BlackRock Kelso Capital (NASDAQ:BKCC) has big credit problems, and the Company has gone from hero to zero in a very brief period. The trouble began to show up in the IVQ 2015 investment portfolio. At the time, the BDC Credit Reporter counted 10 Watch List investments with an aggregate value of $182mn. (We analyze every BDC in great detail to identify which portfolio investments are performing as hoped, and which are not). Two Watch List companies were on non-accrual.
Not Just Us
To put into context, 10 Watch List investments represented a fifth of the entire 45 company portfolio. $182mn of Watch List dollars was equal to 24% of the BDC's equity capital at year end 2015. Nor was this a matter of the BDC Credit Reporter being overly conservative. The Company's internal investment rating system counted investments with an aggregate value of $252mn in its varying under-performing categories. That was equal to a third of the Company's capital at the time.
The Wrong Kind of Diversification
Maybe the most disturbing aspect of BKCC's deteriorating portfolio that showed up last year was its very diversity. Some BDCs took a big bet on lending to the energy sector and got burned, but have managed to keep their troubles quarantined in that ill-fated segment. Unfortunately, the Company's Watch List comes from all over the place. Sure, there are a couple of energy companies (including a huge loss on New Gulf Resources which filed for Chapter 11 late last year). However, there is a manufacturer of capital equipment, a defense contractor, a general store retailer, an herbicide chemical company and so on.
The most surprising part of BKCC's year-end 2015 credit deterioration is that it followed several quarters of excellent portfolio performance, which the Company took advantage of. Earlier in 2015, the Company successfully sold several investments for very big profits, and saw Net Asset Value reach new post-Great Recession highs. Moreover, at the start of the year, there were only a couple of investments on our Watch List.
Back And Forth
No wonder then that as investors we've been schizophrenic about the stock. Back in August 2014, we wrote an article entitled "Why We Went From Bear To Bull." Then in May 2016, we were back in the Bear camp, but mostly due to our perception that Mr. Market was overvaluing the stock. We stuck with a similar theme last summer in yet another article entitled "Mixed Feelings About BlackRock Investment. However, the IVQ 2015 portfolio review took us from "on the fence" to "bearish," even as Mr. Market pushed the stock price up in recent months. We shorted the stock a few weeks ago, and waited. And waited.
Sit Down For This
Fast forward to the release of the IQ 2016 10-Q and our skepticism has been confirmed. The number of Watch List names has increased by two (both of which may be controversial to some of our readers, but more of that in a minute). However, the number of non-accrual credits jumped from 2 to 5. As the filing and the earnings release reveal, 15.3% of the Company's debt investments are not paying income. Moreover, Advantage Insurance Holdings, which is one of the new Watch List names we've added this quarter, is still current but all the income being booked is in PIK form. As a result, the percentage of non-cash paying loans is even higher, and beginning to affect income and Net Investment Income.
Here are some of the lowlights:
Big Write-down in Defense
In addition, BKCC took a big Unrealized write-down on Hunter Defense Technologies, on a Second Lien loan which the BDC serves as the agent of. The investment was valued at $40.3mn just last quarter, and is now at $16.7mn. Hunter has now been written down two-thirds from cost in a short period. Not a good sign. The loan is on non-accrual.
Advanced Lighting Technologies - which was on non accrual last quarter - but which management believed was improving and was said to be down in value only for "technical" reasons was written down another $2mn in the first quarter, despite the bounce back in the credit markets. No details provided as to why on the Conference Call.
Another Energy Loan in Trouble
Shoreline Energy LLC was valued at $24.7mn in the IVQ of 2015, very close to Cost. However, in the intervening 3 months the value has dropped in half to $12mn. The loan is now on non-accrual.
Other troubled investments already on the books have either gone sideways like Red Apple Stores, Vertellus Specialties (written down another $7mn), Marsico and SOURCEHOV (which spells its names entirely in caps as if shouting).
Two New Watch List Names
We've added Advantage Insurance Holdings to the BDC Reporter Watch List because the investment was written down more than 10% in the quarter when the effect of accruing the 8% PIK income mentioned above is excluded, which is the typical BDC Credit Reporter trigger point.
We've also added U.S. Well Services to the Watch List because the very large ($47mn) First Lien loan was written down more than 10%. Confusingly though, BKCC has a Preferred investment in the same company which is valued over cost. However, that premium was reduced in the period, so we're being cautious.
At the end of 2015, BKCC had 10 Watch List names with a FMV of $182mn, 2 of which were on non-accrual. These under-performing investments represented a fifth of all portfolio companies, and their fair market value equaled 24% of BKCC's equity. That was bad enough.
Since then, BKCC took $55.7mn in Unrealized write-downs, but the BDC Credit Reporter's Watch List has still grown in dollar terms to $230mn, spread out over 12 Watch List names, a quarter of all investments. As of now, Watch List investments are equal to 33% of the latest BKCC equity. Despite accretive stock buy-backs and not distributing all earnings, Net Asset Value has dropped 7% in 3 months to $9.46.
How Long Can This Go?
Given that once loans start to deteriorate, the trend tends to be down, we expect to have more bad news in the quarters ahead. 9 of the 12 troubled investments are still valued at $8mn or more. Within that group, there are some very large loans whose fate could materially impact BKCC's future.
For example: BKCC has already written down to zero its Preferred and Equity investments in Red Apple Stores and partly written down its second lien loan (that's $10.5mn already written down). However, the loan is still valued at $19.8mn. That's $0.25 per share in risk on a second lien loan.
SVP Worldwide - a consumer goods company - has already been written down by 25% in a short period. Still, the remaining exposure is $38.4mn, or over $0.50 a share.
Also US Well Services - previously the exception to the rule amongst energy investments because it was being written up in value in recent quarters - is a worryingly large position. Between the first lien debt and BKCC's Preferred in the oil services company, total exposure is $60mn. That's $0.82 a share of POTENTIAL loss.
Of course, we don't know if any of these loans - including US Well - will actually result in any loss. However Bad Things Can Happen. BKCC's $25.5mn investment in New Gulf Resources has been written down a whopping 94% to date.
If all of that wasn't enough to worry about, there are a couple of companies amidst the three-quarters of the performing portfolio investments that bear keeping an eye on (as was brought up by an analyst on the Conference Call) if for no other reason that they're in challenged sectors: oil and gas and coal mining. M.D. Energy is one of the former with a FMV of $8.1mn. Oxford Mining Company is one of the latter (a coal miner) with a near $25mn loan on BKCC's books.
If we added those two "performing" names to the BDC Credit Reporter's Watch List of under-performers, the value would increase to $266mn, equal to 24% of total investment assets at FMV and neatly 40% of BKCC's equity. That's a lot of risk for a BDC that was trading close to NAV till a few hours ago. We're a little surprised ourselves at the number of companies and dollars involved but strangely validated by BKCC's internal rating system which has investments worth $245.3mn in the under-performing camp.
Work In Process
We don't know how this will all shake out. Nobody does, including the management of the BDC which is clearly in battle mode on several credits whose fortunes are being decided in real time. Over the next few weeks we will seek to delve deeper into each of the major troubled credits and estimate whether there will be a Realized Loss down the road and what amount. Until then, we remain in the Bear camp, even after the 10% plus drop in the stock price to around $8.50 at time of writing. With trouble spread out over so many credits, and given the sometimes huge deal sizes involved, and the dearth of information about what's happening, we wouldn't be surprised to see Mr. Market (despite the current enthusiasm for everything in BDC-land) pull back to $8.0 a share or below till greater clarity emerges.
Note: We are short BKCC and have been for weeks, because of our review of the IVQ 2015 portfolio.
Disclosure: I am/we are short BKCC.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.