Saratoga Investment: BDC With Large Discount to NAV Offers Significant Upside

Includes: SAR
by: Philip Mause

Saratoga Investment Corp. (NYSE:SAR) recently filed its annual report for the year ending February 2011. SAR is making solid progress and offers investors an opportunity for significant returns in the months ahead. By way of background, SAR is the successor to GSC which had serious problems during the 2008-09 downturn. New management came in, injected significant new capital and the renamed, recapitalized entity seems on track for solid performance.

The annual report reveals net asset value of $86.1 million (or $26.26 per share) of which some $10.5 is net cash. Backing out the cash from asset value and market cap, an investor is paying for the rest of SAR at a discount of about 24% from net asset value using Friday's closing price of $20.53 per share. This is one of the largest discounts available in the Business Development Company (BDC) universe.

For the year ending February 2011, SAR had net investment income of $2.15 a share and also had substantial net gains on assets. Investors should be aware that income statements of BDCs can be heavily driven by write ups or write downs of assets during a relevant reporting period. While income data is difficult to analyze because fiscal 2011 saw major variation in share count due to the capital injection and the very large stock dividend in December 2010, SAR does appear to have its major road bumps behind it.

A critical issue for SAR will continue to be the performance of its Collateralized Loan Obligation (CLO). A CLO is a special purpose entity which holds various debt instruments. Generally, CLOs have senior debt which must be serviced before the subordinated debt held by the sponsor of the CLO can be paid. In the case of SAR, a significant part of SAR's NAV is the value of its subordinated note position in its CLO.

At this point, I want to draw a contrast between the financial statement of SAR and some of the financial statements of other BDCs and some mortgage REITs which have CLOs. SAR's financial statement does an excellent job of describing the CLO and providing data about the current performance of the CLO. It also explains the rationale for the valuation of SAR's subordinated note position in the CLO. I wish that certain other companies would emulate SAR and provide such clear and understandable descriptions of the special purpose entities with which they are involved. Investors should review SAR's description of its CLO carefully because the CLO position is a key element of SAR's value.

SAR is still not paying a dividend. Thus, interest income should accumulate and produce an upward bias in NAV in the immediate future. This is a stock whose market cap should close up on NAV as things continue to stabilize and a dividend begins to be paid. Investors will probably have to be patient but, if they are, the returns are likely to be attractive.

Disclosure: I am long SAR.