First Patriot Capital was bought by Prospect Capital (PSEC) , then Allied Capital was acquired by Ares Capital (ARCC) . Wednesday, after the market close, GSC Investment Corp (GNV) announced a recapitalization plan, which virtually amounts to a takeover by Saratoga Investment Advisors, a private equity group. One by one, the Business Development Companies [BDCs] which got into trouble during the Great Recession are finding solutions to their troubles short of bankruptcy or liquidation. By our count , only two walking wounded remain: Amercican Capital (ACAS), which has been renegotiating its massive debt agreements for ages, but seems close to succeeding and Kohlberg Capital (KCAP), which remains strangely quiet.
The Saratoga Deal
Getting back to the GSC deal: In return for injecting $15mn in equity for 37% of the Company, Saratoga will get to give its own name to GSC Investment and become the External Manager of the still-public Business Development Company. Saratoga plans to hike the management fees payable by investors, and return to making new loans with whatever availability remains under the $40mn Revolver being provided to refinance existing lender Deutsche Bank at closing.
Bad Deal for Shareholders?
At first blush this does not seem like a good deal for GSC’s long-suffering existing shareholders. After all, the stock was trading at $2.53 before the announcement, but Saratoga is paying only $1.52 a share for 10mn new shares. Then there’s the prospect of higher management fees. (How much those will be is unclear because GSC has not posted to its website the already signed revised agreement which spells out the new terms. We only know it’s worse from the news release). We also don’t know what the terms of the new debt being provided by Madison Capital Funding will be (also not posted on the website as they easily could have been), but we’d guess the interest rate will be relatively expensive as Madison is more of a turnaround lender than a traditional BDC lender.
We Are Buyers
Nonetheless, we’re not running for the exits yet. In fact, we’ve been buying more stock this morning when GNV pulled back on the news and here’s why:
Saratoga is getting a fantastic discount but is not buying the whole company. The remaining shareholders will get some of the benefits that Saratoga will be unlocking by getting the Company back on track.
Pays Off Deutsche Bank
First of all, the recapitalization pays off Deutsche Bank. The glass half-full crowd could say the German bank has been patient after months of continuing defaults and a borrowing base one third of outstandings. The glass half empty commentator might say that a reasonable lender would have been able to restructure the relatively simple facility here given that the Company always had more than adequate collateral (borrowing base calculations notwithstanding). Maybe getting a 9.5% interest rate thanks to charging default rates made renegotiating less appealing. It’s hard to know because nobody tells us what the issues were between borrower and lender.
Dividends To Resume?
Anyway, by bringing in the new equity and a $40mn Revolver from Madison Capital, the $35mn or so remaining Deutsche Bank outstandings can be repaid, leaving debt at only $20mn, and (an estimated) $20mn of available borrowing capacity. That leaves Saratoga clear to resume normal BDC operations, which presumably (this is our assumption and is not spelled out in the Press Release) means resuming dividend payments. We were encouraged by the intention to undertake a reverse 10:1 stock split right after closing, which will take the stock price into the teens rather than the single digits (where they are often ineligle for margin and even for purchase by certain institutions).
Credit Standards Have Been Poor
What kind of earnings can we expect going forward ? This is not so easily answered. Part of the problem is that GSC Investment's credit underwriting has been very poor. At November 30, 2009, $8.5mn of Realized Losses had already been booked. That was 6.5% of the original capital raised by the Company, which is not too bad by BDC standards. However, Unrealized Depreciation was at $53mn or 41% of capital, a very high prospective loss. Given that the Company always stressed that it was lending principally in a diversified portfolio of the senior slice of middle sized syndicated LBOs, this level of prospective losses was unexpected and beyond the industry norm.
Let us illustrate. Of 38 loans on the books, 12 or nearly a third were on non-accrual at the last report. On $156mn of loan assets (including the $29mn subordinated CLO investment),$49mn was on non-accrual or delinquent or 31%. If the CLO is excluded, 40% of GSCInvestment's loans made (mostly during the height of the boom, which may explain the credit problems) were in the troubled category. Even in the last quarter ended November 30 2009, three portfolio companies were added to GNV’s Watch List. Out of 29 borrowers, 16 were on the List or 55%. Moreover, just a couple of quarters ago, GSCInvestment’s $400mn CLO subsidiary was having problems, which was holding up both management fees and interest on the subordinated debt.
Credit Trend Improving?
With all that said, we believe there’s still gold in them thar hills, as presumably Saratoga agrees. As the 10-Q points out , the CLO is on the mend. The subsidiary is largely back in compliance, and (more importantly) receiving both its $2mn a year management fees (0.5% of $400mn) and distributions on its subordinated investment (which we believe is around 11%). In the loan portfolio, a couple of the 8 borrowers in the non-accruing or delinquent categories were not guilty of the former, but only of not being able to pay off their loans at maturity. In fact these borrowers were still paying interest, which is a good sign. In fact, most of GSC Investment loans were getting fixed, principally by restructurings. At last report (based on the latest Conference Call), 11 loans were performing normally, 9 had been restructured and 7 were still in process.
Estimating Earnings in the Future
For our purposes, we’ve divided GNV into a good bank and a bad bank. The good bank has $100mn in assets at cost which are performing, and the bad bank has $50mn of loans that are not performing. We figure that the good portfolio, plus management fees from the CLO should bring in total income of $12-$14mn a year. We are assuming a 12% average interest rate, which may be high amd may not require the circulation of existing assets into new loans by Saratoga over time.
Also in time, the nearly $50mn in non-performing loans will get sold, restructured , refinanced etc, and after losses are recognized, there will eventually be another $25mn in performing assets added to the books or about $3mn a year in incremental income. (We’re not plucking these numbers out of the air. The non-performing assets were carried at a FMV of $22mn at November 2009. We’re assuming a strengthening economy will raise the FMV slightly , and we’re assuming no new additions to these under-performers from the ranks of the performers).
Even assuming onerous borrowing and management fees (including a 20% Incentive Fee), we calculate 50% of the Investment Income will end up with the shareholders in the form of distributions, or $0.27-$0.32 per share . We’re not assuming any incremental earnings from additional asset formation by borrowing under the Revolver (management fees and interest expense usually eat up most of the benefit). Nonetheless, the Company will certainly get an intangible benefit from low leverage, new ownership and some additional working capital capacity.
That’s a lot of numbers, but here’s one more: if everything happens as we assume, Net Asset Value Per Share will ultimately rise to $3.90, despite the dilutive impact of Saratoga’s minority investment. Ironically, that’s 10 cents higher than the NAV at November 30, 2009.
Here are our warnings: we calculated all of this without the benefit of the latest numbers or any guidance from management or Saratoga. Bad debts may get worse, or have deteriorated since the last 10-Q. One of our big assumptions is that GNV’s Unrealized Depreciation will be cut in half in the months ahead and that could prove laughably optimistic. Saratoga may choose not to pay a dividend or a cash dividend. Or the deal itself may not get done, leaving GSC Investment eyeball to eyeball with Deutsche Bank.
Summing It All Up
We are taking the optimistic route and assuming the deal will get done (the GSC Investment Board has approved it) and relatively quickly. We think Saratoga is getting a bit of a bargain basement price, but existing shareholders will benefit from lower interest expenses and professional fees, as well as from ending the uncertainty which has surrounded the Company for over a year. If the Company’s asset values continue to improve, GNV is still available at a healthy discount to its ultimate value once all the dust has settled.
Author's Disclosure: long GNV