The recent big news (and there was much to pick from in the Business Development Company industry space) was Kohlberg Capital’s (NASDAQ:KCAP) announcement that all outstanding debt under its revolver had been paid off and the line of credit permanently retired. Only a few months ago the company had settled its long-standing and contentious lawsuit with its lenders, and agreed to pay off the $137mn in borrowings outstanding.
Then as now details were not forthcoming as to how KCAP was going to pay off its obligations in such a short period. An equity raise was out of the question (dilutive and expensive). The other two alternatives (or a mix thereof) was a massive sell-off of loan assets or finding a new lending group. From yesterday’s press release it appears Kohlberg went with the sell-off. This was not a great surprise as secondary prices for loans (even those principally originated in the Bad Old Days) have risen almost to par, and the company had $230mn in debt securities at cost on its books and available to sell, and $27mn in cash.
The good news seems to be that KCAP was able to de-leverage itself without incurring any great losses. According to the press release, the negative impact of selling assets in bulk and in a hurry only diminished the company’s Net Asset Value (NAV) by 1.9%. Given that NAV at September 30 was $8.84, that suggests the impact was 17 cents a share, or about one quarter of Net Investment Income Per Share. We don’t know if that number includes the $2mn payment KCAP will be receiving from its lending group as a parting gift, which was negotiated as part of the debt settlement.
We also don’t know (as we’ve said this BDC management keeps its cards close to their vest) what the balance sheet or the strategy will look like post repayment. We do know the lending group has released $73mn of collateral “previously securing the facility," which means not all assets were used to pay off the debt. However, we don’t know if that $73mn is the cost or fair market value of the assets returned to KCAP. That’s not an academic issue as the previously mentioned $230mn at cost of debt securities KCAP carried on its books at September 30, 2010 had a fair market value of $191mn. That’s a 17% discount says my calculator.
We also don’t know how many unpledged assets were sold to pay off the lenders. There were not many loans in this category (with the exception of KCAP’s substantial CLO assets which are in a separate category ... more on that in a second). We’re guessing, though, that KCAP did not sell any of the five non-performing loans on its books, with a cost base of $38mn. Our best estimate is that KCAP is left with about $90mn of performing debt securities (or maybe less if the company sold even more assets off to have a cash pile in the absence of a revolving line of credit). Unfortunately these assets are unlikely to yield (when the non accruing loans are included in the mix) more than 5%-7%.
The CLO Solution
For income, management and shareholders will be looking to the far higher yielding income being generated by KCAP’s investments of both debt and equity in CLO securities, and in its external CLO manager-Katonah Debt Advisors. After a rough 2009, most of the CLOs are performing again (as opposed to accruing dividends but not paying any out). As of September 2010, KCAP had $84mn in CLO investments at cost and $44mn invested in Katonah, which distributes all or some of its earnings back to its parent. In the quarter, these sources accounted for 53% of gross investment income (admittedly buoyed by some catch up earnings received at Katonah).
Expenses, not just interest costs but also professional fees and management fees, will drop from this de-leveraging, but will the earnings of KCAP be sufficient to maintain the current dividend level of $0.68 a year, or $15.4mn a year ? We don’t have enough information to hazard a guess but it will be on shareholders' minds as KCAP faces a de-leveraged future.
KCAP = TICC ?
In some ways the company’s balance sheet and possible strategy appear very similar to that of another BDC: TICC Capital (NASDAQ:TICC). That company paid off all its debt several years ago and has remained un-leveraged. TICC has performed very well in recent quarters by investing in the equity and debt of CLO securities, and reaping the high yields involved. This pushed up earnings and the stock price, and most recently allowed the company to raise additional equity for the first time since 2008. Maybe Kohlberg will follow a similar path.
Disclosure: I am long KCAP, TICC.