  • MRCC is trading below NAV yielding 10.4% for a reason.

There are many factors to take into account when assessing dividend coverage for BDCs including portfolio credit quality, potential portfolio growth using leverage, fee structures including ‘total return hurdles’ taking into account capital losses, changes to portfolio yields, borrowing rates, the amount of non-recurring and non-cash income including payment-in-kind (“PIK”). During Q4 2020, there was a meaningful increase in the amount of PIK income from 12.8% to 33.4% of interest income. It should be noted that most BDCs have between 2% to 8% PIK income and I start to pay close attention once it is over ~5% of interest income.

This is typically a sign that portfolio companies are not able to pay interest expense in cash and could imply potential credit issues over the coming quarters. New investments during Q4 2020 were mostly near the end of the quarter so the company did not benefit from a full quarter of interest income for those investments. However, the total amount of PIK interest income increased 135% from $1.6 million in Q3 2020 to $3.7 million in Q4 2020 and could result in an eventual downgrade to ‘Level 3’ or ‘Level 4’ dividend coverage especially if there is another round of credit issues.

Management discussed this on the recent call and mentioned that $1 million was related to onetime activity which doesn’t account for the entire increase and there will still be a very large portion of PIK income:

“some of this is — I would consider about $1 million of this to be what I would consider non-reoccurring, sort of onetime PIK interest that we got in connection with some restructuring activities. So, we did like, for example, we did a restructuring that was very favorable on Familia, where we refinanced out a significant portion of our debt and got some PIK interest as a result and then took back considerable amount of upside equity as it applied to that deal. And so, that income is not likely to reoccur. And then, on HFZ and HFZ Member RB, we did a restructuring there as well. It was also favorable. The valuations are still very strong, and we took in some PIK interest that was kind of onetime, associated with it. There is some of that interest that will recur but some will not.”

It should be noted that we heard the same conversations with the management team at Medley Capital (MCC) just before the serious credit issues hit.

For Q4 2020, earnings would have been around $0.196 per share without the benefit of fee waivers covering 79% of the quarterly dividend which is down from 85% the previous quarter. Dividend coverage should improve in Q1 2021 as the company benefits from a full quarter of interest income from new investments. Also, on March 1, 2021, MRCC repaid $28.1 million in SBA debentures, and on January 25, 2021, the company issued $130 million of 4.75% notes due 2026 using the proceeds to redeem its 5.75% Baby Bond (MRCCL) on February 18, 2021.

Chief Executive Officer Theodore L. Koenig: “We had a very active late fourth quarter, redeploying a portion of the proceeds we received from recent repayment activity into current yielding assets which should positively contribute to earnings in future quarters. We are also very pleased with the January 25, 2021 issuance of $130.0 million in senior unsecured notes at an interest rate of 4.75% per annum with a maturity date of February 15, 2026 (the “2026 Notes”). The proceeds from the 2026 Notes were used to redeem all of the outstanding 5.75% 2023 Notes and repay a portion of the outstanding revolving credit facility. This refinancing lowered our debt financing costs which should positively impact our Adjusted Net Investment Income and earnings in future quarters.”


Non-accrual investments currently account for 4.1% of the total portfolio fair value and if completely written off would impact result in a NAV per share decrease of around 10%.

“As of December 31, 2020, we had 12 borrowers with loans or preferred equity securities on non-accrual status (BLST Operating Company, LLC, California Pizza Kitchen, Inc., Curion Holdings, LLC (“Curion”), Education Corporation of America (“ECA”), Incipio, LLC (“Incipio”) last out term loan and third lien tranches, Luxury Optical Holdings Co. (“LOH”), NECB Collections, LLC, Parterre Flooring & Surface Systems, LLC, SHI Holdings, Inc., The Worth Collection, Ltd. (“Worth”), Toojay’s Management, LLC and Valudor Products, LLC preferred equity), and these investments totaled $22.3 million in fair value, or 4.1% of our total investments at fair value.”

“We are pleased to report another quarter of strong financial results. During the fourth quarter, we reported another increase in our Net Asset Value and we again fully covered our dividend with Net Investment Income. We continue to believe the vast majority of our portfolio companies have strong long-term outlooks and we have seen recovery and stabilization in many of our portfolio companies that have been impacted by the COVID-19 pandemic. As market volatility resulting from the uncertainty related to the impacts of COVID-19 continued to decline during the fourth quarter, we saw spreads continue to tighten and valuations for portfolio companies without significant long-term COVID-19 impact continue to rebound, consistent with our experience in the prior two quarters.”

Grade 3 – Includes investments performing below expectations and indicates that the investment’s risk has increased somewhat since origination. The issuer may be out of compliance with debt covenants; however, scheduled loan payments are generally not past due.

Grade 4 – Includes an issuer performing materially below expectations and indicates that the issuer’s risk has increased materially since origination. In addition to the issuer being generally out of compliance with debt covenants, scheduled loan payments may be past due (but generally not more than six months past due).

Grade 5 – Indicates that the issuer is performing substantially below expectations and the investment risk has substantially increased since origination. Most or all of the debt covenants are out of compliance or payments are substantially delinquent. Investments graded 5 are not anticipated to be repaid in full.



Full BDC Reports

This information was previously made available to subscribers of Premium BDC Reports, along with:

  • MRCC target prices and buying points
  • MRCC risk profile, potential credit issues, and overall rankings
  • MRCC dividend coverage projections and worst-case scenarios
  • Real-time changes to my personal portfolio

BDCs trade within a wide range of multiples driving higher and lower yields mostly related to portfolio credit quality and dividend coverage potential (not necessarily historical coverage). This means investors need to do their due diligence before buying.

To be a successful BDC investor:

  • Identify BDCs that fit your risk profile.
  • Establish appropriate price targets based on relative risk and returns (mostly from regular and potential special dividends).
  • As companies report results, closely monitor dividend coverage potential and portfolio credit quality.
  • Diversify your BDC portfolio with at least five companies. There are around 45 publicly traded BDCs; please be selective.

BDCs Behaving Badly: Part 1

The following information is from the recent FSK Pricing and Projections reports previously provided to subscribers of Premium BDC Reports along with target prices, dividend coverage and risk profile rankings, earnings/dividend projections, quality of management, fee agreements, and my personal positions for all Business Development Companies (“BDCs”).


 


FS KKR Capital (FSK) Update

  • Non-accruals declined to 2.5% due to restructurings/exits driving an additional $0.71/share of realized losses. FSK had a total of $4.01/share of realized losses in 2020.
  • FSK has much higher cyclical exposure including retail, capital goods, real estate, energy, and commodities that account for over 28% of the total portfolio.
  • FSK is for traders, considered higher risk due to its lower credit quality driving a 33% decline in NAV per share and two dividend reductions over the last 3 years.
  • FSK dividend coverage has been reliant on no incentive fees paid over the last 5 quarters. However, management is removing this ‘lookback’ feature in connection with the merger with FSKR.
  • FSK is trading at a 23% discount to NAV with a 12.4% yield for a reason.

During Q4 2020, total non-accruals declined from 2.9% to 2.5% the portfolio fair value due to restructuring/exiting its investments in DEI Sales Inc, Chisholm Oil & Gas, and Z Gallerie driving an additional $88 million or $0.71 per share of realized losses. If non-accruals were completely written off would impact NAV per share by around $1.39 or 5.6%. Most of the investments on non-accrual have been discussed in previous reports and management typically refers to most of them as “legacy investments”.


It should be noted that FSK had a total of $490 million or $4.01 per share of realized losses during 2020 that included the restructuring of Borden DairyFourPoint Energy, and Mood Media during Q3 2020.


FSK has much higher cyclical exposure including retail, capital goods, real estate, energy, and commodities that account for over 28% of the total portfolio. It also many of the same sector exposures in its SCJV which is over 10% of the portfolio.


As mentioned in previous updates, I will be updating the risk profiles for each BDC taking into account sector exposures. I found the following “Timeframe of Recovery of Credit Metrics to 2019 Levels” from S & P Global Ratings on February 17, 2021, to be an interesting view of the recovery prospects. I will likely take a more conservative approach when updating the risk rankings. BDCs such as FSK, FSKR, and AINV have much higher concentrations of sectors that will likely take longer to recover which is taken into account with their risk ranks and pricing.


During Q4 2020, its net asset value (“NAV”) per share reflated by 2.3% (from $24.46 to $25.02) due to unrealized gains in the portfolio and overearning the dividend.

“We were pleased to conclude 2020 with such a positive quarter. Across our BDC franchise during the fourth quarter, we originated approximately $1.9 billion of new investments, $613 million of which were within FSK. At FSK, our net investment income per share more than covered our $0.60 quarterly dividend, and our net asset value increased by 2.3% quarter over quarter. Additionally, in November we announced the proposed merger of FSK and FSKR, which would create a single BDC with approximately $16 billion in assets, and in December we accessed the public debt markets raising $1 billion in long term, unsecured capital at attractive rates. As a result, we enter 2021 with excitement regarding our prospects from both an operational and investment standpoint.”


Over the last three years, FSK’s NAV per share has declined by almost 33%.


The amount of investments with ‘Investment Rating 3 and 4’ decreased from 13% to 10% of the portfolio fair value or 23% of NAV per share and needs to be watched. ‘Investment Rating 3 and 4’ are identified as “Underperforming investment concerns about the recoverability of principal/interest and/or some loss of interest or dividend possible, but still expecting a positive return on investment”.

 


 

FSK has been covering its dividend only due to no incentive fees paid driven by the ‘total return’ hurdle and continued capital losses. The company will eventually need to start paying an incentive fee for the following quarters:

Q. “Do you know how many quarters of additional incentive fee waivers we have in front of us before they’re absorbed if we’d look back?”

A. “Probably two quarters ago now that we said we expected it to be kind of in the five to six quarter range from that period of time. Clearly in our guidance for the fourth quarter, there’s not an incentive fee. Clearly the books moved in a positive direction, too. So forgive me for not having the exact math. But hopefully, that’s maybe a bit of a bookend for you and we can also follow up offline.”

On November 24, 2020, FS/KKR Advisor, LLC announced that FSK and FS KKR Capital II (FSKR) entered into a definitive merger agreement. In connection with the merger, the board has approved an amended advisory agreement for the combined company permanently reducing its income incentive fee to 17.5% from the existing 20.0%. However, the ‘total return’ hurdle or ‘look back’ provision will be removed. FS/KKR has agreed to waive $90 million of incentive fees spread evenly over the first six quarters following the closing. This waiver equates to $15 million per quarter. It is important to note that the company would have paid almost $90 million in incentive fees over the last five quarters without the look-back provision which is almost $18 million per quarter. However, that is based on 20.0% income incentive fees compared to 17.5% but also only for FSK. The merger will double the size of the company with similar holdings and credit issues implying that the $15 million per quarter could be insufficient if there are continued/additional credit issues. FSKR’s NAV per share has declined by almost 30% over the last three years. Please see additional merger information/slides included later in this report.

On the previous earnings call management mentioned that the company might be switching a portion of its quarterly dividend to include a variable component similar to Apollo Investment (AINV) and TCG BDC, Inc. (CGBD):

“As a reminder, over the long term, we expect our dividends per share will equate to a 9% yield on our net asset value per share, but we acknowledge there will be certain quarters where our annualized yield may be greater or less than this range due to quarter-to-quarter fluctuations in the business from an operational standpoint. Obviously, our dividend policy of achieving a 9% target dividend yield on our net asset value means that over time, it would be normal for our quarterly dividend to fluctuate somewhat in concert with the quarter-to-quarter change in our net asset value.”

Q. “Should we think of this variable policy as more transitory or permanent concept?”

A. “I think it’s probably a bit of a combination of creating a sense of stability. But also, I think, understanding what this product is and what the BDC is, I think that a variable component does make some real sense to us. We think of this more as a permanent shift, rather than a transitory shift. And we think, frankly, the industry would benefit itself in the same way, not just our platform. There’s so many variables, every quarter that BDC’s deal with in terms of changing interest rate environments, changing deal environments, we’ve talked a lot about pricing a pipeline, credit quality, it’s just lots of inputs that you handle every quarter as an operator. And to have a fixed dividend over time, this becomes very difficult for all BDC. So we think having more of a floating type policy that matches NAV and creates a target yield for investors over a long sustained period of time, as we think of a more enlightened, better way to go for the industry as the industry continues to mature, frankly.”

FSK had spillover or undistributed income of around $200 million which can be used for temporary dividend coverage shortfalls only and will likely reset its dividend as needed (similar to the previous two reductions).

 



Full BDC Reports

This information was previously made available to subscribers of Premium BDC Reports, along with:

  • FSK target prices and buying points
  • FSK risk profile, potential credit issues, and overall rankings
  • FSK dividend coverage projections and worst-case scenarios
  • Real-time changes to my personal portfolio

BDCs trade within a wide range of multiples driving higher and lower yields mostly related to portfolio credit quality and dividend coverage potential (not necessarily historical coverage). This means investors need to do their due diligence before buying.

To be a successful BDC investor:

  • Identify BDCs that fit your risk profile.
  • Establish appropriate price targets based on relative risk and returns (mostly from regular and potential special dividends).
  • As companies report results, closely monitor dividend coverage potential and portfolio credit quality.
  • Diversify your BDC portfolio with at least five companies. There are around 45 publicly traded BDCs; please be selective.

 

MAIN: Remains On ‘Probation’

The following information is from the MAIN Deep Dive report previously provided to subscribers of Premium BDC Reports along with target prices, dividend coverage and risk profile rankings, earnings/dividend projections, quality of management, fee agreements, and my personal positions for all Business Development Companies (“BDCs”).



MAIN Dividend Coverage Update

On November 4, 2020, Main Street Capital (MAIN) reaffirmed its regular monthly dividend of $0.205 per share:

“Despite the negative impact of these items and the resulting level of DNII in the quarter as a result of our diversified investment portfolio, together with the advantages of our differentiated investment strategy, the increasing benefits from our asset management business, our strong investment pipeline, our efficient operating structure and alignment of interest with our shareholders, combined with our conservative capital structure and strong liquidity position, we remain comfortable with our commitment to maintaining a stable monthly dividend payment level going forward. To that end, earlier this week, our Board declared our first quarter 2021 regular monthly dividends of $0.205 per share payable in each of January, February and March, an amount that is unchanged from our monthly dividends for the fourth quarter.”

The company will likely not cover its dividend over the coming quarters partially due to lower dividend income from equity investments. However, management is expecting higher amounts over the next few quarters:

“These results reflect the continued negative impact of the pandemic on the overall economy, most specifically in the significant decrease in the amount of dividend income we realized from our equity investments and an increase in the number of investments on non-accrual status at quarter end. We remain confident that the decrease in dividend income is a temporary issue, partly due to the conservative approaches many of our portfolio companies are taking in managing their capital and liquidity in response to the pandemic. And we believe this dividend income will recover as the impacts of the pandemic subside.”

“Part of the reason we expect the dividend income to start recovering is that as we touched on our prior comments that the view that our management teams across the portfolio have about their current business conditions is significantly better today than it was couple of quarters ago. So they continue to get more comfortable, they will be more comfortable in paying out dividends as opposed to retain that as liquidity for their business. We don’t expect them to take all that liquidity that they have built over the last couple of months and pay it out in the fourth quarter, we think that they will continue to be gradual in their approach to utilizing their liquidity. So we don’t expect that it will be a one-time event, we think it will be something that will play out over the next three to four quarters as our results continue to improve and the economy overall heals and they continue to be more and more comfortable releasing some of that liquidity that they have retained over the last 6 months.”

 

 


 

I am expecting dividend coverage to improve over the coming quarters due to:

  • Increased dividend income from portfolio companies.
  • Effective October 31, 2020, MAIN became the sole adviser/manager to HMS and the company will now receive 100% of all management and incentive fees.
  • Lower non-accruals (increased interest income from restructured investments).
  • Portfolio growth (increased interest income).

All of this was recently discussed on the earnings call with management and is taken into account with the updated base and best-case projections that I will be watching closely:

Q. “I am wondering if you could just further expand upon your comments in terms of the key drivers for improving foreseeing potential improving distributable net investment income over the near-term, just curious as to potentially what kind of assumptions are being built in?”

A. “So there is a couple of drivers there. One, obviously, is the transaction that we completed through which we became the sole advisor to HMS. So we have not had that prior to 9/30 really that relationship as we announced in our press release last week starts on October 30. So, that will be a driver both in Q4, with incremental income versus Q3, but also additional benefit in Q1 as we have that benefit for the full quarter as opposed to 2 months. So, that’s one of the drivers. I think, David touched on his comments and we have given him some of our responses here to the questions, dividend income from our lower middle-market companies will be another big driver. We do expect that, that benefit or that improvement to be gradual over multiple quarters, but we are seeing improvement there. So, we expect to see that number continue to increase both in Q4 and Q1 and going forward as we continue to move forward from where we have been over the last couple of quarters. The last big driver is just the new investment activity. As we touched on, we are seeing robust activity and very attractive opportunities both in our lower middle-market business and private loans. So as we see those new investments come on in Q4 and then Q1 as well, that incremental investment income that comes from those investments will also be a key driver of that improvement.”

“Based upon the positive developments we have seen in our existing portfolio companies, coupled with the future benefits of the growth in our asset management business and the attractive new investment opportunities we are seeing in our lower middle-market and private loan strategies, we are confident that the third quarter represented the low point for our distributable net investment income, or DNII and we expect to see increases in our DNII in the fourth quarter and future quarters.”

“As we look forward to the fourth quarter, we expect that we will generate distributable net investment income of $0.53 to $0.56 per share as our results begin to recover from the impacts of the pandemic and set us on a pace and expectation to cover our monthly dividend rate with distributable net investment income over the next few quarters.”

Effective October 31, 2020, MAIN became the sole investment adviser and administrator to HMS Income Fund (“HMS”), and HMS Income changed its name to MSC Income Fund, Inc. The new advisory agreement includes a 1.75% management fee (reduced from 2.00%) and the same incentive fee calculations as under the prior advisory agreement, with the External Investment Manager receiving 100% of such fee income (increased from 50% previously).

“We are also very pleased with our recent announcement of the completion of the transaction under which we became the sole investment adviser to HMS Income Fund, which is now known as MSC Income Fund. We are excited about positioning the fund for the future, while also continuing to execute our overall strategy to grow our asset management business within our internally managed BDC structure and continuing to provide this unique benefit to our Main Street stakeholders.”

Over the last 12 months, its DNII per share has fallen by 24% mostly due to declining rates and portfolio yield, and lower dividend income. DNII was only $0.50 per share for Q3 2020 compared to dividends paid of $0.615.

 


 

If MAIN reports closer to its ‘worst-case’ Q4 2020 projections, the company will be downgraded as there is a chance that its conservative management will follow suit with GBDC and proactively reduce its monthly dividend (to over earn the dividend).

 

 

Previously, the semi-annual/supplemental dividends were covered through overearning the regular dividend and realized capital gains. However, as predicted in previous reports, the company suspended its semi-annual/supplemental dividend until dividend coverage improves. Historically, MAIN had better-than-average dividend coverage due to its many advantages over other BDCs, including the lower cost of capital and the lowest operational cost structure. Also, MAIN has an excellent history of portfolio credit quality that delivers a consistent stream of recurring interest income, the potential for increased earnings through its asset management business, the ability to use higher leverage through its SBIC licenses and management with conservative dividend policy.

“Since its October 2007 initial public offering, Main Street has periodically increased the amount of its regular monthly dividends paid per share and has never reduced its regular monthly dividend amount per share. Including all dividends declared to date, Main Street will have paid $30.22 per share in cumulative cash dividends since its October 2007 initial public offering at $15.00 per share.”

For Q3 2020, MAIN hit its base case projections with NII per share of $0.46. As mentioned earlier, distributable net investment income (“DNII”) was only $0.50 per share compared to its regular dividends of $0.615 implying 81% coverage (with DNII). The lower dividend coverage is due to lower interest rates (LIBOR) driving a lower portfolio yield as well as a meaningful decrease in dividend income from equity investments:

“Our total investment income in the third quarter decreased over the same period in 2018 to a total of $52 million primarily driven by a decrease in the dividend income due to the negative impacts from the COVID pandemic and a decrease in interest income, primarily due to lower LIBOR rates. The change in total investment income also includes a decrease of $1.3 million related to lower levels of accelerated income for certain debt investments when compared to the third quarter of last year.”

“The $8.1 million decrease in total investment income in the third quarter of 2020 from the comparable period of the prior year was principally attributable to a $4.4 million decrease in dividend income from investment portfolio equity investments, primarily resulting from the negative impacts of the COVID-19 pandemic on certain of our portfolio companies’ operating results, financial condition and liquidity and a $4.1 million decrease in interest income, which was primarily due to lower floating interest rates on investment portfolio debt investments, based upon the decline in the London Interbank Offered Rate (“LIBOR”).”

 


MAIN Risk Profile Update

Non-accrual investments increased due to adding Independent Pet Partners, Central Security Group, and California Pizza KitchenBluestem Brands and VIP Cinema were previously marked down and exited during Q3 2020. As of September 30, 2020, there were 12 investments on non-accrual status (previously 11 investments) that increased to 2.6% of the total investment portfolio at fair value (previously 1.8%) and 7.1% at cost (previously 6.3%). However, management (as well as myself) is expecting fewer non-accrual investments for Q4 2020 some of which will be restructured and put back on accrual status. MAIN has 193 portfolio companies so a certain amount on non-accrual is to be expected.

“Our current expectation is that we will reduce the number of investments on non-accrual status by 3 to 4 investments during the fourth quarter as we continue to proactively work through these non-accrual investments with management teams and financial sponsors of these companies. We do expect to have, a number of those non-accruals that we work through and would expect to see that number of decrease as we move into the fourth quarter. The negative impact of COVID-19 began to lessen and visibility improved for our portfolio of companies. As a result, we saw the general environment for our existing portfolio companies stabilized as compared to earlier this year.”


Datacom, LLC a provider of communication and data transfer technology solutions to the oil & gas exploration and production and marine industries, was added to non-accrual status during Q2 2018 and needs to be watched as the debt portions are still marked over 80% of cost. But there is a good chance that this will be one of the companies placed back on accrual status.

It is important to note that MAIN has additional investments in some of its non-accrual portfolio companies that are still on accrual and need to be watched including California Pizza Kitchen, AAC Holdings, and Independent Pet Partners:

 


Similar to Capital Southwest (CSWC), MAIN added American Addiction Centers or AAC Holdings, Inc. (AAC) to non-accrual status during Q3 2019 and has been discussed in previous reports. In June 2020, AAC filed for bankruptcy and its lenders agreed to provide the company with $62.5 million of incremental financing aimed at reducing the company’s debt and providing financial stability for long-term growth.

Its non-accrual oil/energy investments in Rocaceia, LLC (Quality Lease and Rental Holdings) previously filed for bankruptcy but has already been written off with no further impact to NAV. During Q1 2018, Access Media Holdings, a private cable operator, was placed on non-accrual status with the equity portion written off, and the debt is marked at 17% of cost which was previously converted to “payment-in-kind” (“PIK”) income and the accrued portions were deducted from Q1 2018.

American Teleconferencing Services, Ltd. (“ATS”) is an investment also held by CSWC, PFLT and SUNS that operates as a subsidiary of Premiere Global Services (“PGi”), offering conference call and group communication services. This investment remains on accrual status marked at 70% of cost (likely has improved over the recent quarter) and previously rated by Moodys as Caa2: “characterized by fundamental challenges from the high rates of decline in its legacy audio conferencing business as a result of competition from cloud-based communications and collaboration offerings.”



Full BDC Reports

This information was previously made available to subscribers of Premium BDC Reports, along with:

  • MAIN target prices and buying points
  • MAIN risk profile, potential credit issues, and overall rankings
  • MAIN dividend coverage projections and worst-case scenarios
  • Real-time changes to my personal portfolio

BDCs trade within a wide range of multiples driving higher and lower yields mostly related to portfolio credit quality and dividend coverage potential (not necessarily historical coverage). This means investors need to do their due diligence before buying.

To be a successful BDC investor:

  • Identify BDCs that fit your risk profile.
  • Establish appropriate price targets based on relative risk and returns (mostly from regular and potential special dividends).
  • As companies report results, closely monitor dividend coverage potential and portfolio credit quality.
  • Diversify your BDC portfolio with at least five companies. There are around 45 publicly traded BDCs; please be selective.

OCSL: Another Dividend Increase?

The following information is from the OCSL Deep Dive report previously provided to subscribers of Premium BDC Reports along with target prices, dividend coverage and risk profile rankings, earnings/dividend projections, quality of management, fee agreements, and my personal positions for all Business Development Companies (“BDCs”).



OCSL Distributions Update

As mentioned in the public article “Still Waiting For a Dividend Increase From Oaktree”, I have been expecting Oaktree Specialty Lending (OCSL) to increase its dividend for a while. In August 2020, the company announced an increase in the quarterly dividend from $0.090 to $0.105, and on November 19, 2020, the dividend was increased to $0.110 paid on December 31, 2020, to shareholders of record on December 15, 2020.

Armen Panossian, CEO and CIO: “Based on our consistent performance and our expectations for continued strong earnings, our board increased our quarterly dividend by 5% to $0.11 per share, the second consecutive quarter with a dividend increase. So we raised the dividend in the last two quarters and part of that was actually driven by COVID in terms of taking advantage of the investment environment COVID created to put more assets in the BDC at higher yields, which generated more income. So COVID actually was helpful in terms of the dividend for us, given the investment activity we did during that period. I think being conservative on the dividend with the view that increasing NAV is a good thing as well. So those are kind of all the things that we put into the equation as we speak to the Board and think about the dividend.”

 

On October 28, 2020, OCSL entered into an agreement to merge with OCSI and is expected to close in calendar Q1 2021. The combined company will trade under the ticker symbol “OCSL”. In connection with the merger agreement, Oaktree has agreed to waive $750,000 of base management fees payable in each of the eight quarters following the closing (please see merger slides at the end) and is taken into account with the updated projections. As shown in the ‘best case’ projections, there is the possibility of additional increases in its quarterly dividend partially due to the merger with OCSI that is expected to close in Q1 2020:

“As you know, OCSL and Oaktree Strategic Income Corporation, entered into a merger agreement with OCSL to be the surviving company. We believe this merger represents a great opportunity for shareholders of both OCSL and OCSI. We expect it will create a larger, more scaled BDC with increased trading liquidity, potentially broaden our institutional shareholder base and may improve access to lower cost sources of debt. We also anticipate that it will drive NII accretion over both the near and long-term. We feel that now is the right time to move forward with this merger. Both portfolios are in great shape and our transition out of non-core assets that we’ve been working on since 2017 is nearly complete. In terms of the next steps, we anticipate filing the N-14 during proxy statements in the coming weeks and expect the transaction will close in the first calendar quarter of 2021, subject to shareholder approval and satisfaction of other closing conditions as outlined in the merger agreements.”

 


I am also expecting improved earnings over the coming quarters through the use of higher leverage, continued rotation into higher yield investments, and higher returns from its Senior Loan Fund (“SLF JV I”):

“Leverage at the JV was 1.3 times at year-end, down slightly from the June quarter. The Kemper JV continues to present an opportunity for us to improve returns. As of year end, the JV had $82 million of investment capacity. We believe that the prudent growth of the JV will also be accretive to ROE over time.”

 


 

OCSL’s incentive fee agreement includes a “hurdle rate” of 6% (relatively low and not shareholder-friendly) is applied to “net assets” to determine “pre-incentive fee net investment income” per share before management earns its income incentive fees. As shown in the following table, the company will likely earn around $0.097 per share each quarter before paying management incentive fees covering around 89% of the recently increased dividend which is ‘math’ driven by an annual hurdle rate of 6% on equity. It is important to note that OCSL could earn less than $0.097 per share but management would not be paid an incentive fee.

 


For the three months ended September 30, 2020, OCSL beat its best-case projections due to “higher make-whole interest income, original issue discount (“OID”) acceleration, and prepayment fees” mostly related to the prepayment of NuStar Logistics.

“The increase was due mainly to higher interest income resulting from increased make-whole interest, OID acceleration and higher prepayment fees on loan payoffs. We also experienced a slightly higher average yield on our floating rate debt investments despite LIBOR being down again for the quarter. The higher make-whole interest and fee income quarter-over-quarter was mostly due to the prepayment of the NuStar loan, which generated over $8 million of nonrecurring interest income and fees.”


There was another increase in the overall portfolio yield from 8.1% to 8.3%. OCSL has covered its dividend by an average of 129% with average earnings of around $0.127 per share over the last four quarters partially due to reduced borrowing rates.

“This deliberate shift in our portfolio has led to higher yielding investments. The average yield in our new debt investments increased over the course of the year and was 10.6% for investments made in the fourth quarter. This all occurred against the backdrop of decreasing interest rates with LIBOR declining by over 180 basis points in the same timeframe. Another major accomplishment in fiscal year 2020 was the further improvements we made to our capital structure, reducing funding costs and improving our finance and flexibility. In February, we successfully completed $300 million note offering that was attractively priced at a coupon of 3.5%. Part of the proceeds were used to redeem our higher coupon bonds, which had a blended interest rate of around 6%.”


There was a slight decline in income generated from its Senior Loan Fund (“SLF JV I”) with $1.8 million during the recent quarter down from $2.0 the previous quarter likely due to lower leverage or the slight increase in non-accruals as shown below:

“Shifting now to the Kemper joint venture. As of September 30th, the JV had $313 million of assets invested in senior secured loans to 56 companies. This compared to $315 million of total assets invested in 53 companies last quarter. Assets were basically flat quarter-over-quarter as the increase in the market value of its investments was offset by payoffs and exits. Leverage at the JV was 1.3 times at year-end, down slightly from the June quarter. The Kemper JV continues to present an opportunity for us to improve returns. As of year end, the JV had $82 million of investment capacity. We believe that the prudent growth of the JV will also be accretive to ROE over time.”


OCSL has growth capital available given its historically low leverage with a current debt-to-equity ratio of 0.78. As of September 30, 2020, OCSL had $39 million of cash and $285 million of undrawn capacity on its credit facility. In June 2019, shareholders approved the reduced asset coverage requirements allowing the company to double the maximum amount of leverage. The investment adviser reduced the base management fee to 1.0% on all assets financed using leverage above 1.0x debt-equity. Moody’s and Fitch have previously assigned OCSL investment-grade credit ratings (Moody’s, Baa3 / Stable, and Fitch, BBB- / Stable).

“Our net leverage ratio decreased to 0.74 times from 0.83 times at June 30th, reflecting both the increase in NAV at $38 million in net payoffs and exits. We are presently just below the low end of our leverage target range of 0.85 times to 1.0 times. So as we see things right now, the 0.85:1 seems like the right level, kind of works for all of our constituents. But that could change, I don’t think it will change tomorrow but that could change down the road if we see kind of a more interesting investment environment.”


OCSL Risk Profile Update

Over the last three years, management has made meaningful progress shifting the portfolio from ‘non-core’ legacy assets that now account for around 9% (same as the previous quarter) of the portfolio fair value.

“We continued our portfolio repositioning during the year and successfully monetized $50 million of non-core investments, which resulted in aggregate proceeds of $59 million. At year-end, noncore investments represented only 9% of the portfolio.”


Net asset value (“NAV”) per share increase by 6.5% mostly due to “unrealized gains resulting from price increases on liquid debt investments and the impact of tighter credit spreads on private debt investment valuations following the improvement in broader credit market conditions, realized gains on equity investments and undistributed net investment income.”

“Our NAV staged an impressive recovery from the decline in the March quarter when the markets concern over the impact of pandemic was at its peak. The rebound was $1.15 per share, recapturing 91% of the decline in that quarter. We had another strong year of origination. During the year, we originated over $800 million of new investments, representing over half of the value of our portfolio at the start of the year. Notably, a large portion of our originations occurred during the post-COVID period. Following the market disruption last March, valuations continue to improve in the September quarter, resulting in a NAV increase of 6% from the June quarter to $915 million, reflecting price recovery in our liquid debt investments and tighter credit spreads. In addition, our investments in the Kemper joint venture were written up by $7 million or 7%, reflecting continued appreciation in this mostly first lien loan portfolio.”

NAV remains 1.7% lower from $6.61 as of December 31, 2019 primarily due to:

“depreciation of certain debt and equity investments related to increased market volatility resulting from the onset of the COVID-19 pandemic in March 2020, partially offset by undistributed net investment income.”

California Pizza Kitchen and PLATO Learning remain on non-accrual status but were previously written down and only account for 0.1% of the portfolio fair value:

“Our credit quality remains strong, with only 2 out of our 113 portfolio companies on nonaccrual status, representing one-tenth of 1% of the total portfolio at fair value. During the quarter, all of our portfolio companies made their scheduled interest payments with the exception of one company that, consistent with prior quarters, made its interest payments in kind.”


A few of the ‘watch list’ investments (Zep Inc., Dominion Diagnostics, and William Morris Endeavor Entertainment) were discussed on the recent call:

“Zep is a cleaning materials company. It did have some execution issues over the pre-COVID that resulted in the company looking more levered as a result of EBITDA declines. People are cleaning more and sanitation products are doing better as is Zep. Now it remains levered and that’s why we have it marked the way we do. But the leverage is, at least post COVID, heading in the right direction, as in down. But we don’t feel comfortable marking it more aggressively, because we do still think that the company is more levered than we would like it to be and that’s the reason why Zep is where it is.”

“Dominion is a little bit of a different issue, it’s a diagnostics laboratory company. They are modestly helped by the coronavirus but there’s some puts and takes, because although there is more work being done around coronavirus and the company certainly benefits from that, there is a decline in elective surgeries, elective cases, going to the doctor for a checkup, et cetera, because of coronavirus as well. So there are puts and takes on that business. There’s some countervailing pressures as well. And as you know, we’re going to be fair and err on the side of conservatism generally in the way we mark things. And we’d like to be proven wrong if and when it’s appropriate that the company’s performance necessitate a markup, but we don’t want to be ahead of that curve.”

“William Morris, as you’re familiar with, is a leading entertainment management and media rights company. You’re right that directionally, with vaccine news and live events starting to come back, NBA in a bubble, baseball, et cetera, that’s generally a good thing for William Morris. And our loan has nice call protection, has a pretty rich coupon relative to the pari passu, LIBOR plus $2.75 first lien term loan that the company has. And that term loan is something that could be observed in terms of trading prices in the market. And it’s moved up nicely. I think that’s all I would say about William Morris. I would hesitate to drive forward guidance, because we also think that COVID cases are going to spike, so there’s going to be some choppiness in the next few quarters. But the company has taken out some cost and is managing very well in terms of its liquidity needs for the foreseeable future.”



Full BDC Reports

This information was previously made available to subscribers of Premium BDC Reports, along with:

  • OCSL target prices and buying points
  • OCSL risk profile, potential credit issues, and overall rankings
  • OCSL dividend coverage projections and worst-case scenarios
  • Real-time changes to my personal portfolio

BDCs trade within a wide range of multiples driving higher and lower yields mostly related to portfolio credit quality and dividend coverage potential (not necessarily historical coverage). This means investors need to do their due diligence before buying.

To be a successful BDC investor:

  • Identify BDCs that fit your risk profile.
  • Establish appropriate price targets based on relative risk and returns (mostly from regular and potential special dividends).
  • As companies report results, closely monitor dividend coverage potential and portfolio credit quality.
  • Diversify your BDC portfolio with at least five companies. There are around 45 publicly traded BDCs; please be selective.

TSLX & TCPC: Preliminary Q4 2020 Results

The following information is from the TSLX and TCPC Deep Dive reports previously provided to subscribers of Premium BDC Reports along with target prices, dividend coverage and risk profile rankings, earnings/dividend projections, quality of management, fee agreements, and my personal positions for all Business Development Companies (“BDCs”).



TSLX Preliminary Estimates

  • NAV increase of almost 2%
  • NII of $0.48 compared to its dividend of $0.41
  • Stable portfolio credit quality with 0.9% non-accruals

As of January 25, 2021, Sixth Street Specialty Lending, Inc. (TSLX) estimates that its net asset value per share as of December 31, 2020 was approximately $17.16 per share, up from $16.87 as of September 30, 2020 (or $16.77 after adjusting for the impact of the Company’s Q3 2020 supplemental dividend that was paid on December 31, 2020). As of December 31, 2020, the Company’s total portfolio was approximately $2.3 billion in aggregate fair value, up from $2.1 billion as of September 30, 2020.

Estimated net income per share for the quarter ended December 31, 2020 is $0.79. Estimated net investment income per share for the quarter ended December 31, 2020 is $0.48. Both these amounts include approximately $0.02 per share of incentive fee expenses that were accrued, but not paid, related to the Company’s cumulative inception-to-date unrealized gains exceeding its cumulative inception-to-date realized gains and losses and unrealized losses as of December 31, 2020. Excluding the impact of the accrued capital gains-related incentive fee expenses, the Company’s estimated net income per share and net investment income per share for the quarter ended December 31, 2020 were $0.81 and $0.50, respectively.

As of December 31, 2020, the Company had approximately $865 million of liquidity in undrawn debt capacity and unrestricted cash. During the fourth quarter, the Company added $20 million of commitments to its senior secured revolver, bringing total capacity to $1.335 billion as of December 31, 2020. Estimated debt to equity as of December 31, 2020 was approximately 0.95x, up from 0.81x as of September 30, 2020. The Company’s debt funding mix at quarter end was comprised of approximately 58% unsecured debt, and the Company had approximately $863 million of undrawn capacity under its revolving credit facility.

There has been no material change to the Company’s weighted average portfolio performance ratings from September 30, 2020, to December 31, 2020. As of December 31, 2020, investments on non-accrual status was approximately 0.9% of the portfolio at fair value, flat from the prior quarter. During the quarter ended December 31, 2020, one additional portfolio company was placed on non-accrual status, American Achievement Corporation. The Company’s investments in MD America Energy, LLC and J.C. Penney Company, Inc. were removed from non-accrual status.

 


BlackRock TCP Capital (TCPC) announced preliminary financial estimates for the fourth quarter ended December 31, 2020.

  • NAV increase of 4%
  • NII of $0.34 to $0.35 compared to its dividend of $0.30



Full BDC Reports

This information was previously made available to subscribers of Premium BDC Reports, along with:

  • TSLX and TCPC target prices and buying points
  • TSLX and TCPC risk profile, potential credit issues, and overall rankings
  • TSLX and TCPC dividend coverage projections and worst-case scenarios
  • Real-time changes to my personal portfolio

BDCs trade within a wide range of multiples driving higher and lower yields mostly related to portfolio credit quality and dividend coverage potential (not necessarily historical coverage). This means investors need to do their due diligence before buying.

To be a successful BDC investor:

  • Identify BDCs that fit your risk profile.
  • Establish appropriate price targets based on relative risk and returns (mostly from regular and potential special dividends).
  • As companies report results, closely monitor dividend coverage potential and portfolio credit quality.
  • Diversify your BDC portfolio with at least five companies. There are around 45 publicly traded BDCs; please be selective.

GAIN: Dividend Coverage Update

The following information is from the GAIN Deep Dive report previously provided to subscribers of Premium BDC Reports along with target prices, dividend coverage and risk profile rankings, earnings/dividend projections, quality of management, fee agreements, and my personal positions for all Business Development Companies (“BDCs”).



GAIN Dividend Coverage Update

GAIN has recently announced two transactions accounting for $43.8 million of portfolio investments or 7.3% of the overall portfolio fair value which will result in significant realized gains and additional income. Around $34.3 million was invested in non-income-producing equity positions potentially driving ~$0.76 per share of realized gains (if exited at recent fair values) and will likely be reinvested mostly into income-producing assets.

On January 4, 2021, GAIN announced the exit of its investment in Frontier Packaging, Inc. resulting in the repayment of its $9.5 million debt investment at par and “realized a significant gain on its equity investment”. Its equity investment in Frontier was valued at $13.4 million as of September 30, 2020, and if exited at the same value would result in realized gains of around $0.36 per share. Also, the proceeds will likely be reinvested into income-producing assets.

“With our sale of Frontier Packaging and from our inception in 2005, Gladstone Investment has exited over 20 of its management supported buy-outs, generating significant net realized gains on these investments in the aggregate. Our strategy as a buyout fund, realizing gains on equity, while also generating strong current income during the investment period from debt investments alongside our equity investments, provides meaningful value to our shareholders through stock appreciation and dividend growth. Significant winners like Frontier prove out our focus on buying high quality businesses, backing outstanding management teams and being able to have investments with long hold periods.”

On December 21, 2020, GAIN announced the recapitalization of its portfolio company Old World Christmas, Inc. with the origination of a new secured term loan. GAIN received “significant equity proceeds and realized a capital gain and other income”. Its equity investment in Old World was valued at $20.9 million as of September 30, 2020, and if exited at the same value would result in realized gains of around $0.40 per share.

GAIN will not be covering its upcoming dividends due to remaining underleveraged, additional non-accruals, lower portfolio yield, and continued lower dividend income. However, dividend coverage should improve due to th recent increase in portfolio yield, higher use of leverage, and likely lower non-accruals.

Also, the upcoming realized gains will more than cover its $0.07 per share monthly dividend as the company reinvests the proceeds.

Also, as of September 30, 2020, GAIN had around $5 million or $0.16 per share of undistributed income “available for distribution to shareholders in future periods”:

“In addition, distributable income to shareholders remained solid. On a book basis undistributed net investment income combined with net realized gains totaled over $5 million or about $0.16 per common share. This amount is reduced by the book accrual of the capital gains based incentive fee that’s required under U.S. GAAP and that number is roughly $7 million which is not contractually due yet. All else equal, the $0.16 per common share would be available for distribution to shareholders in future periods even if the entire capital gains-based incentive fee accrual were to be contractually due which it is not.”

Similar to BDCs such as MAIN and CSWC, the company supports supplemental/semiannual dividends through realized gains typically from equity positions:

“We have maintained and look forward to maintaining our monthly distributions to shareholders at the current levels. And again consistent with our policy, our Board will continue to evaluate any supplemental distributions which we can make and may make from capital gains. When we started the semiannual dividends distributions, which are a function of realized capital gains as we’ve stressed, we’ve been able to maintain it pretty effectively. We made the one in June as we move forward during the year in part as a function of liquidity ourselves being that we’re doing new deals also.”

GAIN has increased its dividend three times over the last two years while growing its NAV per share by 7.5% over the last three years. Also, GAIN has relatively low amounts of leverage with the potential for improved coverage through portfolio growth and rotating out of equity investments. On October 13, 2020, GAIN reaffirmed its monthly dividend of $0.07 per share.

 

Previously, the Board approved the modified asset coverage ratio from 200% to 150%, effective April 10, 2019. However, the company is subject to a minimum asset coverage requirement of 200% with respect to its Series D Term Preferred Stock.

The amount of preferred/common equity accounted for around 25% of the portfolio fair value which is being monetized and eventually reinvested into income-producing secured debt.

 



Full BDC Reports

This information was previously made available to subscribers of Premium BDC Reports, along with:

  • GAIN target prices and buying points
  • GAIN risk profile, potential credit issues, and overall rankings
  • GAIN dividend coverage projections and worst-case scenarios
  • Real-time changes to my personal portfolio

BDCs trade within a wide range of multiples driving higher and lower yields mostly related to portfolio credit quality and dividend coverage potential (not necessarily historical coverage). This means investors need to do their due diligence before buying.

To be a successful BDC investor:

  • Identify BDCs that fit your risk profile.
  • Establish appropriate price targets based on relative risk and returns (mostly from regular and potential special dividends).
  • As companies report results, closely monitor dividend coverage potential and portfolio credit quality.
  • Diversify your BDC portfolio with at least five companies. There are around 45 publicly traded BDCs; please be selective.

ARCC: Provides Preliminary Results & Non-Accruals Update

The following information is from the ARCC Deep Dive report previously provided to subscribers of Premium BDC Reports along with target prices, dividend coverage and risk profile rankings, earnings/dividend projections, quality of management, fee agreements, and my personal positions for all Business Development Companies (“BDCs”).



ARCC Issues An Additional $650 Million 2.150% Unsecured Notes Due 2026

On January 13, 2021, ARCC closed an offering of $650 million of its 2.150% unsecured notes due 2026 at a slight discount of 99.593% of their principal amount, resulting in estimated net proceeds, after estimated offering expenses, of approximately $641.2 million. It should be noted that issuing notes at a discount drives a slightly higher yield-to-maturity of 2.229%.

This is an extremely low fixed rate for an unsecured note due 2026. Many BDCs have been issuing unsecured notes which adds tremendous flexibility to their balance sheets not to mention maintaining net interest margins with the potential to invest at higher rates later this year. This means that we will likely see maintained or even improved earnings over the coming quarters resulting in sustainable dividends.

Source: SEC Filing


Included in the SEC filings related to the offering were the following preliminary results through December 28, 2020:

  • Sold 0.2 million shares for ~$4 million.
  • Funded $2.5 billion of new investments at a weighted average yield of 7.7%.
  • Exited $2.8 billion of investments at a weighted average yield of 7.2%.
  • Net realized losses of $177 million or around $0.42 per share.
  • These realized losses were offset by $199 million of reversed unrealized losses.

ARCC’s portfolio is/was over $14 billion so there will only be a slightly positive impact on the overall portfolio yield. The realized losses were due to exiting or restructuring quite a few of its non-accrual investments but there should be a slightly positive impact to NAV per share as they were completely offset by the reversal of previous unrealized losses. This would imply that the company exited/sold these investments at a higher price (on average) than the fair value as of September 30, 2020.

From October 1, 2020 through December 28, 2020, we sold an aggregate of approximately 0.2 million shares of common stock for total net proceeds of approximately $4 million under our equity distribution agreements with Truist Securities Inc. and Regions Securities LLC.”

“From October 1, 2020 through December 28, 2020, we made new investment commitments of approximately $3.2 billion, of which $2.5 billion were funded. Of these new commitments, 78% were in first lien senior secured loans, 16% were in second lien senior secured loans, 4% were in preferred equity securities and 2% were in other equity securities. Of the approximately $3.2 billion of new investment commitments, 94% were floating rate, 4% were fixed rate and 2% were non-interest bearing. The weighted average yield of debt and other income producing securities funded during the period at amortized cost was 7.7%.”

“From October 1, 2020 through December 28, 2020, we exited approximately $2.8 billion of investment commitments. Of the total investment commitments, 79% were first lien senior secured loans, 15% were second lien senior secured loans, 2% were subordinated certificates of the SDLP, 2% were senior subordinated loans, 1% were other equity securities and 1% were collateralized loan obligations. Of the approximately $2.8 billion of exited investment commitments, 89% were floating rate, 8% were on non-accrual status, 2% were non-income producing and 1% were fixed rate. The weighted average yield of debt and other income producing securities exited or repaid during the period at amortized cost was 8.0% and the weighted average yield on total investments exited or repaid during the period at amortized cost was 7.2%. On the approximately $2.8 billion of investment commitments exited from October 1, 2020 through December 28, 2020, we recognized total net realized losses of approximately $177 million. As a result of the investment commitments exited, we reversed previously recorded net unrealized depreciation related to such net realized losses of approximately $199 million.”

“In addition, as of December 28, 2020, we had an investment backlog and pipeline of approximately $1.1 billion and $15 million, respectively.”


ARCC Portfolio Credit/Non-Accruals Update

During Q3 2020, non-accrual investments increased from 2.6% to 3.2% of fair value (from 4.4% to 5.1% of cost) of the total portfolio due to adding OTG Management, Sundance Energy, and InterVision Systems with the weighted average grade of the investments in the portfolio at fair value remains around 2.9. As mentioned in the previous report, OTG Management is an airport restaurant operator that was partially added to non-accrual status during Q3 2020 and continues to be marked down currently at 69% of cost and accounts for around 1.0% of the portfolio and $0.36 per share or 2.2% of NAV.

Source: SEC Filing

As mentioned earlier, the company will likely have around $177 million or around $0.42 per share of realized losses in Q4 2020 mostly related to the exiting or restructuring of its non-accrual investments. But there should be a slightly positive impact to NAV per share as they were completely offset by the reversal of previous unrealized losses. This would imply that the company exited/sold these investments at a higher price (on average) than the fair value as of September 30, 2020. Also, it’s important to note that there will likely be a meaningful reduction in the amount of investments on non-accrual as well as additional income related to investments that were restructured during the quarter.

We believe that in future quarters, non-accrual levels may stabilize or could improve from these third quarter levels. Of the existing non-accruals we think, for the most part, they’re all pretty darn good businesses, that tier-point are operating in cities impacted by COVID. And through a combination of equity coming into those companies and potentially providing some concessions in the near term, they figured out how to operate. But, yes, I think there will be a path to recovery for most, if not all of them. So, I think it’s being reasonably optimistic on the existing non-accruals. But I think I’m optimistic too around the portfolio, because when you when you look at our non-accrual list, it’s pretty small list, right? And we’ve talked about the grade ones and twos being, I think in my mind, ring fenced at this point, and that we understand where the issues are. And we think that we have them under control, as I mentioned in the prepared remarks, so definitely a lot more optimistic than I was in April.”

Please note that ARCC has a very large portfolio with investments in 347 companies valued at almost $14.4 billion so there will always be a certain amount of non-accruals.

In terms of risk management, we remain focused on maintaining a highly diversified portfolio, which today includes 347 different companies with an average hold position at fair value of only 0.3%. We believe this diversity is a differentiator as it underscores the performance of any single investment and is unlikely to have a material impact on the aggregate performance of our company.”

 

 


My primary concern is 18.1% (previously 18.8%) of the portfolio considered “Investment Grade 2” which indicates that the “risk to our ability to recoup the initial cost basis of such investment has increased materially since origination or acquisition, including as a result of factors such as declining performance and non-compliance with debt covenants, however, payments are generally not more than 120 days past due.” However, ARCC has higher quality management that takes a conservative approach to assess portfolio credit quality and there will likely be a material improvement during Q4 2020 for the reasons discussed earlier.

Regarding the health of our portfolio, our weighted average portfolio grade of 2.9 remain stable versus last quarter, and less than 5% of our portfolio companies changed grades. The ratio of upgrades to downgrades was greater than three to one, which we believe highlights the steady to improving cash flows of our portfolio companies that is followed with partial or complete reopening of many businesses. For the more COVID impacted names, which we largely see in our grade one and grade two names, we believe we have an informed view of their path to recovery but we do think this recovery will take time and likely be quite uneven with the ever-evolving COVID health crisis. Many of these companies are generally strong franchises with every reason to perform as they did pre-COVID and that they will recover during more certain economic times.”

 



Full BDC Reports

This information was previously made available to subscribers of Premium BDC Reports, along with:

  • ARCC target prices and buying points
  • ARCC risk profile, potential credit issues, and overall rankings
  • ARCC dividend coverage projections and worst-case scenarios
  • Real-time changes to my personal portfolio

BDCs trade within a wide range of multiples driving higher and lower yields mostly related to portfolio credit quality and dividend coverage potential (not necessarily historical coverage). This means investors need to do their due diligence before buying.

To be a successful BDC investor:

  • Identify BDCs that fit your risk profile.
  • Establish appropriate price targets based on relative risk and returns (mostly from regular and potential special dividends).
  • As companies report results, closely monitor dividend coverage potential and portfolio credit quality.
  • Diversify your BDC portfolio with at least five companies. There are around 45 publicly traded BDCs; please be selective.

CSWC Projections (W/Baby Bond CSWCL): Headed The Right Direction With 12.2% Yield

The following information is from the CSWC Deep Dive report previously provided to subscribers of Premium BDC Reports along with target prices, dividend coverage and risk profile rankings, earnings/dividend projections, quality of management, fee agreements, and my personal positions for all Business Development Companies (“BDCs”).

Capital Southwest (CSWC) is an internally managed BDC with a ~$600 million portfolio of mostly first-lien debt positions and equity investments historically providing realized gains especially in its lower middle market investments similar to Main Street Capital (MAIN). Previously, CSWC increased its regular quarterly dividend each quarter since 2015, and equity participation is partially responsible for supporting continued quarterly supplemental dividends of $0.10 per share. The current dividend yield is around 12% (MAIN is 8%).



Capital Southwest 5.95% Notes due 12/15/2022 (CSWCL)

On November 5, 2020, CSWC announced the partial redemption (another $20 million) of its 5.95% Notes due 2022 (CUSIP No. 140501206; NASDAQ: CSWCL) on December 10, 2020.

The “Bond Risk” tab of the BDC Google Sheets includes a summary of metrics used to analyze the safety of a debt position such as the “Interest Expense Coverage” ratio which is used to see how well a firm can pay the interest on outstanding debt. Also called the times-interest-earned ratio, this ratio is used by creditors and prospective lenders to assess the risk of lending capital to a firm. A higher coverage ratio is better, although the ideal ratio may vary by industry. When a company’s interest coverage ratio is only 1.5 or lower, its ability to meet interest expenses may be questionable.

The asset coverage ratio is a financial metric that measures how well a company can repay its debts by selling or liquidating its assets. The higher the asset coverage ratio, the more times a company can cover its debt. Therefore, a company with a high asset coverage ratio is considered to be less risky than a company with a low asset coverage ratio.


Previous CSWC Insider Purchases

From previous call: “As a further demonstration of our confidence and shareholder alignment, our directors and officers purchased approximately 107,000 shares of CSWC stock during the quarter, bringing the group’s total ownership in Capital Southwest to approximately 10% of the outstanding common stock.”


CSWC Dividend Coverage Update

“I think we do have an eye on growing the regular dividend over time, based on origination to date and sort of this transition to the five points — getting away from those unsecured bonds, we think our run rate in the next quarter or two is going to be in the $0.42 to $0.43 in terms of NII. When we feel comfortable there, we’ll probably inch up the dividend in turn. When we make the full transition out of those notes, and we start drawing on the revolver next year, we see quite a bit of an increase in NII. To quantify it long term, I think I’ve said this on the last call and once we have fully immersed in the FDIC, fully deployed, we see that’s a 20% to 25% increase relative to using bonds in the next two to three years. So we’re definitely looking ahead towards increasing that dividend slowly and steadily.”

CSWC’s Board declared a total dividend of $0.51 per share for the quarter ended December 31, 2020, including the regular quarterly dividend of $0.41 per share and a supplemental dividend of $0.10 per share.

“Total dividends for the quarter of $0.51 per share represented an annualized dividend yield on the quarter stock price per share of 14.5% and an annualized yield on net asset value per share of 13.3%. I’m also pleased to announce that our board has declared total dividends of $0.51 per share again for the quarter ended December 31, 2020, consisting of a regular dividend of $0.41 per share and a supplemental dividend of $0.10 per share.”


CSWC’s target pricing and dividend yield in the BDC Google Sheets takes into account $0.10 per share of quarterly supplemental/special distributions that will likely continue beyond 2021. Similar to MAIN, the supplemental dividends are typically covered by realized capital gains and over-earning the regular dividend. CSWC had net realized gains of $44 million during calendar Q4 2019 related to the exit of Media Recovery. As of September 30, 2020, CSWC had $1.19 per share of undistributed taxable income and gains. Management is likely going to maintain its dividends going forward as they need to distribute this over the coming quarters:

“We also continued our supplemental dividend program paying out an additional $0.10 per share, funded by our sizable undistributed taxable income balance. As a reminder, the supplemental dividend program allows our shareholders to meaningfully participate in the successful exits of our investment portfolio through distributions from our UTI balance. As of September 30, 2020, our estimated UTI balance was $1.19 per share.”

From previous call: “Due to the successful sale of Media Recovery in late 2019, we were able to replenish our UTI balance to the maximum allowable level as of the end of the 2019 tax year, providing visibility on the longevity of the program well into the future. The program will continue to be funded from UTI earned from realized gains on both debt and equity, as well as undistributed net investment income earned each quarter in excess of our regular dividends. The good news is the UTI balance that you have is not affected by having realized losses. What it does create is sort of an amount that you have to overcome with realized gains before you’re able to book additional pennies into the UTI bucket. We feel like we’ve got two to three years of runway to create those gains to apply against those losses to continue this program without any interruption.”


For calendar Q3 2020, CSWC reported just above its best-case projections with higher-than-expected portfolio growth, interest and fee income covering its regular quarterly dividend by 109%. The company is now above its upper targeted leverage (1.20) with a debt-to-equity ratio of 1.29 but recently submitted its application to form a new SBIC subsidiary with access to an additional $175 million of low-cost capital with potential approval by the end of this year as discussed later.

“This quarter, we had probably about $400,000-ish of one-time fees that are above our normal expectation or run rate. Then in terms of this quarter repayments — right now I think of the one to three prepayments, one of them does not have a [indiscernible], and I think that there’s maybe one small one between the other two. So I would tell you, it’s like $50,000-ish but having said that, there’s always something that comes up so that number could be elevated by the end of the quarter.”


As predicted in the previous report, dividend coverage improved partly due to adding Delphi Intermediate Healthco back on accrual status. Over the coming quarters, dividend coverage should continue to improve due to additional investments added back to accrual status (discussed later) and reduced borrowing expenses including the previously discussed redemption of $20 million of its Baby Bond “CSWCL” and SBIC license, and new investments at a relatively higher yield. An SBIC license will provide CSWC an incremental source of long-term capital by permitting it to issue up to $175 million of SBA-guaranteed debentures. These debentures have maturities of ten years with fixed interest rates currently around 3%.

“During the quarter, we raised an additional $50 million on our 5.375% unsecured notes due 2024 and subsequently paid down $20 million on our 5.95% baby bond due 2022. We will continue to be opportunistic in paying down higher price debt to optimize net investment income while also being mindful of maintaining appropriate flexibility in our liability structure. So we will be ramping up our revolver, in fact, to both pay down some of the 5.95% bonds, as well as to accommodate originations that are not in the SBIC going forward. Finally, as we mentioned last quarter, we continue to work with the U.S. Small Business Administration towards becoming officially licensed as an SBIC. We are pleased to report that we completed our final license submittal during the quarter, and look forward to reporting developments on the status of our pending license application to our shareholders as warranted. As a reminder, final approval, and issuance to Capital southwest of an SBIC license would provide a 10-year commitment to provide Capital Southwest with up to $175 million in debt financing to be drawn to fund investment in our lower middle market strategy.”

Also, management is actively growing the portfolio including $66 million of new originations in Q3 2020: “On the new origination front, we remained active, committing $66.3 million in originations to both new and existing portfolio companies.”

On July 30, 2020, CSWC announced that the U.S. Small Business Administration (the “SBA”) has issued a “green light” letter inviting the company to file its application to obtain a license to operate a Small Business Investment Company (“SBIC”) subsidiary. During Q3 2020, the CSWC submitted its final application and is expecting to receive its first license by the end of the year with qualifying investments that could be funded as early as Q1 2021:

“We estimate that the vast majority of the deals we have reviewed over the past five years would qualify for SBIC financing, giving us a high level of competence that we will be able to invest this capital in our existing strategy and continue to support growth and employment in small businesses across the country. As a reminder, each draw from the SBIC debenture program separately represents a new debt security in our capital structure with a 10-year maturity from the date of draw, making this capital truly long term in nature. From a cost perspective, if treasury rates remain close to today’s level, the all-in cost of the SBIC debentures would be less than 3%. This program is clearly a perfect fit for our lower middle market focus and we look forward to continuing to work with the SBA in completing the application process and in successfully executing the SBA’s mission of supporting growth and employment in U.S. Small businesses. We believe we’re in the final stages of the licensing process and are hopeful of receiving our license by the end of the calendar year. We are excited to integrate the SBIC license into our capitalization strategy as the flexibility and low cost of SBIC debentures should be highly accretive to our net investment income per share, while also allowing us to continue to provide important growth and acquisition capital to U.S. Small businesses.”

“We actually expect that we’re weeks away from actually having that application. We don’t want to be presumptive, but that’s the kind of the guidance we’ve been given. So we’re going to just wait until probably December and likely start allocating those assets to the SBIC, probably in January.


On September 29, 2020, CSWC redeemed $20 million of its 5.95% Notes due December 2022 and recognized realized losses on the extinguishment of debt of $0.3 million. In August 2020, the company issued an additional $50 million of the 5.375% Notes due October 2024. As of September 30, 2020, CSWC had almost $16 million in unrestricted cash and almost $135 million in available borrowings under its credit facility for upcoming portfolio growth. In April 2018, the Board approved the application of the modified asset coverage requirements and the minimum asset coverage ratio applicable to the company was decreased from 200% to 150%. Previously, management was targeting a debt-to-equity ratio between 1.00 and 1.20 but is expecting around $30 million of prepayments in Q4 2020 and is taken into account with the updated projections along with additional prepayment fees:

“If you think about leverage up to 1.28, the answer is, yes, we’re comfortable with where we are. It is higher than our 1.1 to 1.2 target range we gave pre-COVID. If you look at — if you just take a high level, look at the depreciation in the portfolio during COVID, retracing that COVID effect on the portfolio, we’re basically back to the top end of our leverage range and so, you have to keep in mind that as the portfolio re-appreciate that leverage, all else equal will come down. So that’s one point and why I can say we’re comfortable with where we are. The next thing is we’ve got visibility on $30 million to $35 million of pre-payments coming in from portfolio companies that are performing very well and are being sold or refinanced or what have you. So if you of think about leverage, we have visibility on cash coming in. So we’ll obviously be redeploying that cash in originations.”

In March 2019, CSWC established its equity “At-The-Market” (“ATM”) program of slowly issuing small amounts of shares at a premium to book value/NAV and accretive to shareholders. As CSWC’s stock price continues higher, management will likely use the ATM program for raising equity capital, rather than larger equity offerings. This approach is beneficial for many reasons including being more efficient, delivering higher net proceeds to the company and less disruptive to market pricing. During Q3 2020, the company sold only 35,112 shares of its common stock at a weighted-average price of $14.99 per share, raising $0.5 million.

“But that’s another point. And the third thing I would say is, if you think about — we traded well above book for almost two years pre-COVID. So I believe that we’ve proven that our business model and our strategy in a more normal market should trade above NAV. So if it trades above NAV, as you know, we’ve got an ATM program that we’re diligent about accessing at very low spreads to trade. So that’s obviously a function and our yield on NAV today is 13.5% or so. And on the stock price, it’s north of 14%. The market will figure out the risk premium on our stock over time. So we’re comfortable and just letting the market play out. But those yield levels, based on our strategy and track record, really are not where we believe those yield levels will normalize out over time, which we believe will trade above NAV and we’ll be able to raise equity. So, those are all the points that are in my head, as I look at the leverage of 1.28 and go, am I comfortable with that or not?”

As expected, its I-45 Senior Loan Fund was marked up again, remains around 10% of the total portfolio and is a joint venture with MAIN created in September 2015. The portfolio is 96% invested in first-lien assets with CSWC receiving over 75% of the profits providing 11.0% annualized yield (previously 12.5%) paying a quarterly dividend of $1.7 million compared to $1.8 million during the previous quarter.

“Turning to Slide 16, the I-45 portfolio shows meaningful improvement during the quarter as our investment in I-45 appreciated by $4.7 million or 8%. Leverage at the I-45 fund level is now 1.39x debt to equity at fair value, which is substantially improved from the March 31, quarter average of 2.51x.”


Its regular quarterly dividends are covered mostly through recurring cash sources:


CSWC Risk Profile Update

There were no additional investments added to non-accrual status during the quarter. American Addiction Centers (“AAC”), AG Kings Holdings, and California Pizza Kitchen (“CPK”) remain on non-accrual status with a total fair value of $10.9 million or 1.7% of the total portfolio. If completely written off would impact NAV per share by around 3.8% as shown in the following table.

These investments were discussed on the recent call and management is expecting some positive results including either being restructured back on accrual status (AAC and CPK) or outright sales (AG Kings is being purchased by Albertsons) and then reinvested into income-producing assets:

Q. “I wanted to touch on the non-performing loans, if I’m not mistaken, they’re all in certain stages of bankruptcy. And I think there’s been some movements since our last call. So starting with American Addiction, from what I’ve read, the information is a little sparse, it looks like you’re going to be repaid in cash on that from asset sales. Is that correct? And when will that be?”

A. “So based on what’s public, it’s going to emerge from bankruptcy relatively soonIt’ll be restructured. So the lender group, which we are a part of, will end up holding a debt security, first lien debt security in the new restructured company, and then ownership of the equity in the company. So it’ll be restructured, it will emerge from bankruptcy and Capital Southwest actually will have a board seat. And so, that’s that, it will all be resolved relatively soon. I mean, it’s not in our control, but it’s basically got to work through taxes and various things, structuring the recap, the restructuring, so that’s AC. Anyway, you want to talk about Kings and CPK, as well?”

Q. “So CPK, it looks like similarly you’re going to get equity and debt. Is that correct? And when is that going to happen?”

A. “Similar story as AC as far as what will happen from the bankruptcy perspective. So we’ll end up with a performing, firs lien note and equity in the company, we will not have a board seat in that instance. We think that’s going to happen — I think it may be announced, but it’ll be relatively soon. This manager team seems to be doing a really good job with the business. And it’s one thing, and then the other thing is that the restaurants that have opened, people come eat there, and so it tells me that the brand is relevant, and it’s desired, and there’s a demand for that brand and that concept in the market. So that’s encouraging. Clearly COVID is a bunch of noise out there. It’s affecting all the restaurants, the management team is doing some interesting creative things around that, with respect to CPK. The election and any kind of unrest that may result — unrest in an area affects all the retailers, all the places, restaurants included in those areas. So there’s clearly noise out there. But the thing I grab on to is manager team is seem to be doing a great job, we have weekly calls, and the restaurants that are open, people want to eat there. And so, based on those two things, that gives me a lot of encouragement as to the future of that concept once all the market noise, COVID pandemic noise sort of fades away, which will, this too shall pass. And so, still challenges, but good team, and there’s some definitely some signs of relevance of that concept and brand.”

Q. “And on AG Kings, obviously there was a stalking-horse bid. I haven’t seen another bid come through unless I’m mistaken. Is that correct? Or are there other folks snooping around and potentially going to offer?”

A. “Yes, so that’s actually been announced, and they signed a purchase agreement to sell the Albertsons. That’s in a process of closing/documentation process. And it’s pretty much all I should really say about it, but our evaluation is the best guess on waterfall analysis around the proceeds on a sale.”

Similar to other BDCs, I am expecting additional increases in its net asset value (“NAV”) per share over the coming quarters:

“So as far as NAV I think a big uplift in NAV for many BDCs including us will be just re-appreciation of the noise that’s been created by the current market environment. I think we certainly expect to see that. Then we have a nice equity portfolio with some companies that are growing, a couple of companies that we’ve had to decrease the appreciation to write it down based on COVID, which we certainly expect that to re-appreciate. So I think that clearly there are — from where we sit today, there are definitely tailwinds that should support NAV growth going forward.”

“Our investment strategy has remained consistent since its launch in January of 2015. We continue to focus on our core lower middle market, while also maintaining the ability to invest in the upper-middle market when attractive risk-adjusted returns exist. In a lower middle market, we directly originate opportunities consisting of debt investments and equity co-investments. Building out a well-performing and granular portfolio of equity co-investments is important to driving NAV per share growth as well as aiding in the mitigation of any credit losses over time.”

For Q3 2020, CSWC’s NAV per share increased by $0.18 or 2.7% (from $14.95 to $15.36) “primarily due to net unrealized appreciation on the investment portfolio”,

“Turning to Slide 20, the company’s NAV per share as of September 30, 2020, was $15.36 as compared to $14.95 at June 30, 2020. The main driver of the NAV per share increase was $8.4 million of appreciation in the investment portfolio, much of which was in the upper-middle market portfolio.”

There was an improvement in overall credit quality including two upgrades to ‘Investment Rating 1’ and no downgrades. Similar to other BDCs, my primary concern is the 10.0% (previously 12.5% in Q1 2020) of the portfolio considered ‘Investment Rating 3’ which implies that the “investment may be out of compliance with financial covenants and interest payments may be impaired, however, principal payments are generally not past due.”

“Turning to Slide 14, we have laid out the rating migration within our portfolio for the quarter. During the quarter we had two loans upgraded while having no loans downgraded. As a reminder, all loans upon origination are initially assigned an investment rating of two on a four-point scale, with 1 being the highest rating and 4 being the lowest rating. The upgrades consisted of two loans to one portfolio company previously rated at 3, which were upgraded to a 2 rating based on much-improved performance. As of the end of the quarter, 80% of our investment portfolio at fair value was rated in one of the top two categories a one or two. We had seven loans representing 10% of the portfolio at fair value rated a three and only two loans representing 2% of the portfolio at fair value rated a four.”

Investment Rating 3 involves an investment performing below underwriting expectations and the trends and risk factors are generally neutral to negative. The portfolio company or investment may be out of compliance with financial covenants and interest payments may be impaired, however principal payments are generally not past due.

Investment Rating 4 indicates that the investment is performing materially below underwriting expectations, the trends and risk factors are generally negative and the risk of the investment has increased substantially. Interest and principal payments on our investment are likely to be impaired.

“Turning to Slide 12, as I previously alluded to, we had two lower than the market exits this quarter, Danforth Advisors and Trinity 3. Our debt at Danforth was refinanced by a traditional bank, repaying our loan in full, generating proceeds of $6.7 million and an IRR of 12.4%. We continue to hold equity in Danforth alongside the sponsor and we are excited to watch this management team and sponsor continue its stellar performance.”

“In the case of Trinity 3, which also appears on the New Deal funding’s for the quarter, we were able to participate in a much larger club deal which refinanced our original loan and finance a large strategic acquisition for Trinity 3. We also hold an equity interest in this company and are very excited about its continued growth prospects going forward. This continues our track record of successful exits. To date, we have generated a cumulative weighted average IRR of 14.7% on 33 portfolio exits, generating approximately $308 million in proceeds.”

New portfolio company investment transactions that occurred during the quarter ended September 30, 2020, are summarized as follows:

  • Electronic Transaction Consultants LLC, $10.0 million 1st Lien Senior Secured Debt, $3.7 million Revolving Loan, $1.0 million Common Equity: Electronic Transaction Consultants Corporation designs, implements, supports and maintains software systems used to facilitate electronic toll collections for toll road authorities and operators.
  • Ian, Evan, & Alexander Corporation (d/b/a EverWatch), $10.0 million 1st Lien Senior Secured Debt, $2.0 million Revolving Loan: EverWatch is a technology solutions company providing advanced defense, intelligence, and deployed support to mission critical missions in the national security and intelligence space.
  • RTIC Subsidiary Holdings, LLC, $6.9 million 1st Lien Senior Secured Debt, $1.1 million Revolving Loan: RTIC Holdings, LLC is the largest pure-play direct-to-consumer eCommerce provider of high-quality outdoor products that are priced for value-conscious outdoor enthusiasts.
  • Sonobi, Inc., $8.5 million 1st Lien Senior Secured Debt, $0.5 million Common Equity: Sonobi, Inc. is a digital media technology platform that directly connects advertisers in order to efficiently connect brands with their desired consumers.
  • “We had 39 lower middle market portfolio companies with a weighted average leverage ratio measured as debt to EBITDA through our security of 3.9x down from 4.1x weighted average leverage in the prior quarter. This reduction in leverage was primarily driven by EBITDA performance across the lower middle market portfolio during the quarter. Within our lower middle market portfolio, as of the end of the quarter, we held equity ownership in approximately two-thirds of our portfolio companies.”
  • “Our own balance sheet upper middle market portfolio excluding I-45 consisted of 12 companies with an average leverage ratio through our security of 3.7x down meaningfully from the 4.4x weighted average leverage for the prior quarter. This decrease was also driven primarily by EBITDA improvement quarter-over-quarter across the portfolio.”


Volatility is your friend!

BDC pricing can be volatile and timing is everything for investors that want to get the “biggest bang for their buck” but still have a higher-quality portfolio that will deliver higher-than-average returns over the long term. One of my goals is to help subscribers take advantage of “oversold” conditions.



Full BDC Reports

This information was previously made available to subscribers of Premium BDC Reports, along with:

  • CSWC target prices and buying points
  • CSWC risk profile, potential credit issues, and overall rankings
  • CSWC dividend coverage projections and worst-case scenarios
  • Real-time changes to my personal portfolio

BDCs trade within a wide range of multiples driving higher and lower yields mostly related to portfolio credit quality and dividend coverage potential (not necessarily historical coverage). This means investors need to do their due diligence before buying.

To be a successful BDC investor:

  • Identify BDCs that fit your risk profile.
  • Establish appropriate price targets based on relative risk and returns (mostly from regular and potential special dividends).
  • As companies report results, closely monitor dividend coverage potential and portfolio credit quality.
  • Diversify your BDC portfolio with at least five companies. There are around 45 publicly traded BDCs; please be selective.

TCPC: 10.7% Yield & Improving Net Interest Margin

The following information is from the TCPC Deep Dive report previously provided to subscribers of Premium BDC Reports along with target prices, dividend coverage and risk profile rankings, earnings/dividend projections, quality of management, fee agreements, and my personal positions for all Business Development Companies (“BDCs”).



Previous TCPC Insider Purchases

  • Last month, Howard Levkowitz, TCPC Chairman and CEO, purchased 20,000 shares at $10.95 per share for a total of $219,000.


TCPC Dividend Coverage Update

Previous reports correctly predicted the reduction of TCPC’s quarterly dividend from $0.36 to $0.30 which was at the top of my estimated range of $0.28 to $0.30. At the time, the company had spillover or undistributed taxable income (“UTI”) of almost $45 million or $0.78 per share. However, this is typically used for temporary dividend coverage issues. The previously projected lower dividend coverage was mostly due to lower LIBOR and portfolio yield combined with management keeping lower leverage to retain its investment-grade rating.

Howard Levkowitz, TCPC Chairman and CEO: “The board’s decision to adjust the dividend rate was a prudent response to substantial declines in LIBOR over the last year and a half. We are confident in the sustainability of our dividend at this level. We also strengthened our diversified and low-cost leverage program by extending and expanding our SVCP credit facility and replacing our TCPC Funding credit facility with a new facility with improved terms. We appreciate the ongoing support of our lenders.”

The rapid decline in interest rates (LIBOR) has mostly been responsible for the decline in portfolio yield with “limited exposure to any further declines”. During Q3 2020 there was an increase in the overall portfolio yield due to “amendments made on several loans coupled with the higher yield on originations versus exits”:

“Investments in new portfolio of companies during the quarter had a weighted average effective yield of 9.5%. Investments we exited had a weighted average effective yield of 8.8%. The overall effective yield on our debt portfolio increased to 10%, primarily reflecting amendments made on several loans coupled with the higher yield on originations versus exits. Since the end of 2018, LIBOR declined 257 basis points or by 92%, which put pressure on our portfolio yield over this period. However, our portfolio is largely protected from any further declines in interest rates as over 80% of our floating rate loans are currently operating with LIBOR floors as demonstrated on slide nine.”

Historically, the company has consistently over-earned its dividend with undistributed taxable income. Management previously indicated that the company will likely retain the spillover income and use it for reinvestment and growing NAV per share and quarterly NII rather than special dividends.

“Today, we declared a fourth quarter dividend of $0.30 per share payable on December 31, 2020 to shareholders of record as of December 17 and in line with the third quarter dividend of $0.30 per share paid on September 30th. We are committed to paying sustainable dividends and continuing our track record of having covered our dividend every quarter as a public company. In the third quarter, our dividend coverage ratio was 117%.”


For Q3 2020, TCPC beat its best-case projections mostly due to much higher-than-expected dividend and other income as well as improved portfolio yield and $0.03 per share of income related to prepayment premiums and accelerated original issue discount amortization. Its net interest margin improved due to the higher yield combined with lower borrowing rates.

“Investment income for the third quarter was $0.74 per share. This included recurring cash interest of $0.54, recurring discount and fee amortization of $0.06 and PIK income of $0.06. We had modest prepayments in the quarter that contributed $0.03 per share including both prepayment fees and unamortized OID. Investment income also included $0.03 of other income and $0.02 of dividend income. Our income recognition follows our conservative policy of generally amortizing upfront economics over the life of an investment rather than recognizing all of it at the time the investment is made. Combined, our outstanding liabilities had a weighted average interest rate of 3.3%, down from 3.8% or 51 basis points since the end of 2019.”

On October 29, 2020, the Board re-approved its stock repurchase plan to acquire up to $50 million of common stock “at prices at certain thresholds below our net asset value per share”. There were no additional shares repurchased during Q3 2020. From October 1, 2020 through October 30, 2020, TCPC has invested approximately $18 million primarily in three senior secured loan with a combined effective yield of approximately 10.9%.

Howard Levkowitz, TCPC Chairman and CEO: “We are pleased with the continuing strength of our highly diversified portfolio even in this challenging environment, which led to a 4.1% increase in NAV. We also further strengthened our leverage structure by increasing our unsecured debt, adding an accordion commitment to our operating facility, and replacing our funding facility on even better terms. While we remain highly selective in this lending environment, our pipeline of investment opportunities is growing, and we are prudently deploying capital to achieve strong risk-adjusted returns for our shareholders.”


Payment-in-kind (“PIK”) income declined from 7.6% in Q2 2020 to 7.4% in Q3 2020 and needs to be watched. As shown below, TCPC’s portfolio is highly diversified by borrower and sector with only 5 portfolio companies that contribute 3% or more to dividend coverage:


TCPC Risk Profile Update

During Q3 2020, TCPC’s net asset value (“NAV”) per share increased by another $0.50 or 4.1% (from $12.21 to $12.51) “primarily driven by continued spread tightening”:

“Our net asset value increased 4.1% from the prior quarter, reflecting a 1.8% net market value gain on our investments, driven by spread narrowing on middle market private credit transactions as well as improved financial results for several portfolio companies. Importantly, the overall credit quality of our portfolio remains strong.”

Some of the largest markups during the quarter were Edmentum and One Sky Flight:

“Unrealized gains included $6.9 million of appreciation in the value of our investment in Edmentum and $4.4 million of appreciation on our investment in OneSky. The strong performance at One Sky as charter flight activity has outpaced expectations and Edmentum continues to benefit from a shift toward online learning that has accelerated in the current environment.”

However, there were net realized losses of $18 million or $0.31 per share mostly due to the restructuring of its non-accrual investment in AGY Holding Corp that was discussed on the call:

“Net realized losses during the quarter were comprised primarily of the restructuring of our investment in AGY. AGY is fundamentally good business, but it has struggled with the cost of one of its major inputs rhodium. And we reached the conclusion that it was more appropriate to let a third party come into the business and pay down our position and sell down significant part of our economics and retain small preferred upside.”

CIBT Solutions, Inc. was added to non-accrual status during Q3 2020 and is a provider of expedited travel document processing services serving multinational corporations, global travel management companies, tour and cruise operators, government agencies and Do-It-Yourself travelers. GlassPoint Solar, Inc. and Avanti Communications remain on non-accrual. As of June 30, 2020, loans on non-accrual status represented 0.6% of the portfolio at fair value and 1.2% at cost. If these investments were completely written off the impact to NAV per share would be around $0.17 or 1.3%.

“As of September 30, total non-accruals were only 0.6% of the portfolio at fair value. This is a testament to our disciplined approach to underwriting, our more than 20 years of experience lending to middle market companies and the strength and breadth of the BlackRock platform.”

“We have loans to just three portfolio companies on non-accrual, GlassPoint, CIBT, and Avanti, which together represented only 0.6% of the portfolio at fair value and 1.2% of costs. CIBT, which is new this quarter is a leading global provider of immigration and visa services for corporations and individuals and the company has been challenged, given the current slowdown in international travel.”


TCPC will likely finally exit its investment in Kawa Solar Holdings “in the near future”:

“Kawa Solar Holdings is part of a larger series of securities and some of the loans in certain regions were paid off via loans [ph]. The Kawa loans, I believe, were also paid off and then what’s remaining is, some of the equity that was converted in the APAC region, which is the outstanding position. So the loans that were paid off are no longer on the balance sheet and there were a number that were successfully completed. What remains is simply the equity position as part of a conversion in Asia. That’s in a run-off mode that we’ve talked about a few times in the past. The primary asset is also an operating facility that we expect to exit at some point in the near future as we’re going through a process there.”

“91% of our investments are senior secured debt and are spread across a wide variety of industries. We have a diverse portfolio of companies with an emphasis on less cyclical businesses with limited direct exposure to sectors that have been more severely affected by the pandemic. Furthermore, our loans to companies in more impacted industries including retail and airlines are generally supported by strong collateral protections and most of our investments in these industries continue to perform well. As an example, the value of our investment in OneSky, the second largest provider of private jet aviation services in the country appreciated during the quarter based on strong performance, resulting from increased charter flight activity. At the end of the third quarter, our diverse portfolio included 101 companies. Our largest position, which represented only 4.5% of the portfolio is an equipment leasing company that itself has a highly diversified underlying portfolio of lease assets. As the chart on the left side of slide seven illustrates, our recurring income is not reliant on income from any one portfolio company. In fact, over half of our individual portfolio companies contribute less than 1% to our recurring income.”

“Our investment activity in the fourth quarter to-date has been selective and focused on companies that are minimally impacted by the pandemic or beneficiaries of the COVID impacted operating environment. Dispositions in the third quarter included payoffs of our $29 million loan to InMobi, our $16 million loan to American Broadband and the refinancing of our $11 million loan to Pulse Secure.”


Volatility is your friend!

BDC pricing can be volatile and timing is everything for investors that want to get the “biggest bang for their buck” but still have a higher-quality portfolio that will deliver higher-than-average returns over the long term. One of my goals is to help subscribers take advantage of “oversold” conditions.



Full BDC Reports

This information was previously made available to subscribers of Premium BDC Reports, along with:

  • TCPC target prices and buying points
  • TCPC risk profile, potential credit issues, and overall rankings
  • TCPC dividend coverage projections and worst-case scenarios
  • Real-time changes to my personal portfolio

BDCs trade within a wide range of multiples driving higher and lower yields mostly related to portfolio credit quality and dividend coverage potential (not necessarily historical coverage). This means investors need to do their due diligence before buying.

To be a successful BDC investor:

  • Identify BDCs that fit your risk profile.
  • Establish appropriate price targets based on relative risk and returns (mostly from regular and potential special dividends).
  • As companies report results, closely monitor dividend coverage potential and portfolio credit quality.
  • Diversify your BDC portfolio with at least five companies. There are around 45 publicly traded BDCs; please be selective.

TSLX: Continued Special Dividends Driving 11.2% Yield

The following information is from the TSLX Deep Dive report previously provided to subscribers of Premium BDC Reports along with target prices, dividend coverage and risk profile rankings, earnings/dividend projections, quality of management, fee agreements, and my personal positions for all Business Development Companies (“BDCs”).


 

This update discusses Sixth Street Specialty Lending (TSLX) which has been an excellent investment. Over the last 5 years, TSLX has provided me with annualized returns of 14% to 15% and likely headed higher as the stock rebounds and the company continues to pay supplemental dividends.


TSLX Distribution & Q3 2020 Update

On November 4, 2020, TSLX reaffirmed its regular quarterly dividend of $0.41and announced a supplemental dividend of $0.10 per share to shareholders of record as of November 30, 2020, payable on December 31, 2020.

“Based on a net asset value rebound and the overearning of our base dividend this quarter, our board declared a supplemental dividend and dividend in accordance with our formulaic dividend approach, a supplemental dividend of $0.10 per share, which is half of the quarter’s overearning was declared yesterday to shareholders of record as of November 30 payable on December 31.”

During Q3 2020, the company had realized gains of $11 million or $0.16 per share (to support continued supplemental dividends) due to the sale of its equity position in AFS Technologies, Inc. Also, TSLX still holds its Series A preferred shares of Validity, Inc. valued at $9.2 million over cost and will likely result in upcoming realized gains of $0.13 per share to support additional supplemental dividends:

TSLX is clearly one of the highest quality BDCs that actually performs well in distressed environments such as this. The management team is very skilled at finding value in the worst-case scenarios including previous retail and energy investments. TSLX often lends to companies with an exit strategy of being paid back through bankruptcy/restructuring so they are proficient at stress testing every investment with proper coverage and covenants. Please see the “Previous TSLX Portfolio Credit Track Record” section at the end of this report for some historical examples. Management has prepared for the worst as a general philosophy and historically used it to make superior returns.


Previously, the company paid $0.06 per share of supplemental in Q1 2020 and $0.50 per share of supplemental dividends paid in Q2 2020. When calculating supplemental dividends, management takes into account a “NAV constraint test” to preserve NAV per share. This is one of the reasons that management prefers not to pay large supplemental dividend payments even though the amount of undistributed/spillover income continues to grow. However, management also likes to avoid paying excessive amounts of excise tax through “cleaning out” the spillover as it “creates a drag on earnings”. This was discussed on the recent call:

“We’ve tried to avoid doing large specials, when we put in the recurring supplemental dividend framework, two, 2.5 years ago. And then given that the level set earlier at $0.50, we ended up having friction costs and kind of growing the spillover income and growing unfortunately on a per share basis, the excise tax. And so we wanted to clean it out. I think we’re basically back pre-cleanout. At the beginning of this year, when we went to the board with the proposal, we were at $1.61 per share of undistributed income and at the end of Q3 we were at $1.55. So we’re pretty much back there. The plan is to look at where we sit on tax basis and looking at the 90% rule and look at how much of excise tax is a drag on earnings. And we’ll go through the same work we did at the end of the year – at the end of this year.”


For Q3 2020, TSLX beat its best-case projections (again) covering its regular quarterly dividend by 156% due to higher than expected dividend and fee income as well as higher portfolio yield.

“Other fees, which consists of prepayment fees and accelerated amortization of upfront fees from unscheduled pay downs continued to be relatively strong at $9.3 million led by our fees related to Dye & Durham and now Neiman ABL FILO. Other income increased from $6.5 million to $8.1 million quarter-over-quarter, primarily due to the receipt of a one-time termination fee for a commitment we made in Q1 of 2019, but it was never eligible to be funded given the required milestones in the underlying loan agreement we’re not satisfied.”

Leverage (debt-to-equity) remained mostly flat and similar to many other BDCs this quarter, TSLX improved its net interest margin with higher portfolio yield and lower borrowing rates likely driving improved dividend coverage over the coming quarters:

“Looking ahead into Q4 based on our current asset level yields and assuming average leverage in line with Q3, we would expect further net interest margin expansion of approximately 10 basis points based on this quarter’s movement in LIBOR.”


Annualized return on equity (ROE) on net investment income and net income of 15.1% and 30.1%, respectively, and an annualized year-to-date ROE on net investment income and net income of 13.5% and 14.7%, respectively.

“On a year-to-date basis, we’ve generated an annualized return on equity on net investment income of 13.5% and net income of 14.7% based on the beginning year pro forma net asset value per share of $16.77, which is adjusted for the impact of our Q4 2019 supplemental dividend of $0.06 per share. Of note, these annualized year-to-date return on ROEs both exceed our average annualized performance since our IPO through the end of 2019, which we think is notable given the difficult operating conditions experienced during the first three quarters of 2020.”

As shown in the following chart there was another increase in its portfolio yield (from 10.0% to 10.2%) and there was another decline in its borrowing rates for improved net interest margins:

“The weighted average total yield on our debt and income producing securities at amortized cost increased by approximately 20 basis points to 10.2% this quarter, primarily driven by the favorable impact of this quarter’s funding activity. The yield at amortized cost of new investments in Q3 was 11.5% compared to 10.8% for exited investments. Note that LIBOR move into Q3 had minimal impact on this quarter’s portfolio yield given that LIBOR had already fallen below the effective average LIBO floor across our portfolio in the prior quarter. Net expenses this decreased by $1.6 million to $28.2 million, primarily driven by lower interest expense from a lower effective LIBOR on our entirely floating rate liability structure; this quota, our weighted average cost of debt decreased by a notable 90 basis points. This was primarily a function of movement in LIBOR during Q2, which flowed through our cost of debt in Q3 due to the one-quarter timing lag on the libel reset dates on our interest rates swaps. We benefit from net interest margin expansion, given a decrease in the cost of that floating rate liabilities, while the earnings power of our contractual floating rate assets is protected by the LIBOR floors that we’ve structured into our loan agreements. The combination of these two forces has been the primary driver of the 100 basis points of net interest margin expansion we’ve experienced year-to-date; equating to incremental earnings of approximately $2.4 million or $0.04 per share.”

As of September 30, 2020, TSLX had $16 million in cash and cash equivalents and over $1 billion of undrawn capacity on its revolving credit facility:

“Our financial leverage of 0.81 times remained well below the regulatory limit of two times. And we had ample liquidity at quarter end with $1.02 billion of undrawn revolver commitments. At quarter end, our funding mix was comprised of 69% unsecured and 31% secured debt. And our nearest maturity was approximately two years away and only $143 million principal amount. We continue to be matched funded with a weighted average remaining life of our investments funded with debt of two years, compared to a weighted average remaining maturity of four years on our liabilities from revolver commitments.”

During Q3 2020, MD America was added to non-accrual status but TSLX received its regularly scheduled cash interest payment during the quarter and applied those proceeds to the amortized cost of the position due to the “imminent reorganization of the company’s capital structure”. In October 2020, MD America made a voluntary paydown of $1.4 million and subsequently filed for protection under Chapter 11. In Q4 2020, TSLX expects to put $9 million of its loan, or ~70% of its remaining prepetition loan at 9/30/20 fair value, back on accrual status upon MD America’s emergence from Chapter 11 and the remaining investment will be restructured into an equity position. This was discussed on the recent call:

“On MD America, we received a roughly scheduled cash – our regularly scheduled cash interest payment during the quarter, but applied those proceeds to the amortized cost of our position given our view of an imminent reorg of the company’s capital structure that result in a reduction of the value of our loan. Post quarter end, the company made a voluntary pay down of $1.4 million on our position and are subsequently filed for protection under Chapter 11 that implements prepackaged plan of reorganization. For Q4, we expect to put $9 million of our loan or approximately 70% of our remaining pre-petition loan at 9/30 fair value, back on accrual status upon the company’s emergence from Chapter 11. Our remaining investment will be restructured into an equity position. Note that the quarter-end, our total energy exposure was 2.4% of the portfolio at fair value.”

J.C. Penney was added to non-accrual status during Q2 2020 but there was a partial roll-up of its first-lien term loan into the DIP term loan and the rest remains on non-accrual. Mississippi Resources was added to non-accrual status in Q1 2020 and was previously written off with no further impact to NAV per share. The total current fair value of non-accrual investments is $19.7 million or 0.9% of the portfolio but will likely decline in Q4 2020 as MD America is restricted.

“There was a slight increase in our non-accruals this quarter from 40 basis points to 90 basis points on a fair value basis. This was primarily driven to the addition of first lien loan in MD America, an upstream E&P company, which is partially offset by removal of our pre-petition Neiman Marcus term loan and a partial roll up of our JCP’s pre-petition first lien term loan into the debt term loan.”

In September 2020, Neiman Marcus Group was removed from non-accrual status as it completed its Chapter 11 bankruptcy protection process eliminating more than $4 billion of debt and $200 million of annual interest expense. The new owners, which include PIMCO, Davidson Kempner Capital Management and Sixth Street Partners LLC funded a $750 million exit financing package that fully refinances its debtor-in-possession (“DIP”) loan.

“In September, upon the full repayment of the Neiman ABL FILO and debt loans, we subsequently funded a new $17 million par value first lien loan related to our exit financing backstop commitment. And our schedule of investments roughly $4 million difference between the par value and the cost basis of the new Neiman loan reflects our fees on the backstop, which were payable and common stock of the reorg company. Our loan today is trading at a price of approximately 104.75. This again was another way that we created value during the volatile market environment earlier this year. We believe our attractive cost base along with the company’s high quality assets and improved perspective cash flow profile post restructuring provide considerable downside protection on our investments.”

“Retail and consumer products was our third highest industrial exposure increasing from 11.3% to 13.9% quarter-over-quarter; this was primarily driven by new fundings for designer brands and centric brands, which was partially offset by the repayment of the Neiman ABL FILO Term Loan. Post quarter end, we fully exited our investment in Centric Brands in connection with a new financing obtained by the company as it emerged from bankruptcy. Pro forma the pay down of Centric Brands, our retail and consumer exposure would have been 10.5% at quarter-end and retail names – with retail names comprising 9.5% of the portfolio and 77% of this exposure consisting of ABL investments. 99 Cents is doing well and there’s going to be a significant refi risk.”


First-lien debt accounts for around 95% of the portfolio and management has previously given guidance that the portfolio mix will change over the coming quarters with “junior capital” exposure growing to 5% to 7%.

“While none of our portfolio companies have been immune to the economic impact of COVID, only 11% of our portfolio by fair value at quarter end has experienced meaningful performance issues directly related to it. We believe the relative resilience of our portfolio is mostly a result of a deliberate shift we made in late 2014 towards a more defensive portfolio construction. Today, 95% of our portfolio by fair value is first lien and nearly 75% of our portfolio by fair value is comprised of mission critical software businesses with sticky predictable revenue characteristics. These businesses also tend to have variable cost structures that it can be fluxed down to support debt service and protect liquidity in cases of challenging operating environments.”

“A portfolio weighted average performance rating was 1.21 compared to 1.23 in Q2, on a scale of one to five with one being the strongest. There were no material changes in the overall credit metrics of our portfolio companies. Interest covers this quarter remain flat at 3.3X, net attachment point was unchanged at 0.4X, and that leverage increased slightly from 4.3X to 4.4X, which is on par with our trailing two-year historical quarterly average.”

 


Volatility is your friend!

BDC pricing can be volatile and timing is everything for investors that want to get the “biggest bang for their buck” but still have a higher-quality portfolio that will deliver higher-than-average returns over the long term. One of my goals is to help subscribers take advantage of “oversold” conditions.



Full BDC Reports

This information was previously made available to subscribers of Premium BDC Reports, along with:

  • TSLX target prices and buying points
  • TSLX risk profile, potential credit issues, and overall rankings
  • TSLX dividend coverage projections and worst-case scenarios
  • Real-time changes to my personal portfolio

BDCs trade within a wide range of multiples driving higher and lower yields mostly related to portfolio credit quality and dividend coverage potential (not necessarily historical coverage). This means investors need to do their due diligence before buying.

To be a successful BDC investor:

  • Identify BDCs that fit your risk profile.
  • Establish appropriate price targets based on relative risk and returns (mostly from regular and potential special dividends).
  • As companies report results, closely monitor dividend coverage potential and portfolio credit quality.
  • Diversify your BDC portfolio with at least five companies. There are around 45 publicly traded BDCs; please be selective.