There's a new Business Development Company ("BDC") trading in the public markets this week: FS Investment Corporation (NYSE:FSIC). We've initiated coverage in recent weeks of the latest two new additions to the BDC roster that we track for our investments in the sector, bringing the total to 41. First there was American Capital Senior Floating (NASDAQ:ACSF) and then TPG Specialty (NYSE:TSLX) There's a lot to talk about with FSIC , so we will be initiating our coverage of the Company in a two-part series.
FROM NON-TRADED TO PUBLICLY TRADED
FSIC, like TPG Specialty, is not strictly speaking a new BDC. The Company has been operating as a "non-traded BDC" since 2009, and has grown into what will be one of the larger companies in the sector by asset size, with a loan book over $4 billion. The original investors are principally retail investors, brought into by Franklin Square Holdings, "a national sponsor of alternative investment products designed for the individual investor". This is an intriguing development in the publicly traded $30 billion plus BDC industry: a newly listed company managed by a firm that specializes in raising capital, rather than managing non-investment grade loans.
Franklin Square has delegated the day-to-day business of searching for, booking, monitoring and selling loans to a renowned third party: a subsidiary of GSO, which itself is a subsidiary of private equity giant Blackstone (NYSE:BX). GSO manages $65 billion of leveraged finance assets, across a number of different platforms. This marriage of Franklin Square and GSO is one of the notable features of the new BDC. In some ways this is a strength, and in others a weakness, as we shall elaborate.
THE ALTERNATIVE UNIVERSE OF THE NON-TRADED BDC
We've been tracking the non-investment grade BDC sector for a number of years, intrigued by the success of a handful of firms in raising equity capital from retail investors, notwithstanding very high placement charges and the illiquidity of the investments. Regarding the latter, a would-be seller of a non-traded BDC has to request the right to sell some or all their shares and wait for a periodic liquidity event when new money comes in and sellers get out, but with no guarantee on the price to be received or the certainty of being able to sell all shares tendered. The sponsor claim this is better for everyone concerned because it causes investors to take a long-term view because there's no easy escape. Just like in prison or the French Foreign Legion.
MATERIALS REVIEWED AND INITIAL REACTION
We read the initial 2009 Prospectus, but for this report we reviewed the latest FSIC 10-K and their related Investor Presentation. Unfortunately, and just like with the other two BDCs that we initiated coverage on, we came away underwhelmed by what we understand of FSIC's business model, and we question whether the current dividend level is sustainable in the medium and long term. (You'll notice we were more sanguine about the short term: the next 12 months).
First, though, let's have a look at the key numbers. At the close of 2013, FS Investment Corporation had investment assets of $4.1bn at fair market value, and $4.4bn in Total Assets. Debt-from three different financings-was in excess of $1.6bn and net equity was $2.6 bn. The Net Asset Value is $10.18, and the Debt To Equity ratio 0.63.
The Company's "investment objectives are to generate current income and, to a lesser extent, long term capital appreciation". The 10-K explains that the objective is to be met by utilizing the resources of GSO/Blackstone "in sourcing, evaluating and structuring transactions", and "focusing primarily on debt investments in a broad array of private U.S. companies, including middle-market companies". As usual, middle market is in the eye of the beholder, herein defined as companies "with revenues between $50 million and $2.5bn" which is a little like saying you're willing to date anyone between the ages of 18 and 65.
The existing investment portfolio is comprised "primarily" of senior secured loans and second lien secured loans, but also includes Subordinated Debt (9% of the total) and CLO investments (2%) and equity investments (a very minimal 1%). There are 165 loans in portfolio and, as you'd imagine diversified into every imaginable industry. 72% of the loans are floating rate. The gross yield on "income producing" portfolio assets is 10.2%, at original cost.
Credit quality appears to be in good shape. We did not notice any loans on non-accrual. Judging by the Company's "Portfolio Asset Quality" metrics (page 71), 91% of investment assets are performing at or above expectations, and some kind of loss is expected on just 1% of the portfolio, a reduction from a year ago.
Recurring Earnings Per Share (i.e. Adjusted Net Investment Income) was $0.99 in 2013, but was slightly down in the IVQ 2013 to $0.24 (or $0.96 annualized). See page 22 of the IVQ Investor Presentation, which also includes 2 month 2014 data, which, if annualized, pegs recurring earnings per share at $0.90.
Distributions to shareholders have trended downwards slightly in 2013 to $0.8303 from $0.8586, just a -3.3% drop. In 2011, the distribution totaled $0.9098, which means the 2013 distribution level is -8.4% below two years ago. Currently, the Company is paying a $0.0720 monthly dividend or a $0.8640 annual pace. At a recent $10.17 stock price, the effective yield is 8.5%.
POTENTIAL PROBLEM: YIELD COMPRESSION
New prospective public shareholders are not left with much in the way of future upside in the short run in terms of higher recurring earnings or higher yields. What's good for the existing shareholder (liquidity and a stock price in line with NAV) goose may not be so for the new investor gander. With the debt to equity level already at elevated levels, and FSIC unlikely to raise new equity at a premium to Net Asset Value based on the current price, any material growth in investment income appears unlikely. Moreover, the Company is facing a very familiar problem in the BDC space: yield compression on existing assets. The aggregate yield just north of 10% is unlikely to survive much longer if the Company sticks with it's current loan mix.
As the 10-K itself points (page 12) the Senior Secured Loans, which account for nearly two-thirds of assets are paying out rates of just 4.0%-8.0% over LIBOR (which is virtually nil). If we just assume new loans are made at the median (6.0%) and assume a 0.25% LIBOR rate, the all-in yield will be 6.25%. Using similar logic, the average yield on 2nd lien loans comes in at 8.25%.
BIG IS NOT ALWAYS BETTER
The challenge which the Company faces is compounded by the alliance with Blackstone's GSO. Admittedly, the GSO organization is experienced and huge, but that very heft and the size FSIC's portfolio causes loans to be made to the larger "middle market borrowers". Until recently GSO has been essentially selling slivers of much larger loans, which they originated or were trading in the secondary market to FSIC. According to the 10-K the average EBITDA of FSIC's borrowers in 2012 was $302mn, which suggests their enterprise value was well in excess of $2 bn on average. Unfortunately for FSIC and it's investors, this is the sweet spot of leveraged finance at the moment, and borrowers are able to command very low yields and very favorable terms. BB and even single B borrowers are able to borrow at all-in yields below 5.0%. If all FSIC invested in were senior secured and second lien loans to the larger of these borrowers, it's average gross yield would drop by 30% or more.
LOOKING FOR THE MIDDLE OF THE MIDDLE MARKET
Clearly, GSO has recognized the risk. As the 10-K shows, there has been a major shift in their target market borrower in recent months, and in how that deal is sourced. At the end of 2013, the average EBITDA of borrowers has dropped to $191mn (large but still a third lower). Moreover, where in 2012 27% of loans were "direct originations", last year the proportion increased to 51%, as GSO attempted to make loans directly to smaller-and higher yielding borrowers.
Nonetheless, the new yields are still way below the levels achieved in 2009-2012. See page 69 of the 10-K, which spells out some of the data. In the fourth quarter of 2013, loans which were repaid were yielding 16.9%, and for all of 2013, 14.0%. However, new Direct Origination loans made in the IVQ of 2013 and for the year were at 9.2% and 10.5% respectively.
If Direct Origination loans are only yielding 9.2% we're guessing (which we have to because FSIC's 10-K is quiet on the subject), we're guessing Broadly Syndicated and Opportunistic loans booked were yielding even less. Holding up the average yield are higher risk CLO and subordinated loans presumably, but FSIC cannot draw too much from that well without materially altering it's risk profile. So we're predicting that in 2014 the average yield will drop, and average assets will not increase by near enough to offset the drop. The result: lower investment income, even if the credit picture remains pristine.
PROBLEM: EXPENSES ARE HIGH
Expenses are just too high for what you get with FSIC. Currently, 50% of income gets paid out as expenses of one kind or another, and only 50% is earmarked for the investor. The number one culprit is the 2.0% of assets management fee and the 20% Incentive Fee. In a relative sense those fees are high, both in terms of the business model and by comparison with the (very well paid) BDC industry-at-large.
The management fee is fixed as a percentage of assets. Therefore, when yields drop (as we discussed above), it's the shareholder who bears 80% of the burden. Most BDCs yielding around 10.0% charge a management fee of 1.5%-1.75%. BDCs that chose to focus on senior debt have reduced the management fee to 1% of assets or lower (ACSF is the winner in the "how low can you go" category). Presumably because this company has two mouths to feed, and/or because non-traded BDCs have traditionally been able to charge retail-focused BDCs higher charges, fees are very high.
LET'S TALK FEES
Frankly, we don't begrudge BDC managers "high" fees when the business model includes an organization that generates a difficult to replicate, "proprietary" deal flow. Chances are if a lender sources, structures, leads and monitors their own loans-and retains the bulk of the credit risk-control over the loan and credit outcomes will be better. Here the situation is more nuanced.
GSO is partly filling FSIC's portfolios with loans bought in the secondary market (presumably the Opportunistic segment), and slices of Broadly Syndicated loans. Even the Direct Originations- one has to assume- are larger loans placed in several different GSO credit vehicles, including FSIC. For a 2.0% management fee and an Incentive Fee (here called a Subordinated Incentive), we'd expect the BDC to be the primary originator, rather than the participant. In my days in the banking business we used to call the latter "the stuffees". These were the smaller institutions, which did not have the lending network to generate their own proprietary loans, and bought slices of loans generated by the Big Boys. The "stuffees" received a lower all-in yield; usually had limited access to the borrower, not much impact on the loan structuring and little influence on amendments.
Even when GSO is the Direct Originator, FSIC may have little influence on a credit as GSO is in charge, and may have different interests than FSIC. We do take some comfort that all loans generated by GSO have to be approved by FSIC, but the latter do not have the team, experience or capabilities to provide more than cursory oversight of the flood of deals that comes over the transom.
The most intriguing question here is how good a credit underwriter is a group like GSO, which has a reputation to protect but no capital at risk, and whose roots are more in investment banking (finding and selling on loans) than in lending (finding and holding loans till maturity). We don't know the answer-nor will we until the next recession. Certainly, we didn't find much in the way of data about GSO's credit performance in the past in transactions of the size which FSIC is now invested in.
CONCLUSION OF PART I
So far, our review suggests the yield compression underway, the high cost structure of Franklin Square, and the almost fully leveraged (by BDC standards) state of the balance sheet, will make any material increase in earnings unlikely. In fact, in the quarters ahead, we would expect investment income to drop as newer, lower yielding loans replace refinanced higher yielding ones. In the short run-like many BDCs-the Company has retained some earnings to support the distribution, but that cannot go on forever. Which is why we expect distributions will be OK for a year or so, but may get challenged in 2015 unless there's a change in strategy (possible); or the Fed raises short term rates by more than 1% (unlikely), or the Company increases leverage by bringing debt to equity above 0.70 or more (unlikely, for reasons we will explain in Part II). From our standpoint, an 8.5% yield with risk to the downside does not make for an appealing investment, especially as the Company was established after the Great Recession and the formula of using a third party sub-adviser (even one as big and famous as GSO/Blackstone) to underwrite loans remains to be proven in a market downturn. Of course, every investor has different risk and reward parameters, so what is a No Thank-You for us, may be a Yes, Please for someone else.
PREVIEW OF PART II
Beyond and above the short/medium term of earnings and dividends, which is the bread and butter of most analysis of Business Development Companies on Seeking Alpha and elsewhere, we try to peer into the uncertain future to project how a company might perform in the inevitable but unpredictable Next Recession. We tend to focus on de-constructing a BDC's capital structure to determine how well or how poorly performance might look like under a variety of scenarios, including a range of credit losses and drastic changes in market liquidity.
We've reviewed FSIC's borrowing arrangements and come away with a couple of concerns about how the Company has chosen to fund itself, which may show up when the rubber meets the road during the next crisis. Ironically, we find ourselves wishing FSIC was paying more for it's own debt than it is. We'll explain why at length in Part II.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.