With a more than 10% trailing twelve month dividend yield, and trading at a 9% discount to book value (i.e. net asset value), Apollo Investment looks like an attractive, compelling investment for a an investor seeking both income and capital appreciation.
|Apollo Investment Corporation (AINV)|
|Last Sale (11/09/12)||$7.72|
|Book value (Source: Conference Call)||$8.46|
|Price to Book Value||0.91|
|Dividend (12m forecast)||$0.80|
AINV is organized as a "Business Development Corporation," and invests in or lends money to middle market companies. In general, it is able to negotiate more favorable terms than typically found in the high yield bond market, because the companies that it is investing in often do not have access to the capital markets. In order to fund those investments, AINV uses its own equity and borrows money. The leverage is limited to 200% on a statutory basis or one dollar of equity for every dollar of debt. AINV makes money between its cost of funding and the dividends and interest it receives on its investments. It pays out 90% of its net income in the form of a dividend quarterly. AINV or Apollo Investment was incorporated under the Maryland General Corporation Law in February 2004. AINV is externally managed by Apollo Investment Management, L.P, an affiliate of Apollo Global Management, LLC, a leading investment firm with $105 billion of assets under management led by Leon Black.
Forecasted Total Return
If we assume that AINV continues to pay an $0.80 cent dividend over the next twelve months, and that the stock price appreciates to trade at 1x book value instead of the current discount, AINV offers an investor a potential return of more than 15% over the next twelve months. The company already indicated that it will pay a $0.20 per share dividend in December.
I do not believe that the current valuation reflects the quality of the management team and the scope of the lending platform and portfolio. The discount to book value is likely to be eliminated as the company further demonstrates progress with its new investment strategy, which is the shift to "Senior Secured Lending" reducing the overall credit risk in its portfolio. This includes increases in energy lending and aircraft leasing along with the Cengage Learning note exchange from unsecured to $107 million secured notes with a higher coupon and a longer maturity.
Management stated in its most recent conference call that it is focusing on "complexity risk" and "liquidity risk" rather than "credit risk" given where it thinks it is in the credit cycle.
From my perspective, this appears to be exactly the right step, because too much money is "chasing yield." Credit spreads are tightening, and default rates are likely at a cyclical trough. Tightening credit spreads diminish the risk reward of moving down in credit quality, or the capital structure, when investing in bonds. The demand for yield by investors is allowing more companies to issue covenant light bonds, and as we have seen in the past these "stories" rarely have a "happy endings."
AINV Recent Quarterly Results
Quarterly results indicate the company is continuing to make progress adjusting its strategy. In the most recent quarter, Apollo reported net investment income per share of $0.22. Net asset value was $8.46 per share compared to $8.30 at the end of June or a 1.9% increase. The increase was driven primarily by unrealized appreciation from its liquid securities.
On the funding side of the balance sheet, Apollo issued $150 million 30-year senior unsecured notes in early October at a cost of funds of 6 5/8%. Adding a 30-year unsecured debt allows the Apollo to extend the duration of its liabilities and add fixed-rate debt to its capital base. In addition, the Board of Directors did approve a $0.20 dividend for shareholders of record as of December 18, 2012.
The AINV Portfolio
As of March 31, 2012, AINV's net portfolio consisted of 62 portfolio companies or $2.677 billion and was invested 30% in senior secured loans, 60% in subordinated debt, 1% in preferred equity and 9% in common equity and warrants measured at fair value. The weighted average yield on its portfolio at the end of fiscal 2012 was 11.9% versus 11.6% in 2011. All of AINV's investments are classified as "Level 3" investments for the purposes of ASC 820 fair value hierarchy which means there is little transparency for shareholders.
Structure of Loans
AINV typical structures their investments one of three ways - senior secured loans, unsecured, and or subordinated. These loans typically have relatively high interest rates that provide AINV with significant current interest income. It also has interest-only payments and in some cases, debt might convert into equity or additional debt securities or defer payments of interest. Also, in some cases its mezzanine debt investments may be collateralized by a subordinated lien on some or all of the assets of the borrower. Typically, mezzanine loans have maturities of five to ten years.
I see an emerging investment theme which Apollo will benefit from as well as other BDCs. It appears to be uniquely positioned to benefit from a "new lending environment." This new environment has been characterized by structural changes to the capital markets coming out of the 2008 financial crisis and subsequent regulation. This has had the effect of limiting or diminishing competition lending to middle market companies. Banks and hedge funds who once might once have been competitors of BDC's are becoming more risk averse either due to regulation or capital constraints. The implementation of the Dodd Frank Bill, the Volker Rule, and or Basel III will likely continue to cause structural changes to the capital markets supporting this trend. This is potentially creating a shortage of long term illiquid capital. As Apollo's recent funding success illustrates, the company appears to be uniquely positioned to benefit from this trend with a large credit platform and industry expertise.
Risk Factors to Consider
Historically, an investment in AINV has been very volatile, significantly more volatile than the overall market over the last five years. The stock price has ranged from a high of $23.78 in June of 2007 to a low $2.06 in March of 2009. The total return for the stock with dividends reinvested for the following years is as follows in the table below (Source: Company Filings).
This volatility would be hard for any potential investor to take. As the historical results suggest, AINV future results are likely to be influenced by a disruption of global capital markets including a lack of liquidity in the debt capital markets, significant write-offs in the financial services sector, and or the re-pricing of credit risk in the broadly syndicated credit market. More specifically, a slowdown in the economy or recession could negatively impact its portfolio of companies to repay its loans.
From a regulatory perspective, if AINV could not meet the requirements to be a BDC, it would be regulated as a closed-end investment company under the 1940 Act, which would subject them to substantially more regulatory restrictions under the 1940 Act and correspondingly decrease operating flexibility.
Since AINV borrows money to fund some of its investments, an increase in interest rates and or cost funding is likely to make the business less profitable. AINV's investments are in privately held companies and as a result there is little transparency unlike a typical mutual fund. In addition, the use of leverage tends to magnify gains and losses.
In summary, while volatility has been in an issue in the past, an investment in AINV offers a very competitive potential return of 15% or more of which 10% would be a dividend and capital appreciation. Moreover, such an investment is likely to further diversify an investor's portfolio by including an asset class that is otherwise hard to gain access to.