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There are a number of relatively new, smaller Business Development Companies ("BDCs"), which fly under the radar of publicly available analyst comment. Full Circle Capital Corporation (NASDAQ:FULL), which went public August 2010, falls into this category. We thought it would be interesting to undertake a broad review (i.e. this article goes on and on) of the company, both for the benefit of existing and prospective investors.

Bit of Background: Full Circle focuses on making senior loans to lower middle market companies. Not just senior, but senior secured. Or in other words, FULL is an asset-based lender, which looks to liquidating a borrower's assets to ensure repayment if all else fails. In the BDC world there are a number of players who make senior loans, but in most cases, recovery rates when companies default tend to be low. In fact, there is many a defaulted senior loan where the BDC lender has received nothing when the underlying borrower has filed for Chapter 11 or Chapter 7 bankruptcy.

For the BDC model, asset-based loans have traditionally been too management intensive, the returns too low and deal volumes too weak to be of interest. In any case, this has been a sector with competition from specialized subsidiaries of bank groups and finance companies. We were intrigued when Full Circle, which is owned and managed by a group with prior experience in this segment but with private partnerships, went public just under two years ago. We wondered if the economics of the business model would work and if the promise of a "second way out" (as lenders refer to the presence of liquid stable collateral) would be proved out over time, and reduce or eliminate material credit losses when defaults occurred.

Let's look at the various components of the business :

Making Loans: We'll start with loan activity, where the evidence that FULL is on to a good thing, which is very promising. We should start out by pointing out this is a tiny BDC by any standard. The company had only 14 loans on its books at March 31,2012 and total loan assets at fair value of just $66mn. If some BDCs are "black boxes" with dozens of portfolio companies, spread amongst multiple subsidiaries and funded with a complex mix of short and long-term debt capital, Full Circle is the antithesis. After reading a couple of 10-Qs you'll know every portfolio company by name.

Anyway, getting back to our point: we were concerned that Full Circle might find, with the Great Recession in the rear-view mirror, no new asset-based loans to book. The company started with a portfolio of loans purchased from its parent and which had been assembled over a multi-year period.

In the intervening months virtually all those "starter" loans have been repaid. Thankfully, the company has been able to book new , similarly structured asset-based loans on terms in line with its "starter" portfolio. Of course, judged on a quarter-by-quarter basis, portfolio size has wavered up and down marginally, but nothing dramatic. In fact, May 12, 2012, the company reported having 16 companies on its books ( the 14 at quarter end and 2 new loans) with an aggregate value of $75mn, compared with an initial portfolio at IPO time of $72mn.

Good Yield: The portfolio yield, a healthy 12.1% at launch, has even managed to increase to 12.9% at the end of March 2012. As before, FULL (based on the assertions in the public filings) continues to have collateral in excess of loan balances outstanding. In the last 10-Q the company claims loan to collateral value is 61%. The company principally makes loans, but has a sprinkling of common stock and warrant positions in some of the portfolio companies that may get harvested one day to offset losses that might be incurred.

Earnings Model: Turning to the economics of Full Circle, we were worried at the outset that the small size of the BDC, its high cost of capital (the company has medium-term Notes outstanding bearing an 8% cost, and a Revolver priced at a very high rate of LIBOR plus 5.5%) might not generate an adequate return on equity. In this regard, Full Circle started strong but has faded in recent quarters. A year ago, quarterly Net Investment Income Per Share was $0.22 or $0.88 annualized. As a percentage of Investment Income, Net Investment Income was running at 60%, which is a good result in the BDC world. Net Investment Income return on net assets was just shy of 10%, which is OK for a newly minted BDC still in growth mode (at the time the company had no outstandings under its $35mn Revolver).

In the past 12 months, though, earnings have been more anemic. Net Investment Income per share dropped, reaching $0.18 in the quarter ended March 2012. Net Investment Income is running at 8% of the $9 IPO price and of the latest NAV. One-third of the available capacity under the Revolver has now been used up. Where most BDCs in their first years if operation are able to gradually increase earnings (see the performance of newly minted THL Credit or TCRD) Full Circle has been going in the opposite direction.

We don't believe that this is a permanent trend. In fact, a bit of variance analysis between the March 2011 and 2012 financial statements shows what has occurred. Last year the Manager was absorbing some of the company expenses on a temporary basis, but in the last quarter that's no longer the case. More importantly for anyone trying to divine the company's future earnings, it's clear that fee income varies substantially depending on new loan books and portfolio company repayments and pre-payments. Last year several of the original portfolio loans were refinanced and fees jumped. In the March 2012 quarter there was less activity and fee income was $200,000 lower or 3 cents a share. Actually, recurring interest income on loans is slightly higher in 2012 over 2011. Maybe 2011 Net Investment Income looked better than it deserved or maybe 2012 a little worse. We assume FULL is building the same type of prepayment penalties and other similar fee sources into its newer loans and this will ultimately translate into bigger fee contributions in the quarters ahead, but the public filings and the comments on the Conference Calls do not address the issue. Presumably the one or two analysts covering the stock are aware. For the moment , given that the metrics we know about the new loans (yield, collateral coverage, loan size) appear to be similar to those which FULL began with, we are assuming imbedded fees will be similar and will ultimately be realized, which should boost future earnings.

Pro-Forma Portfolio Size: If we also assume the company draws down $30mn of its $35mn Revolver, total investment assets will go from $66mn at March 2012 to $80mn. The extra $14mn in loans at a 13% gross yield, even after interest expense, management fees ( a fair enough 1.75% of assets), incentive fees and some variable expenses, will add nearly 2 cents a quarter to Net Investment Income. This suggests FULL's quarterly earnings will fluctuate between 20-24 cents a quarter, with the higher end being reached when fees are higher than usual.

Discount To NAV: Unfortunately, that does not represent a very high return on net assets (8%-11%) for a fully invested BDC. This, rather than concerns about credit quality, might explain why the company trades at a perennial discount to its Net Asset Value. Recently FULL was trading at $7.3, nearly 20% off NAV and the IPO price. Investors may be asking themselves if earnings will ever catch up with the $0.924 in annual dividends (paid monthly). Moreover, FULL is clearly in need of a new round of capital raising, and with earnings potential modest, it seems likely that any new equity raised (if that's even possible) will be closer to a $7 price than the $9 achieve on its IPO.

Credit Underwriting To Date: Of course, the key test of FULL's business model is how successful it will be over time in preserving investors capital. The months since the IPO have not provided any conclusive evidence. Amongst the nearly 30 companies the company has lent to, 2 so far have defaulted on their loans. The first instance was a company called Bloomingdale Partners, which defaulted in February 2011. The borrower's assets were acquired by a new company set up by Full Circle called Texas Westchester and over $800,000 of Unrealized Depreciation recognized. Also, the assets ceased to pay any income. A year on, Texas Westchester is valued slightly higher by FULL but remains a potential loss and is not generating income.

More recently, Equisearch Acquisition, in which FULL has invested $2.8mn ($2.5mn of which in a loan) also defaulted. Again, the company has an unrealized valuation loss on its balance sheet of $800,000, and is in the process of liquidating the underlying assets and expects substantial recovery.

As a credit underwriting record, this is not a stellar performance to date, but it's too early to draw any definitive conclusions about credit risk and recoverability. For the type of company and at the interest rates FULL charges troubled loans go with the territory. However, with its short history, we do not know if during an economic downturn the number of non performing companies will surge. We also cannot yet tell if the company's claim that the collateral available in these loans will really keep realized losses to a reasonable level. There has been no explanation from management as to why both the defaulting loans have been written down from cost despite FULL's assertion on the portfolio as a whole to have collateral in excess of loan outstandings.

By the way, there are two other loans on FULL's books which have been written down from cost but are not on non-accrual with a cost of $13mn, and a fair market value $0.5mn lower.

Upside Potential?: We also have no clear idea whether - over time - we can have some reasonable expectation that the equity stakes owned by FULL will be sold and offset all or some of the inevitable bad debts that any lender incurs. On the latest 10-Q we note a $140K interest in The Finance Company, whose fair value is nearly $700K. The CEO of FULL serves as a director of The Finance Company, which suggests FULL has some element of control on this investment. Other BDCs like Main Street Capital (NYSE:MAIN) and Triangle Capital (NYSE:TCAP) have had considerable success harvesting equity investments, but we don't know if that's a plausible outcome in the type of companies in which FULL is invested. Time will tell.

A Word About FULL's Liquidity: Liquidity, thanks to the Revolver availability, has been good, as underscored by the two new loans added since the end of the quarter. However, we note that the Revolver lender had to waive a default by FULL, and change the way one of its key covenants is calculated in this last quarter. Moreover, we are not aware that the Revolver has been extended beyond July 2012. Relations between FULL and its lender seem good, based on the Conference Call, so the absence of a renewal or extension is troubling, but may amount to nothing.

Put Us Down As Undecided: At this stage, though, with nearly two years of FULL as a public company, and erring on the side of caution because this is new territory for the BDC industry and the company's shareholders, we are left on the fence. The earnings model is not proven, as profitability remains constrained by a high cost of debt capital and relatively high other expenses, and profits will fluctuate with fees. The dividend remains set at a level substantially above current earnings, which has augured badly before with other BDCs (think American Capital or Fifth Street Finance, which set dividend levels higher than earnings could meet and had to suspend or reduce distributions). The short credit history is not spotless, but hardly disastrous. Today's troubled loans may yet get recovered in full, and /or equity stakes may keep NAV from dropping materially. Portfolio turnover has been good and diversification is improving. The company just announced the addition of a new vice president to its investment team, which suggests management is optimistic about being able to grow.

What To Look For Going Forward: As we noted previously, whether FULL, with its asset-based model, will be successful or not remains unclear. We will be watching developments in the months ahead to give us a better idea. On the positive side, we'd be impressed if the company could raise additional equity at $7 or over in order to enlarge its footprint, increase its loan diversification and strengthen its balance sheet. Another plus would be a renewal of the Revolver for the medium term, to more closely match the loan book. Eventually a lower cost of borrowing would help earnings. (A reduction in borrowing costs of 2% on a pro-forma $30mn of Revolver debt would increase Net Investment Income Per Share by nearly 8 cents a year). Why FULL has not sought to access SBIC debt (available at 10-year rates of under 4% currently!) is not known.

What To Worry About: On the downside we'd be worried if matters with the Revolver lender are not resolved soon, and/or bad debts increase or recovery rates disappoint. The latter will not begin to be known till the next quarter's filings, but the former may be the subject of a release at any time. Also disturbing would be a capital raise at a price materially below $7. Maybe just as concerning would be FULL unable to raise any capital at all because of market conditions and the 20% drop in value since the IPO. The company would become a zombie-like BDC, unable to grow and to demonstrate that its business model works in the BDC format. If that were to happen, and things could go any number of ways, it would be a shame both for the company and the BDC industry.

Source: Full Circle Financial: A New Kind Of BDC