We have been writing brief articles about new BDC (business development company) THL Credit (TCRD) throughout its one-year history. Generally, we’ve been impressed with TCRD’s fast growth from a minuscule portfolio to 15 companies with a market portfolio of $153mn as of December 31, 2010. The company’s not done: This year a Revolving Line of Credit has been established with ING Capital for $115mn, and there is still $110mn in cash sitting on the balance sheet. Down the road, if the SBIC approves the company’s application to borrow, up to another $150mn in junior capital will be tapped. By our calculations, we can see the company more than doubling its portfolio assets before needing to return to the equity well.
Just Rank and Serial Number
We’ve commented in the past on the company’s tight fistedness with information, which is something of a handicap for a new public company. Here’s a recent example: while virtually other BDCs provide a full balance sheet and income statement in their quarterly earnings release, TCRD only offers up summary information. Similarly, when TCRD enters into a major co-funding arrangement with an institutional group in January, TCRD cannot provide either the name of the investor or the percentage of management fees referred to in the press release, but not detailed. Likewise for the “performance fee subject to a return hurdle” and the share of the front-end fees to be retained. When you have $153mn in total investment assets outstanding, a $150mn junior co-investment arrangement is a potentially major contributor to earnings, and is deserving of more light.
We understand that all the parties may not want these details announced, but shareholders are left discomfited. Both the principals of the firm and its parent company Thomas H Lee do not have much experience operating in the public market, and this may explain the initial reticence of the Company to reveal information that most other BDCs splash all over their filings and releases.
Opening the Kimono
The above notwithstanding, there does appear to be progress on this front. The company just released an Investor Presentation on April 8 (the first of its kind), which is a treasure trove of information. The presentation is certainly worth reading for an up-to-date overview of where the company stands just before the upcoming first quarter 2011 financial reporting, scheduled for May 9. Then there’s the company’s 10-K, which we’ve reviewed in detail recently. Rather than give a blow by blow recitation of recent earnings and balance sheet items, all of which are in constant transformation as TCRD grows, we thought we’d highlight five issues about the company which we gleaned from our review and which will influence future performance for years to come.
1..TCRD is targeting unsponsored investments. Here’s a quote from page 3 of the 10-K;
“We believe that unsponsored middle market companies represent a large, attractive and less competitive mezzanine investment opportunity for two primary reasons: (1) the number of unsponsored companies far exceeds the number of sponsored companies; and (2) most mezzanine investors focus primarily on sponsored companies. We also believe that investments in unsponsored companies will provide for the most attractive economics, alignment of interests with management and the greatest control for us as an investor because unsponsored companies generally have less access to capital providers.”
Taking the Road Less Traveled
Most BDCs finance buy-outs or recapitalizations “sponsored” by private equity groups, which provide the equity capital and the corporate supervision leveraged buy-outs require. THL Credit is seeking to arrange senior or subordinated debt transactions directly with private companies (and even smaller public entities), albeit introduced by an investment banker or other intermediary. The theory is that this is an undeserved market and on a risk-adjusted basis TCRD may be able to build a superior portfolio with this approach. (The company, though, also continues to work with sponsor groups.)
This is a very intriguing strategy, but it’s impossible to tell at this early stage if that will be even possible (will there be enough deals?), and if it is will the returns bear out management’s optimism? Unfortunately the company does not disclose what deals are sponsored and which are unsponsored, so this is a work-in-progress.
2. TCRD has committed itself to relatively low leverage. Sort Of. All BDCs are restricted (with certain exceptions to be discussed below) to a maximum debt to equity of 1.0: 1.0. TCRD has imposed a limit upon itself, which is spelled out in the 10-K, of financing its assets with no more than 33% debt obligations. Once we do the math to convert that limitation on the share of assets financed to a debt to equity calculation, the latter maxes out at 0.5:1.0. That’s a commendable and conservative limit. Moreover, it’s a policy which TCRD can probably afford to follow because its yield on loan assets booked are so high (over 15.0%), and the company is virtually fully focused on building yield assets rather than common equity investments that pay no current income.
Wait, there’s a possible caveat. As we reported, TCRD is applying for an SBIC license. Most BDCs that have received BDC licenses have asked for and received permission to exclude SBIC debt from the 1.0:1.0 debt to equity maximum required. Chances are THL Credit will do the same should an SBIC subsidiary take root. Should that occur, and everything else being equal, debt to equity will be much higher. In theory, the number could be above 1:1.
We’re probably months away from an SBIC license being approved, funds drawn and a portfolio built, and longer until the $150mn limit is reached. This, too, is worth watching. There’s a trade-off here. Higher leverage will give superior earnings, but in a downturn you’d expect that loans earning up to 16% per annum interest rates might face an above average rate of defaults.
3. TCRD has an investor friendly fee structure. One of the other BDC newbies, Golub Capital (GBDC) has been making much of its progressive fee arrangements compared to the 2/20/20 that most BDCs charge on total assets, profits and capital gains. We believe TCRD’s is even better. Here’s why:
- The Base Management Fee is 1.5% of assets. Admittedly that’s calculated on total assets, without any reduction for cash on the balance sheet (which some BDCs have waived charging on). Nevertheless, that’s 25% lower than the industry convention, and drops straight into shareholder pockets.
- The Incentive Fee is 20% of operating income, with an 8.0% hurdle rate. That’s the conventional approach. However, TCRD has added a total return calculation that reduces fees incurred if the assets of the company deteriorate in value. We have no way of explaining this clearly but to quote from the 10-K language that was put together by the best and the brightest:
“The foregoing incentive fee is subject to a total return requirement, which provides that no incentive fee in respect of the Company’s preincentive fee net investment income will be payable except to the extent 20.0% of the cumulative net increase in net assets resulting from operations over the then current and 11 preceding quarters exceeds the cumulative incentive fees accrued and/or paid for the 11 preceding quarters. In other words, any ordinary income incentive fee that is payable in a calendar quarter will be limited to the lesser of (i) 20% of the amount by which our preincentive fee net investment income for such calendar quarter exceeds the 2.0% hurdle, subject to the “catch-up” provision, and (ii) (x) 20% of the cumulative net increase in net assets resulting from operations for the then current and 11 preceding calendar quarters minus (y) the cumulative incentive fees accrued and/or paid for the 11 preceding calendar quarters. For the foregoing purpose, the “cumulative net increase in net assets resulting from operations” is the amount, if positive, of the sum of pre-incentive fee net investment income, base management fees, realized gains and losses and unrealized appreciation and depreciation of the company for the then current and 11 preceding calendar quarters."
- TCRD only gets to keep that portion of its incentive fee that consists of Pay-In-Kind interest income when the interest is received in cash. If the PIK income gets written off so does that portion of the fee accrued but unpaid. This is unique for the industry as far as we know, and aligns shareholder and manager interests more closely.
4. THL Credit’s investment assets are principally fixed rate. In recent months many BDCs have been preparing for a higher interest future and booking a high proportion of floating rate loans. However, TCRD is principally a fixed rate lender, with 85% of loans booked in that category. Given that the company has substantial equity, no borrowings and a revolver that is limited to $125mn we doubt that TCRD will ever face having more floating rate borrowings than fixed rate assets. Management is too sophisticated for that. However, with interest rates being charged to borrowers already amongst the highest in the industry, TCRD is no play on higher interest rates in the way that Fifth Street Finance (FSC) or TICC Capital (TICC) appear to be.
5. TCRD’s stock is thinly traded. THL Credit’s daily share volume trading is low. Yahoo Finance says the three-month daily average is 37,000. That’s about $500,000 a day of shares trading hands, which is low compared to most of the company’s peers. Recently, the volume was just 23,226. Golub Capital, to make a comparison, trades 2-3x more heavily.
This is the classic challenge of any micro-cap stock. We expect that TCRD will shortly burn through its initial capital, and some portion of its revolver and raise new equity. That will create more float, and can only be a good thing from this perspective. The company just requested shareholder approval (in what has become a universal BDC theme since the Great Recession) to sell new shares below Net Asset Value should the Board decide the need. Moreover, with over half the stock held by insiders and founders and the stock lock-up period expired, we might see more shares on the market. As always, this a matter which is still evolving.
We’re wishing THL Credit a happy first anniversary as a public company. The company is taking a different approach to lending into the middle market and running a BDC than most of its peers, and that’s refreshing. The jury is out on virtually every major initiative the company has chosen, but there’s much to cheer for. With its famous sponsor, deeply experienced management team and ambitious approach to providing mezzanine and senior debt, TCRD may be able to build itself up to the half a billion in dollars in assets level within another year or two.