There is a new trend in the Business Development Company ("BDC") sector: the issuance of medium term publicly traded Notes. Previously, only a handful of BDCs were able to raise unsecured Notes or convertible debt, and most of the investors/lenders were major financial institutions, and the debt was raised as a private placement. That essentially means the debt does not trade and is not available to the "ordinary investor". Ares Capital (ARCC) undertook just such a private placement only a few days ago, raising an impressive $175mn of convertible notes due in 2017 at an even more impressive rate of $4.875%. Still, as the company's press release pointed out :"The Convertible Senior Notes will be offered only to qualified institutional buyers (as defined in the Securities Act of 1933, as amended … pursuant to Rule 144A under the Securities Act".
However, another recent and unexpected development has been the issuance of medium term Notes in publicly registered form, which trade on the exchanges with a ticker symbol just like a stock and can be bought/sold by anyone. Ironically, the leading BDC in this form of financing is also Ares Capital. The company inherited publicly-traded debt issued by Allied Capital Corporation upon acquiring that ill-fated BDC a couple of years ago. The issue has a nominal maturity of 2047 (!), pays a yield of 6.875%, is rate investment grade and trades under the ticker AFC. Subsequently, Ares has also issued its own 30 year unsecured publicly-traded Note in 2010, with a yield of 7.75%, and the symbol ARY. Most recently Ares was at it again: issuing in January of this year $125mn in 2022 Notes, with a yield of 7.0%, trading under the ticker ARN.
THE MORE THE MERRIER
In recent weeks,though, the number of issuers for publicly traded BDC debt has exploded. First we had Gladstone Capital, which issued the first "Preferred Stock" instrument in the industry. Reading the prospectus,though, underscored that the new issue bore a closer similarity to debt than to preferred or equity. The Preferred yields 7.125% (paid monthly) and matures in 2016. Sister company Gladstone Investment issued a similar Preferred instrument, back in February.
Also joining the party has been Triangle Capital (TCAP) with Unsecured Notes due in 2019 and bearing a 7.0% coupon, which raised $67mn in net proceeds for the company in March. Medley Capital (MCC) raised $40mn of 2015 Notes at a 7.125% interest rate. The debt will trade under the ticker MCQ. The latest issuer to join the party is Horizon Technology Finance (HRZN), with an issue maturing in 2019 and yielding 7.375%.
EQUITY INVESTORS SHOULD BE CHEERING
For equity investors in these BDCs (and the many more likely to tap this source of funding while the window remains open), this is good news. The BDCs are able to access medium to long term capital at reasonable rates, and with virtually no covenant requirements and without providing any collateral. If LIBOR rates do move up sharply in the near to medium future fixing these borrowings at or around 7.0% will appear even more beneficial. Admittedly the cost of capital is higher than what these BDCs pay for Revolving debt but the gap is only a couple of percentage points in some cases and without the ongoing cost of unused line fees, frequent renewals etc.
In fact, management and equity investors should consider themselves very fortunate. Even 6 months ago the prospect of smaller BDCs such as Triangle Capital, Gladstone Investment etc. being able to tap multi-year long debt was unthinkable. David Gladstone, the eminence grise behind GLAD and GAIN has been seeking out medium to long term financing for his companies since the cut and run approach of its previous lender in the Great Recession demonstrated the risk of funding 5-7 year loan investments with 1-2 year Revolvers. Gladstone had apparently talked to insurance companies and other long term institutional investors for years, without being able to arrange the right amount of funding for the right period of time and at the right price.
We're very surprised that micro-cap companies with short histories as BDCs such as Medley Capital and Horizon have gained access to the public debt markets in this way. Both BDCs have performed well in their brief time on the BDC stage, but have had difficulty raising as much secured Revolving debt as they might like from banks. Horizon is paying off its former main lender West LB, and has managed to raise $75mn from Wells Fargo but with far more stringent advance rates and pricing than West LB previously allowed. Medley Capital has nearly $250mn in investment assets but had managed to only arrange a Revolver limit with ING Capital /Credit Suisse (apparently not all European banks have abandoned the U.S. market-but we digress) of $100mn. MCC is coy about the advance rates on the Revolving facility but they must be conservative. Then there's the pricing, which adds up to an all-in cost north of 5.0%-5.5%, and a 4 year maturity. Compare that with the new Notes, which have no borrowing base or any meaningful covenant, pricing only 1.5%-1.75% higher and three more years of length. As MCC is able to generate new loans at a yield around 14.4% the new debt should result in higher earnings even after interest cost and the 1.75% management fee, additional operating costs, and 20% of incentive profits the management company earns are taken into account. MCC's shareholders should earn 3.0% on the $46mn (including over-allotments) in new capital, or about 8 cents a share. At a 10x multiple that increases MCC's stock market value by $0.80 on a pro-forma basis.
FROM A DEBT HOLDER'S POINT OF VIEW
However, what's good for the shareholder may not be so good for the holders of the newly minted debt of these BDCs. Here are a few words of caution, gleaned from reading the Horizon, Medley and Triangle Capital prospectuses.
1. Remember that the issuers are smaller BDCs with less diversified portfolios than a larger BDC such as Ares Capital. For example, Horizon Technology Finance points out on page s-75 of its Prospectus that its 5 biggest loans represent 28% of its total assets, and 21% of its income. A few key defaults from HRZN's borrowers and both the Revolving debt and the company could face troubles.
2. How much the new issues will trade remains to be seen. Activity on the Gladstone Capital Preferred has been modest: anywhere from a few hundred to a few thousand shares a day. For a very small position getting in and out should not be a problem but for larger positions it may not be so easy.
3. The Notes may call themselves "senior obligations", but the fact is that they're structurally subordinated to the issuing BDCs secured Revolver lenders. Effectively this means that the Notes are deeply subordinated. This relates to how the financing structure of the BDCs work. Bankruptcy-remote subsidiaries are set up, and the bulk of investment assets that the BDC has made are included therein. These subsidiaries then borrow from the Revolver lender on the strength of this investment collateral. However, the unsecured Notes are issued by the parent BDC, which has little or no assets on its books. Any assets that exist are not pledged to the Noteholders and can be pledged to the Revolver subsidiaries at any time.
As long as the subsidiaries remain in covenant compliance all goes well. The subsidiaries receive interest income from their loans, pay their Revolver lender and distribute excess income up to the parent who uses the proceeds to service the Notes. However, should asset values fall and/or bad debts increase at the subsidiaries and a default occur the gates suddenly swing shut. The Revolver lender will want to ensure getting repaid and forbid excess income distribution to the parent. The Note holders will cease to receive interest payments until the Revolving debt is resolved. This could take weeks to years. The good news is that the BDC industry has a very good record of paying off its Revolver lenders and the 200% asset coverage required by BDC regulations means that the Note should ultimately be repaid in full but there could be considerable delays, much drama and the potential for a substantial drop in the value of the Notes (the value of Allied Capital's public notes dropped 86% before Ares Capital came on the scene).
4. Judging the balance of power between the Revolver and the Notes is difficult using the regulatory filings. It's hard to determine what assets are held by which subsidiaries. We go to the quarterly list of all investments, which has a note that lists to whom every loan is pledged. However that can change at any time and requires making your own calculations and assumptions. Moreover, most BDCs are very reluctant to provide much information about the advance rates and borrowing rates available at any time from their Revolver lenders. As a result it's difficult to determine how close or how far a subsidiary might be from defaulting. We trawled through the Horizon and Medley Capital Prospectuses and quarterly filings with this subject in mind, and came away completely unclear as to what would have to happen before a default would occur. Even if you are able to stay awake long enough to read through the loan agreements between lender and borrower which set out the framework of the Revolver, the ever changing nature of the collateral and the arcane calculation of facility availability make an independent assessment impossible.
We don't want to sound too gloomy about the new public debt issues of the BDCs. If we avoid a new recession, chances are matters will go seamlessly, BDC earnings will rise to the benefit of shareholders and Noteholders will earn a superior rate of interest. Moreover, not all the issues that we've discussed are structured in the same way, so doing the homework is essential. For example, we are much more positive about the structure and outlook for the Ares Capital and Gladstone company investments than what we've read about the Triangle Capital, Horizon and Medley Capital deals. Even if there is a recession, if a BDC can remain in compliance with its debt agreement the Notes may be unaffected. Nonetheless, given the opaque reporting and the new nature of these instruments note holders could find themselves flying blind.
P.S. : Although nobody has asked us, we would suggest that a more attractive structure would be for a BDC intent on tapping the public market for medium term to jettison Revolver borrowing and the pledging of assets. Instead, we'd suggest keeping all investment assets-unsecured and unpledged- at the parent level, with an asset coverage test whereby the Notes would be paid down if asset values dropped below a pre-determined threshold. That would provide note holders effective security and the knowledge that income could not be suddenly stopped. The benefit for the BDC would be longer term funding, still virtually no covenants and less dependence on fickle bank lenders. With an investment grade rating this type of unsecured debt might cost only marginally more than borrowing from a bank, and would match a BDC's assets and liabilities better.
Or else, BDCs could keep some loans assets as collateral at the parent level and the rest pledged to Revolver lenders. If the latter were to default and income be cut off, at least the note holders at the parent would have access to some income sufficient to pay expenses and interest. This is similar to how Kohlberg Capital (KCAP) was able to continue paying a dividend through the Great Recession despite being in violent dispute with its bank lender. The company had access to a separate pool of assets/income sufficient (despite some non-performing loans) to remain operational.