Saratoga Investment Corp. (SAR), one of the smallest Business Development Companies (“BDC”) and one of only two “lender” BDCs to not be paying a regular dividend, is seeking to convince investors to permit raising new capital at below Net Asset Value. It’s one of the key rules in BDC-land that shareholders have to approve any such dilutive issuance.
In recent years many BDCs have routinely asked for permission every year to raise below NAV capital, just in case. In most cases permission has been given by shareholders and then never called upon on by management, either because the company in question traded above NAV or because the dilutive effects were not deemed worth the price by the BDC manager.
However, with the market swoon of recent weeks, the likelihood that Saratoga will trade above NAV in the months ahead seems well nigh impossible, so the only way the company will be able to access new equity capital is by going to shareholders for approval.
Saratoga has been asking for shareholder approval to raise equity below NAV for some time, in advance of its annual board meeting. On September 26, 2011, though, the company offered up a sweetener to its shareholders to ensure passage of the proposal. Saratoga announced that its Board of Directors adopted a policy that will modify its treatment of a equity raising proposal contained in the company’s 2011 Annual Meeting of Stockholders proxy statement. The new Board policy requires the company to sell or issue shares of its common stock at an offering price per share that is not less than 85% of the then current net asset value per share. This policy, a company press release declared, was developed in response to feedback from shareholders and caps the maximum dilution percentage amount in connection with potential common stock offerings pursuant to the authority sought by the company under the second proposal in the proxy. No change can be made to this proposal without unanimous approval of the company’s independent directors. If approved, the authorization would be effective for a period expiring on the earlier of the one year anniversary of the date of the company’s 2011 Annual Meeting of Stockholders and the date of the company’s 2012 Annual Meeting of Stockholders.
MUSINGS AND AN UNSOLICITED SUGGESTION
We’re not going to handicap whether the revised stock issuance proposal will be approved or not. We just don’t know enough about the composition of the shareholding group. However, here are a few thoughts:
-The current gap between the latest stock price ($16.54) and the May 2011 Net Asset Value ($28.01) is considerable. The discount to NAV is over 40%. Even if the NAV to be reported for the quarter ended August 2011 is lower due to the market turmoil, it appears the stock price will have to climb well over $20 a share to even be in spitting distance of being allowed to raise new equity. The big gap between the company’s reported NAV and its stock price can be blamed on the company’s new manager-Saratoga Investment Corp.- and their idiosyncratic managerial style since taking charge of the company’s fortunes. Most critically, management has shot itself in the foot, in our opinion, by deciding not to resume the payment of dividends after turning round the fortunes of the company by injecting new capital and paying off the prior lender and supplanting the prior manager: GSC Investment. Here is what the company said on this subject at the time of the last earnings release:
Given the size of Saratoga Investment’s asset base and its growing pipeline of attractive investments, the company’s board of directors believes that using capital resources to build and diversify the portfolio best serves stockholders’ interests by positioning the company to generate current income and capital appreciation on an increasing scale in future periods. Therefore, the company’s board of directors has determined not to pay any dividends at this time.
To be blunt, we don’t agree with the company’s approach. We would argue that most shareholders who have invested in a Business Development Company have done so with a reasonable expectation that the management will follow the basic industry model, which includes the payment of dividends, and that it’s somewhat churlish of the Board of Saratoga to take the company in a completely different direction than most every other BDC. Nor is Saratoga so small in size as to be uneconomical, as the quote above suggests. In fact, the company is very similar in many ways to recent BDC entrant Full Circle Capital (FULL) in terms of investment portfolio, yield (above 11.0% in both cases) , credit quality (both companies have no non-performing loans outstanding) and current borrowing capability (both have expensive Revolver lines under $50mn in size which are still untapped). Full Circle has been paying a dividend since going public, and recently switched to a monthly pay-out. Yes, FULL trades at a discount to NAV but only half of the one at Saratoga.
For an investor in the company, there is a very real prospect that Saratoga will generate substantial income in the current fiscal year, but not provide much, if any, cash to pay the liability. Last year, when the company was in turn around mode, it paid its taxes through a combination of stock issuance (90%) and cash (10%). That was thanks to a tax provision that was allowed to help REITs and BDCs meet their tax obligations without forgoing precious cash during a recession. Based upon what we heard on the Conference Call a few weeks ago, there is a very strong chance Saratoga is going to pay its tax liability with the issuance of more shares when the fiscal year ends in November.
Saratoga’s decision to not pay a dividend and focus on growing Net Asset Value may be tied up with the way the new management group is incentivized, or it may have something to do with the private equity background of Saratoga Investment Corp. The new management group earns 20% of all Realized Gains (net of Unrealized and Realized Losses) on the company’s investment assets as valued at May 31, 2010. Of course, at that date the company had considerable financial difficulties and the asset values were much lower than today. We’re guessing, but maybe management is harboring its cash in the hope of maximizing its increase in asset values, and the corresponding capital gain should a new buyer be found for the company in the months or years ahead. Or maybe management is just accustomed to re-investing, like most private equity groups, all income into additional investments. Whatever the reason, the stock has traded sharply down in recent weeks: in excess of 20%. We suggest that if Saratoga was paying an annual dividend of $0.75-$1.0 the company would find a broader investor base and would see its stock price soar. That would give the current proposal to raise new equity above 85% of Net Asset Value more of a fighting chance to succeed.
EYE ON THE PRIZE
The prize here is the prospect of an SBIC license and access to long term and inexpensive debt capital provided by Uncle Sam. Just a few days ago, Saratoga announced that the SBIC had given the “green light” to continue with its application for an SBIC license. Getting final approval is not in the bag, but the odds look good. However, to access the full capacity of the SBIC program Saratoga will have to invest up to $75mn into a new SBIC subsidiary. If that capital can be raised, the SBIC will ante up twice as much in 10 year debt, or up to $150mn. That would open up the prospect of $225mn in new investment assets. Given that as of May 2011 the company had just $75mn in investments at fair market value, the SBIC opportunity must be regarded as a game changer for the prospects of the company. Moreover, the rate that companies like Saratoga have to pay for 10 year debt is currently at record low levels, and probably half the rate or less that its current Revolver lender charges for a far shorter loan. The foregoing notwithstanding, will existing or new investors be attracted by the prospect of tying up their capital in a small, thinly traded stock which invests in loans with an average life of 5-7 years, incurs “phantom income ” (i.e. taxable income without the cash to pay it) and pays no dividend ? We shall see in the weeks ahead