An investor seeking yield and modest capital appreciation might consider adding THL Credit (TCRD) to his or her portfolio. The investment thesis is that TCRD has a highly capable management team and significant unused lending capacity, and as it is deployed it will hopefully drive returns in the form of growing dividends and rising net asset value.
TCRD currently yields approximately 8.80% paying $1.32 per share. In the simplest context, TCRD is a publicly traded mezzanine fund; more specifically, it is externally-managed, non-diversified closed-end investment company employing leverage regulated as a business development corporation. It pays dividends quarterly and is required to pay out 90% of its net income as a dividend.
I expect that over a complete business cycle TCRD will provide superior return on capital versus the Standard and Poor's on a total return basis. This assumes the reinvestment of dividends. Studies published by Wells Fargo have shown superior historical returns by BDCs versus the Standard Poor 500 and financial index over the last five years.
TCRD is in the early stages of "portfolio growth" with unused capacity, and I expect the dividend to increase as the portfolio grows in size. TCRD is positioned to benefit from increase demand from middle market companies to finance growth. There is vacuum for lending to private middle market companies. The implementation or pending implementation of Basel III, the Volker Rule, and Dodd Frank (i.e. the "new regulatory" environment) along with risk aversion and capital constraints is making it more difficult for middle market companies to source capital. Mezzanine funds, like TCRD, fill a need and have the opportunity to fund this gap. Most retail investors do not have the financial wherewithal to invest in a mezzanine fund. TCRD is the opportunity.
|THL Credit (TCRD)|
|Market Capitalization (millions)||$406.0|
|Last Sale (02/10/13)||$14.69|
|Price to Book Value||1.15|
|Dividend (12m forecast)||$1.32|
TCRD is a publicly traded business development corporation having come public in April of 2010. TCRD is managed by THL Credit Advisors LLC, a registered investment adviser and specialized high-yield credit manager responsible for managing $2.8 billion. THL Credit Advisors is affiliated with the well known private equity firm Thomas H. Lee Partners, LP. Thomas H. Lee Partners is one of the oldest growth-oriented private equity firms in the U.S. having raised $22 billion of equity capital since 1974. The firm's headquarters is in Boston, with offices in Houston, and Los Angeles.
Experienced Credit Team Should Drive Performance
The success or failure of any investment fund lies at the doorstep of the management team; TRCD is no exception. THL Credit Advisors is led by James K. Hunt, W. Hunter Stropp and Sam W. Tillinghast, who, along with Terrence W. Olson, Stephanie Paré Sullivan, Christopher J. Flynn and Kunal M. Soni, constitute its principals.
Before joining THL Credit Group in 2007 Hunt, Tillinghast and Stropp were responsible for over $40 billion in investments over the period from 1990 to 2006. Hunt and Tillinghast separately had ultimate investment authority for Sun America Corporate Finance and the Private Placement Group of AIG, respectively, where these investments were made. The responsibilities of the management team included sourcing, identifying, evaluating, structuring, managing and monitoring mezzanine debt, leveraged loans, private placements and private equity investments. Over the past five years, these individuals have held ultimate responsibility for approximately $460 million in investments. The THL Credit principals have worked together extensively in the past and have invested through multiple business and credit cycles, investing across the entire capital structure.
THL Credit principals bring a unique experience and skill set by virtue of their work history on both the debt and equity side. They bring an active equity ownership mentality and they have said that they intend to focus on adding value to portfolio companies through board representation, when possible, active monitoring and direct dialogue with management. This should hopefully drive returns at TCRD.
TCRD Investment Strategy
TCRD's investment strategy is similar to many BDCs and that is to generate both interest income and capital appreciation, primarily through investments in private debt and equity securities of middle market companies. As mentioned before, this area of the financial markets is potentially underserved and here lies the TCRD opportunity. TCRD is focused primarily in junior capital securities, including subordinated, or mezzanine, debt and second-lien secured debt, which junior capital may include an associated equity component such as warrants, preferred stock or other similar securities. TCRD may also invest in first-lien senior secured loans. It defines middle market companies to be public and privately held companies with annual revenue of $25 million to $500 million. It has stated that it generally does not intend to invest in start-up companies, operationally distressed situations or companies with speculative business plans.
Returns are expected to be generated through a combination of interest income on debt investments, equity appreciation that is through options, warrants, conversion rights or direct equity investments and origination and similar fees.
Recent Developments - The Momentum Continues
The third-quarter results show the momentum continues at TCRD. TCRD invested $68.8 million in five new investments in the third quarter. Third-quarter net investment income rose to $0.41 per share with a dividend of $0.32 per share. The dividend was increased to $0.33 per share for the fourth quarter.
Overall portfolio credit quality remained strong. There were no loans on non-accrual status as of September 30, 2012, and a weighted average leverage ratio of 3.6x (debt/EBITDA) with an average EBITDA ~ $20 million for portfolio companies in which TCRD has debt investments. TCRD started the fourth quarter with $166.0 million of cash and available capacity from credit facility as of September 30, 2012, which puts the company in a position to grow the portfolio further.
Investing in TCRD does come with risks. Like any credit fund, if the economy were to slip into recession, or even worse a European financial crisis developed, the investments that the fund holds would likely start to underperform. We might see a rise in accruals and a greater portion of income might come in the form PIK; and we could even potentially see the dividend cut.
TCRD does trade at a premium to book value, and this is a risk. If the valuation were to return to one times book value, an investor would have a loss. However, I am not sure that this premium should not be warranted given the low interest rate environment and unused investment capacity that TCRD currently has.
While BDCs have generally outperformed the board market during the last five years, they did substantially underperform in the bear market of 2008. This sector fell further and harder than the rest of the market and this represents a risk that an investor should be familiar with.