The latest Business Development Company ("BDC") to come to market is American Capital Senior Floating (ACSF), the creation of one of the oldest BDCs in existence-American Capital (ACAS). We're going to review the proposed business model of the new BDC, and determine what market opportunity one of the oldest, largest and most controversial Business Development Companies is offering the investment community.
The past few years have been very good for BDC capital raising. Virtually every one of the BDCs that survived the Great Recession without being acquired by another BDC (RIP Patriot Capital and Allied Capital) has gone on to raise one or more rounds of additional equity capital. Furthermore, many BDCs that could not even arrange or renew a normal secured, short term Revolving Line of Credit with a bank in 2008-2009 have been able to raise unsecured publicly traded, long-term Notes; as well as Convertible Debt, securitized loans, etc. over the past 4 years.
What's more a host of new BDCs have come to market, in both publicly traded and non-publicly traded formats, each with different investment strategies, capital and business models. We're especially interested in that last point because we underwrite Business Development Companies primarily on the soundness of their business model. We look through to the type of borrower, which the BDC seeks to serve and how large a segment of the credit markets is involved; we seek to assess the relative risk (in terms of likely loan default and recovery) and the micro-economics of each entity when likely income, cost of capital and operating expenses are taken into account.
However, the soundness of any BDC's business model has not and will not be fully "battle tested" until economic conditions deteriorate again with the next recession. Until then, we can only make some tentative assessment of how any BDC will perform when market conditions tighten; liquidity dries up; loan values drop and the number of troubled loans drastically rises.
Judging from what we've seen five years into the economic expansion, and remembering what we learned during the very difficult period between mid 2008 and mid 2009 when most of the BDCs' stock prices went into free-fall and net asset values dropped sharply, there will be as many winners as losers, and a number of today's high fliers could be brought low. On the other hand, BDCs with the right business model, management and credit skills should fare very well.
Sorting out which BDC is likely to be wheat and which chaff over the long term (which has to include a day of reckoning of a future recession of unknown timing, scope and shape) is the principal focus of our analysis of every BDC out there. We are especially intrigued by new entrants into a market already crowded with existing players, virtually all of which are well capitalized; have cleaned up their loan portfolios and are anxious on expanding their balance sheets. What opportunity do these Johnny-Come-Lately's claim to see in these highly competitive debt markets, and do their strategies makes sense in all weather conditions?
AMERICAN CAPITAL SENIOR FLOATING JOINS THE PARTY
The new BDC is targeted at a very crowded-and very low yielding- segment of the market: large cap senior loans. In ACSF's prospectus large-cap is defined as borrowers with EBITDA greater than $50mn (which is the standard used by S&P Capital IQ-the standard setter in this regard). Thanks to the huge amounts raised by Collateralized Loan Obligations ("CLOs"), as well as by Exchange Traded Funds ("ETF") and Closed End Funds ("CEFs"), big borrowers of non-investment grade debt are able to borrow at very, very low yields. (Just check out the latest data on LeveragedLoan.com, which shows that today BB floating rate loans are being made at an average yield of 3.33% and B at 5.03%. It's a mixture of amazing and gut wrenching for anyone invested in non-investment grade debt). This low rate environment is reflected in the average yield of 4.88% on ACSF's first lien loans, which accounted for 78% of the total loan portfolio.
American Capital argues that this segment is of interest because of "attractive Risk-Adjusted returns" and because long-term data shows that:
"leveraged loans issued by large-market companies have... historically experienced lower default rates and higher recovery rates in the event of default compared to loans issued by middle-market companies."
MICRO-ECONOMICS OF A LOW YIELD BDC
Nonetheless, if the Company devoted itself exclusively to large cap senior loans alone, the economics of the BDC structure would make the return on capital too low to be attractive. With BDCs limited to 2:1 asset to equity leverage a portfolio composed exclusively of sub 5% loans would generate-at best- a return on equity well below 6%.
As a result, the new BDC's business model includes a strategy of investing 20% (or even 30% under certain circumstances) of its investment portfolio in the equity portion of CLOs. CLOs are the chalk to the senior secured loan's cheese i.e. they are on the opposite spectrum of risk and return. Today an equity stake in a CLO sits under 8x-10x of more senior tranches, each with superior claims to interest and principal on the portfolio in the case of defaults or asset deterioration. In exchange, CLO equity pays an effective yield in the mid teens, or roughly 3x as much as a senior loan.
At the time of going public only 15% of ACSF's portfolio was in the form of CLO investments. However, if and when the proportion rises to 20% as promised in the prospectus, nearly 40% of the BDC's income will come from CLOs.
OPPORTUNITY IN MIXTURE OF LOW AND HIGH RISK
Therein lies both the opportunity and the risk. Let's look at the opportunity first. By mixing up low yielding and high yielding investments in the BDC, ACSF should be able to generate a gross yield around 8.0%. Furthermore, the BDC has arranged low cost financing (all-in cost just over 2% per annum at today's rock bottom LIBOR rates), which will allow a decent arbitrage between lending yields and borrowing cost.
LOWEST MANAGEMENT FEE FOR A BDC-EVER
Most interesting-and unusual in the BDC space-is the very low management fee, which ACSF's adviser is charging: just 0.8% of total assets (not including cash). Remarkably, and at complete variance with all other BDC fee structures, there is no "incentive fee" equal to 20% of surplus Net Investment Income or any capital gains fee. (Before you cheer too loud, note that the management fee is based on portfolio value at cost. That means if the portfolio is written down by any percentage in the future due to Unrealized Losses-as often happens in a recession-the management fee remains the same. However, we feel that's an investor friendly fee arrangement, something you'll rarely hear in the BDC space).
COMPETITIVE RETURN IN A LOW YIELD WORLD
Thanks to low cost financing and low management fees and low operating expenses, we believe the BDC may ultimately generate a dividend yield north of 10.0% on Net Asset Value, once maximum portfolio size is reached. Furthermore, given that the senior loans are almost all floating rate in nature (albeit with fixed floors), a decent uptick in short-term rates will generate even higher income and higher yields. On a pro-forma basis, once ACSF is fully invested in gross yield terms its returns will be more than competitive with CEF Floating Rate Loan Funds, which also invest primarily in senior loans and which also use margin (albeit slightly less, with borrowings limited to 50% of equity). Today most Floating Rate Loan CEFs yield 6.5%-7.5% (but that's because they don't have 20% of their assets in CLO equity).
In the short term, or maybe the medium term, the micro-economics of the new BDC should remain attractive. Yields on large-cap loans are unlikely to tighten much more, and even in the heated conditions of today's CLO market equity stakes in these highly leveraged vehicles should remain close to their current levels or even rise. With current loan defaults in single B and BB rated debt virtually nil, the new BDC should be able to offer a competitive return in a low yield environment.
IN THE MEDIUM TO LONG TERM...
However-and you can see where we're going with this-we question how ACSF will perform in a recessionary environment. We won't bother to get out our crystal ball and imagine the conditions of the next recession. Let's just assume that we face the conditions of 2008-2009 again. In a very short period of time the value of the senior loans in ACSF's portfolio will drop sharply in value as holders of loans dump assets into a market with few buyers. In 2008-early 2009 the drop in value exceeded 25% in a very short period. Even more dramatic will be the drop in the market value of the CLO investments. After all, who will care about retaining a 15% return if investors become worried about the very future of the financial system and doubt the resilience of every CLO in existence?
RISK OF DEFAULT
If ACSF is fully leveraged (we are assuming debt to equity of 0.8 to 1.0) the 2-year Bank of America Revolver which it finances itself with will probably be in default. Furthermore, the Company may no longer have the required 200% asset coverage required by BDC rules, and that will mean suspension of the ability to pay dividends-even if ACSF wanted to. (Instead, investors may get paid in stock, which results in phantom income and leads to more selling of stock and lower stock prices).
The decline in asset values will be followed by defaults from 5-10% of the senior loan borrowers, which will cut into income. Worse, most of the CLOs will probably default, in that interest and principal payments will be re-directed to paying off the senior tranches of the structure at the expense of the equity portions. In a worst case all the income from the CLOs could be cut off for a time. As a result, the 10% + yield being received by investors may be cut in half or suspended altogether in a recession.
IMPACT ON NAV OF THE NEXT RECESSION?
Once markets have adjusted and defaulting loans settled out over a period of 12-18 months (in the bulk of cases), will Net Asset Value take a permanent hit? We think so, but it's very hard to tell how much, and depends largely on a big unknowable: the behavior of the Revolver Lender when the recession hits the fan. American Capital-with its long history of investing in both senior loans and CLOs-will argue that net losses will be minimal. In the Great Recession CLO assets fared much better than anyone invested after all the dust settled.
However, we fear that drops in asset values may cause the BDC's senior lender to force asset sales at fire sale prices to protect their borrowing base. It has always been so. Why would next time be different? A lender being paid 2% per annum has little economic incentive to take the long view.
On the other hand, if ACSF is able to avoid being forced into a fire sale of assets, we'd estimate the maximum Realized Losses, after all the smoke has cleared and following a very volatile movement in the stock price, should not be too onerous: 10-15% of Net Asset Value by our lights. We buy the argument that the large cap senior loans, which ACSF invests in at the senior level and which are the stuff of which their CLO investments are made of will ultimately fare OK by the end of the next recession. However, an investor will have to have nerves of steel.
CAPITAL STRUCTURE WEAKNESS
If the new BDC had access to longer-term unsecured debt, with no borrowing base or covenants, the risk of being forced to sell a portion of the loan assets at the wrong time would be diminished. That's the thinking that many BDCs have been using since the Great Recession to avoid a repetition of the conflicts that developed between BDCs and their Revolver lenders when the markets soured. (Patriot Capital was scuttled and had to find a buyer pronto; Allied Capital had to drastically de-leverage, Kohlberg Capital went to court; TICC sold off enough loans to give up borrowing altogether, GSV Investments had to find a white knight, Gladstone Capital and Gladstone Investment had to put a third of their assets on the auction block, etc).
However, the tight micro economics of BDC lending in a Zero Interest Rate Policy environment apparently make that adding of a higher cost unsecured debt layer prohibitive in the case of ACSF. If ACSF manages to raise unsecured Notes in the future for a portion of their borrowing (which will hurt Net Investment Income), we may become less pessimistic about the Company's chances of surviving the next recession without a big drama with its bank lender.
This new BDC - despite its investing focus on the most competitive segment of the Leveraged Loan market-has many unusual and attractive features that should result in a high and consistent yield as long as the sun shines. Furthermore, the credit track record of the parent - American Capital - in the senior loan and CLO segments is very strong, and should inure to the benefit of ACSF's shareholders. Furthermore, we're delighted to see management intends to build a highly diversified portfolio of loans and of CLOs, which we are great believers in, rather than making huge bets on a few names. We appreciate the low fee and cost structure, and have no question that the BDC's capital can be deployed relatively quickly and easily given the type of loan assets involved.
In its very short history, the stock is trading up 7.6%, helped presumably by an Outperform rating from Oppenheimer. We wouldn't be surprised if the stock went even higher as ACSF becomes better known and its dividend increases as management puts available capital to work.
Unfortunately, and as we've shown, we question how resilient a BDC can be when the weather changes; with 20% of its assets invested in the very riskiest credit investments; a capital structure reliant on a 2-year Bank of America Revolver packed with covenants and a borrowing base and an owner (American Capital) who owns only 3% of the entity and makes only a modest fee. Individual investors should be especially cautious. ACSF may perform fine for months or years, but the stock price could decline very quickly should institutional investors lose confidence when market conditions change. For the moment, though, the sun is shining.