At close of business on October 18, 2010, upper middle market Business Development Company ("BDC"), Blackrock Kelso (BKCC) announced its intention to issue another 6.9mn shares (including the underwriters over allotment), presumably just below the $12.69 closing price. That will bring around $80mn in new equity, or an extra 13% addition to the equity line on the balance sheet as measured at the last earnings report in June 2010.
We have a few immediate thoughts:
- You can’t really blame BKCC for jumping at the opportunity to raise equity, even though the last offering occurred only back in June 2010, a mere 4 months ago. The company has always sought to remain disciplined and ,when matters were at their worst during the Great Recession, avoided selling stock at bargain basement prices to shore up their balance sheet. Eighteen months ago the stock traded as low as $2.41. Today‘s BKCC close is way above the latest NAV of $9.83. That means BKCC is raising its equity at a great price. Even if the offering closes at $12, that’s still a 17% premium over June’s raise and 22% above the NAV.
- We doubt that BKCC really needs the money in the short run. As late as the last quarter loan payoffs were running at a faster pace than new loan formation. The company’s availability under its borrowing arrangements, even accounting for lenders not renewing their commitments when the Revolver expires in December of this year, was $230mn, plus $20mn of cash. That’s equal to one-third of investment assets already on the books. With the new equity BKCC will have a whopping $330mn or so to spend. Maybe BKCC is benefiting from the pick-up in leveraged loan demand in the second half of the year and will quickly use up its pile of capacity, but we doubt it. Going along with the new deal activity is robust refinancing activity in the larger sized transactions and BKCC will probably consider itself lucky to marginally increase its total investment assets by year end.
- The balance sheet, already strong, will only get stronger in the short run. This is a phenomenon across much (but not all) the BDC sector: companies are raising equity after having de-leveraged and cleaned up their bad debt portfolios. Based on the June 30th data, BKCC may end up with virtually no borrowings after the equity raise (maybe $50mn-$70mn), almost three quarters of a billion in equity on a GAAP basis and near to a billion on a market cap basis. For anyone worried about a sudden and unexpected credit crisis and/or double dip recession, BKCC is making itself virtually immune. Of course that will change eventually when new deal activity really picks up the pace, but BKCC could have half a billion dollars in debt (versus $145mn today) and debt to equity would still only be a reasonable 0.65:1.00.
- If there is a fly in the ointment, it’s the impact that this new equity will have on the ability of BKCC to maintain its dividend in the long run. With the new shares, BKCC will have to earn Net Investment Income of $92mn a year to meet its dividend commitments at the current quarterly rate of $0.32 a share. Last quarter Net Investment Income, after making a pro-forma adjustment for a likely incentive fee to the managers, the running rate of earnings was $64mn. This suggests BKCC will have to raise its earnings by 44% to be making enoiugh money to maintain its current dividend rate. Our calculations suggest that BKCC would need to leverage itself to a level of 0.7:1 or higher to achieve that level of income generation. However, BKCC-like many other BDCs-is wary of taking on too much debt so as to avoid the agonies experienced during the Great Recession (remember the $2 share price of 18 months ago). Will management leverage itself up to a vulnerable level to keep the dividend unchanged or will they choose to trim the obligation modestly to remain conservatively structured?
Maybe BKCC’s management itself is playing the 'wait and see' game. The ability of the company to maintain the dividend despite this flood of new shareholders will depend upon a number of variables including what loan yields will be in the months ahead, the cost and availability of financing (BKCC needs to increase its borrowing capacity and probably will follow Apollo and Ares in announcing new debt arrangements), the mix of income producing and non- income investments (the latter don’t contribute to Net Investment Income and BKCC’s portfolio is 12% in this category) and what happens with bad debts.
The company has $24mn in undistributed Net Investment Income that can be used to fund shortfalls for quite some time, but sooner or later BKCC will be forced to make a choice. Still bruised by the Great Recession we’d vote for a lower dividend obligation and a permanent commitment to keeping debt to equity at or under 0.5:1.0, but management is rarely willing or able to address such issues head on with shareholders so we’ll have to wait and see what BKCC’s ultimate decision looks like a few quarters out.
Disclosure: Author is long BKCC