I recently suggested that business development companies merit further investigation for income-oriented investors. Given the complexity of some of the management structures, as well as the risky nature of the underlying investments made, investors interested in this niche should pay careful attention to the alignment of interests between management and shareholders.
I had indicated that I would follow up with a review of this dynamic if readers were interested, and that was overwhelmingly the case. Therefore, I am reviewing each of the 14 dividend-paying BDCs I had highlighted in order to assess the amount of "skin in the game."
So far, I have reviewed Ares Capital (ARCC), the largest of the group, Apollo Investment (AINV), the worst in terms of alignment, Prospect Capital (PSEC), Fifth Street Finance (FSC), BlackRock Kelso (BKCC), PennantPark (PNNT), Solar Capital (SLRC), Hercules Technology Growth Capital (HTGC), Main Street Capital (MAIN), Triangle Capital (TCAP), MCG Capital (MCGP), TICC Capital (TICC) and Gladstone Investment (GAIN). Kohlberg Capital (NASDAQ:KCAP), which has a market cap of about $140 million, has traded publicly since late 2006:
The company filed its annual proxy statement on April 21st. Unlike most of its larger peers, where management is provided by an affiliated company, KCAP is internally managed. With that said, the company invests in CLOs managed by its wholly-owned portfolio company Katonah Debt Advisors. As a result of the potential requirement for further disclosure, the company is in a state of non-compliance with NASDAQ (see 8-K filed 11/16). The company also has a strategic relationship with Kohlberg & Company. KCAP has been under formal SEC investigation since April 2010.
Total ownership of directors and officers is listed at 7.2%, which puts it a well above the average for the BDCs. To me, though, the alignment isn't so clear. Why? The guy one would expect to own a lot is the CEO, Dayl Pearson, but his beneficial ownership at the time of the proxy was just 100K shares. At current prices, this is just $600K for a guy who took home $1.2mm in cash in 2010. Who holds the bulk? Christopher Lacovara, Samuel Frieder and E.A. Kratzman. Lacovara and Frieder, Kohlberg & Co. Partners, serve as members of the Management Committee of Katonah Debt Advisors. Kratzman is President of Katonah Debt Advisors. My read of the 10-K suggests that while KCAP owns KDA, there are potential performance payments, which could lead to conflicts of interest. Mitigating these potential conflicts, Jim Kohlberg owns 9% of the company through various entities. While many BDC executives and directors have bought their stocks in the past few months, there wasn't a single insider buy at KCAP despite a sharp sell-off during the summer.
Due to the common structure of outside management, BDC investors are often unable to clearly weigh the alignment of interests, as there is no disclosure regarding salary and incentive pay levels (or metrics) for the individuals involved in running the company. While MAIN is structured with outside management, it still discloses this information, but most don't. With internal management, KCAP discloses compensation data. KCAP's highest paid employee is Kratzman, who received $2.123mm in 2010 (all cash with the exception of $500K in restricted stock). Overall compensation levels appear high compared to the few other BDCs that disclose this information. Cash bonuses outside of the normal performance-based incentives were material in 2010.
Having reviewed now 14 different BDCs, Kohlberg Capital appears below average with respect to shareholder alignment despite high insider ownership levels and an internal management structure. The SEC investigation and potential conflicts of interest are concerning, but the main issue is the lack of exposure of the CEO as well as a compensation structure that is very heavily weighted towards cash. Main Street looks superior to all of the previously reviewed BDCs, especially Apollo Investment and Gladstone. With the exception of MCG Capital and Fifth Street Finance, all of the BDCs I have reviewed are permitted to sell stock below the NAV, which I find to be a negative. The best alignment so far beyond MAIN has been Hercules Technology Growth Capital. I think that Solar Capital, Triangle Capital and Fifth Street Finance stand out from the crowd as well.
While many factors ultimately influence the level of future dividends, it is unclear if the ownership of KCAP's management team and outside directors creates enough of an incentive for its executives to steer it in a direction that sustains or even grows the payment without taking excessive risk.