Saratoga Investment Corp: A Way to Buy Debt at Deep Discount to Book Value

Oct.19.10 | About: Saratoga Investment (SAR)

On August 30, I posted an article to my instablog recommending Gladstone Investment (NASDAQ:GAIN), then trading at $5.77. Yesterday, it closed at $7.38. While I would like to think that I am smarter than the market, I believe that I just made a reasonable long-term investment and got lucky in the short term. It is on that note that I will discuss Saratoga Investment this piece.

Saratoga Investment Corp. (NYSE:SAR) is a business development company (BDC) making loans in the middle market space. It is the successor to a troubled BDC named GSC which experienced an enormous erosion of value during the financial crisis. BDCs are limited to 200% leverage (total assets must be no more than double net assets) and many BDCs have had leverage covenants in their borrowing terms. Like many BDCs, GSC had to write down many of its assets and got itself into leverage and covenant difficulties. Recently an investor group agreed to recapitalize the company and change its name and leadership.

As part of this effort, a committment was obtained for a new revolving loan; the funds generated by the recapitalization (a purchase of some $15 million worth of stock) and funds made available pursuant to the revolver allowed SAR to repay its old loan. Thus, SAR is now in the ranks of BDCs that do not have lender or ratio problems. While some BDCs have traded at large discounts to NAV, these have generally been BDCs with lender or ratio problems and SAR's exit from those ranks suggests that it will gradually (and perhaps not so gradually) trade up closer to the NAV of $29.71 per share.

Like other BDCs, SAR is a RIC and must pay a large portion of its taxable earnings as dividends. Investors in BDCs tend to be dividend oriented and, as SAR has not paid a dividend in some time and has not announced its future dividends, it trades at somewhat of a discount to the group. Thus, as of Friday's close, SAR was trading at $19.25 - less than 67% of its NAV of $29.71. Earnings were released after Friday's close and a conference call was held Monday morning. Monday, it closed at $20.28.

BDCs trading substantially below book value provide an opportunity to buy debt in the equity market and to essentially acquire a book of loans for a price well below the book value. In the early stages of this financial crisis this opportunity also existed in closed end funds (many of which were trading well below NAV) but that window has pretty much closed and some high yield funds are now actually trading above NAV. Thus, the opportunity to buy loans at deep discounts to book value is becoming more and more unusual. My general investment approach has been to stay of ahead of the thundering herd of investors who are gradually accepting more risk because of their hunger for more yield. My central thesis is that this trend will continue and that the BDCs in general and BDCs trading at substantial discounts to book value will become increasingly attractive to investors.

SAR's book is almost exclusively made up of debt instruments, many of which have already been written down substantially. As of August 31, it had $101 million in total assets and $ 21 million in liabilities. Of the assets, some $14m and $19m are first and second lien term loans, respectively and $29 are senior secured notes. Reviewing the financial statement, the book value of the assets is some $48m below the cost of the assets, indicating that there have been substantial write-downs already and that the face amount of the loans may be significantly in excess of the book value. It appears that the write-downs were primarily with respect to the unsecured loans and second lien term loans.

The new management is very optimistic about the market for lending in its space and is committed to expanding in a responsible manner. It has a commitment from its lender to allow the revolver to reach the level of $40m so that it has some "dry powder." Cabell Williams, a highly regarded figure in the BDC world, is on the board. The management, pursuant to the recapitalization, now owns a substantial part of the SAR common equity and its interests are aligned with those of the shareholders.

My expectation is that SAR will gradually trade up to book value and that book value may increase modestly in the next quarter or two. I expect dividends to be resumed some time in calendar 2011. The catalysts for appreciation in value are likely to be: 1. a resumption of dividends; 2. a takeover (not too likely because management seems to committed for the long haul); and 3. gradual improvement in earnings and modest improvement in per share book value. The risks are that dilution occurs due to the issuance of shares below NAV, there are more write-downs in the portfolio, and costs are excessive because operations are below scale (small BDCs can have higher costs per asset dollar).

Obviously, I would rather buy this at $19.25 than at $20.28, but even at $20.28, I believe that the $29.71 book value provides an investor with a reasonable degree of insulation against adverse developments. It is entirely possible that, within a year or two, this stock could be trading at $30 and yielding 10-12% at that price. Investors should bear in mind that this stock is very illiquid (trading volume has averaged 3600 shares per day); this will probably limit institutional interest in the stock and also will make it difficult to exit a large position quickly. On the other hand, one of the few advantages a small investor has in this market is that he can participate in opportunities like this one.

Disclosure: Long GAIN, SAR