Why We Are Short TICC Capital

| About: Oxford Square (OXSQ)
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Summary

There has been a struggle over who will control TICC Capital for several months that recently resulted in shareholders rejecting a proposed new Investment Adviser.

As the battle over TICC has occupied the headlines, behind the scenes fundamentals have deteriorated rapidly because of poor decisions by the current Investment Adviser, with no end in sight.

We have initiated a "Short" position in the stock, which we explain in great detail, by reference to recent TICC filings and a number of key assumptions.

For months now, there has been a titanic three-way struggle for control of TICC Capital (NASDAQ:TICC) that has just (temporarily) ended in a draw. The story-so-far goes like this: the existing Investment Adviser of TICC Capital called TICC Management sought to sell its rights to serve as TICC's "External Manager" (and receive those juicy management and incentive fees) to Benefit Street Partners (NYSE:BSP). Hold on! said two other very large asset management organizations: NexPoint Advisors (owned by behemoth Highland Capital Management with $21 billion of "assets under management" or AUM) and TPG Specialty (owned by another behemoth TPG Capital with $70 billion in AUM). NexPoint offered itself up to TICC's Board as a better, lower cost alternative External Manager. TPG Specialty - a BDC itself with the ticker TSLX - went further and asked to buy TICC lock, stock and barrel, albeit at a discounted value.

BACK AND FORTH

The Board of TICC brushed off both NexPoint and TSLX with barely a cursory review, presumably given the pecuniary benefits that TICC Management was to receive from the BSP transaction. Certainly, that was what NexPoint argued before a judge when seeking to get its directors nominated for a Special Election that the Board called to vote on the BSP switchover. TSLX, too, was not shy in calling out the apparent conflicts of interest between TICC's Board, TICC Management and BSP. The Special Election was delayed by NexPoint's legal challenge and TICC had to admit in a revised Proxy that several pronouncements it had made in press release and legal filings were misleading and that there was a substantial payment negotiated between BSP and TICC Management. However, NexPoint did not get its director slate on the ballot, as the judge was not convinced this was allowable under law. After being postponed, a Shareholder's Meeting was finally held on December 22nd to vote on the BSP hand-over.

SURPRISED BY SHAREHOLDER VOTE

We've been following this imbroglio from the outset. The BDC Reporter has written a slew of articles about the ever-changing drama. Just before the Special Election, we predicted that regardless of the shenanigans that preceded the vote, BSP would be voted in as the new External Manager, so please take our predictive powers in what follows with a grain of salt. In fact, the BSP proposal did not get enough votes from TICC's long-suffering shareholders. TICC Management and BSP appear to have accepted the defeat (as we shall see the latter probably with a sigh of relief as much as anything else). TICC Management has announced its intention to continue as External Manager. NexPoint and TSLX have re-iterated their respective offers. The Christmas holiday has brought everything to a temporary halt, but in 2016 everyone expects a resumption of hostilities.

INCOMPLETE LIST OF ALTERNATIVES

Perhaps the Board will decide to hire an investment banker and explore "strategic options", as some shareholders have requested. Perhaps the Board will engage with NexPoint or TSLX. Or the Board might do nothing at all, and will seek to continue "business as usual".

NO SKIN IN GAME. TILL NOW.

We've been following this episode with great interest to see what we can learn about how far "shareholder activism" can go in bringing about change in a BDC system that appears to greatly favor the incumbent External Manager, even when they own little of the stock of the underlying company. As we've written in our articles at the BDC Reporter, we had no position in TICC - either Long or Short - through the months of back and forth. Given the many uncertainties involved, we could not find a credible investment opportunity.

SHORT INTEREST

However, the failure of the BSP proposal, has stirred us to "short" TICC's stock. We are certainly not impelled by a sense that we have any idea how this will end. Nor do we have any idea how long this battle for control of TICC will continue. Both NexPoint and TPG Specialty have the resources to keep going indefinitely, and have said as much. TICC Management and the TICC Board are not crying uncle either, so your guess is as good as ours.

AWAY FROM THE SPOTLIGHT

Our decision to "short" the stock has got a lot more to do with what has been happening to the business of the Company in the background while press releases, lawsuits and multiple Proxy filings have been happening in the foreground. We are increasingly certain that irremediable damage to TICC's business has already occurred, and will continue to occur, until a resolution occurs. Even then, we expect the value of TICC's assets may drop further, depending on who "wins the war" and when.

SHORT VERSION OF OUR "SHORT" THESIS

Our thesis is that the Company's stock price has been buoyed both by the struggle for control and by a recently instituted buy-back program (more on that below). However, when investors come to grips with what has been happening to the fundamentals of the business, they will recognize that TICC's "true" value is sharply lower than the current $6.14 stock price (closing price Friday December 26, 2015).

From what we've been able to divine from the recently issued financials, and other company disclosures, the business of TICC Capital has been changing fast, and not for the better. Whoever ends up in charge of the Company will find the portfolio asset mix, liabilities, share ownership and direction have greatly altered since we first heard that TICC Management wanted out as Investment Adviser in the summer. We would say to NexPoint or TPG Specialty or whoever might step up to "rescue" TICC : be careful what you wish for. The TICC of mid-2015 (the last time results were posted before the news of TICC Management's disaffection) no longer exists, and is shrinking fast. Nor is there any guarantee that ANY buyer or manager will be able to rescue the business.

DETERIORATION

Here's what's happened. When TICC reported IIIQ 2015 results, it was revealed that the value of the Company's CLO portfolio was falling fast. That was partly due to unfavorable market conditions for all leveraged investments (September 30 was a four-year low for most forms of non-investment grade debt); and to the natural depreciation built into the CLO format (investors get a huge cash return, but the value of the vehicle shrinks as the finite life of the vehicle kicks in). Given that TICC Management had unwisely leveraged the Company to the hilt, the drop in aggregate asset values impacted one of the key BDC rules: the necessity to keep asset coverage of debt above 200% at all times. If that coverage is breached, a BDC is not permitted to make any additional borrowings and may be forced to suspend making cash distributions till minimum coverage is restored. At the end of the IIIQ 2015, TICC's asset coverage had dropped to 192%. (See page 35 of the 10-Q).

NECESSITY IS THE MOTHER OF INVENTION

Net Asset Value dropped by a mighty 10% in 9 months, from $8.64 at the end of 2014 to $7.81 at the end of September 2015. The stock price, too, dropped, and to even lower depths. TICC Management - presumably spurred by shareholder calls that action should be taken to boost the stock price in the short term (buybacks !), and with the need to win the long delayed vote to sell its management contract - began a major shift in strategy, without even waiting around for the shareholder vote. To bring asset coverage into line, the Company announced its intention (on November 18th in a press release that received surprisingly little attention from the financial press) to pay off its $150mn Citibank Revolver, which represented nearly a third of all debt at TICC. This pay-off is ongoing but will be completed before year's end (just a blink away at this point), and is being accomplished by selling off many of the lower yielding, relatively liquid assets which the portfolio is composed of. After the $150mn owed to Citibank is repaid, that will free up another $142mn in previously pledged loan assets that can be sold and redeployed one place or another.

BUYBACK ! BUYBACK !

Simultaneously, the Company initiated a major stock buyback program, committing up to $75mn of share repurchases (in two different mechanisms), with $10mn already done by the Company itself, as announced on December 3, again with surprisingly little fanfare. Before the buybacks TICC had 60mn shares and now has 1.5mn less that we know of. If the full $50mn of TICC"s announced Rule 10b5-1 trading plan is implemented (which seems possible given the programmatic nature of this type of buyback) and the remaining $15mn by the Company itself, the stock count may drop by close to 11mn shares or nearly 20% of the total. Again, with no borrowing capacity, the cash for these buyback ambitions will come from selling off loan assets in an equal amount. Unfortunately, these asset sales are happening against the backdrop of the worst conditions for a would-be seller in years.

BOTH A BUYER AND A SELLER BE ?

We're assuming the value of the Company's CLO assets continue to shrink. In the interests of full disclosure, that's not what the investment adviser is saying will happen. In fact, TICC Management have made noises of being a buyer of CLO investments in the secondary market, given the "cheap" prices available, but it's unlikely they will have the resources to add much to their existing trove on a net basis. After all, one of the main premises of the switch to BSP was to minimize or eliminate CLO exposure, so we can't see how TICC could be a material net buyer. Moreover, there are those pesky BDC rules that keep CLO investments to a maximum of 30% of all assets. With the sell-off of its "qualifying" syndicated loan portfolio, the amount of CLOs that can be held (even if they wanted to) is shrinking fast. Still, here is some of what was said on the latest Conference Call:

The combination of depressed NAVs, weakness in the broader markets, and actually trades of CLO equity at those lower levels, have contributed to lower marks on our CLO equity portfolio, and for the CLO equity market as a whole. Given the meaningful dislocation that has occurred in the CLO market, we are starting to see a much more compelling investment opportunity set, relative to the last twelve months, especially if certain portfolios continue to differentiate themselves from a credit perspective. Since we began investing in the CLO market in 2009, we've focused on both the primary and secondary markets, and have varied our emphasis according to which we believe offered relative values at various times - better relative values at various times.

Given our active participation in both markets, we believe we have a deeper understanding of that market's trading dynamics, compared to other more recent market participants, especially in periods of market volatility. We continue to deploy our CLO investing strategy where we see opportunities to generate attractive current cash flows, and/or the potential for capital appreciation. As part of that opportunity, and because we have also seen a similarly pronounced dislocation in the CLO junior debt markets, we may more opportunistically invest in CLO debt tranches that can provide a compelling risk adjusted and absolute return. Lastly, we plan to continue to rotate out of certain older vintage CLO equity tranches, when we see an attractive bid or redemption opportunities.

REDUCE LEVERAGE

Management has also conceded that riding up Company leverage to the BDC regulatory limit and beyond may not have been the best idea. On the Conference Call, TICC suggested that there would be a concerted effort going forward to improve asset coverage:

...we believe that a reduction in our statutory leverage ratio is appropriate. While the cost of capital associated with our two leveraged structures has been and remains attractive, we believe that the corporate loan market may now provide us with higher yielding opportunities that can be held on a less leveraged basis. With that in mind, we expect our statutory leverage ratio to decline in the coming quarters.

We applaud the notion, but wonder how TICC is going to be able to simultaneously buyback $75mn of stock, repay a major lender in full, cope with declining asset values across the board (but mostly in the CLO arena) and build in an asset coverage reserve. When we project out the numbers, we come to the conclusion that "something's got to give". As they say on NPR: "let's do the math":

BEGIN AT THE END OF SEPTEMBER 2015

At the end of the third quarter, TICC had $927mn in portfolio assets at fair market value ($994mn at cost, but that is neither here nor there). In addition, the Company had $21mn in free cash, but we're assuming that will not be available for portfolio purposes given the need to pay accruals, dividends and expenses at a time when no new borrowing facility is available.

USES OF CASH

To repay the Citi Revolver, and get the $291mn of loans pledged to that Revolver released, $150mn of loan assets will need to be sold to pay off the lender. In addition, $75mn of cash has to be "created" by selling off assets for stock buy-backs. That's $225mn that TICC has to come up with on short notice. At 9-30-15, TICC had $681mn in syndicated loans, but $312mn are pledged to its on-balance securitization and cannot be readily accessed. That leaves a pool of $369mn (including the $291mn pledged to Citi) spread out over dozens of relatively liquid loans. That's the first source TICC will be tapping to implement its new strategy. We wouldn't be surprised if $225mn of assets have already been liquidated, about 60% of the $369mn pool.

NOT ENOUGH TO BE SAFE

That would bring total assets down to $700mn by year-end 2015, quite a drop from the $984mn at the end of last year (a 29% drop). However, even such portfolio shrinkage still leaves TICC with $350mn in debt outstanding and asset coverage at 200%. If TICC wants to bring asset coverage to, say, 230%, more asset sales and debt repayment will be necessary. The math suggests the Company will need to sell another $80mn of assets, and use the proceeds to pay down debt. That would bring assets down to $620mn and debt to $270mn to achieve the desired coverage metric.

$64,000 CLO QUESTION

Then there's the $64,000 question: What will happen to the value of the $240mn in CLO assets at fair value on the books? Just in the last quarter, the CLO investments dropped $33mn in value. The future of TICC will probably be decided by what happens to CLO values in the next few quarters given that they represented 25% of total assets at 9-30, and an even greater proportion with the ongoing reduction in the syndicated loan portfolio. Unfortunately, these are not the Best Of Times to be a CLO equity tranche investor. More like the Worst Of Times. Values have dropped very sharply in the market as concerns about the credit impact of lower oil prices and weakening corporate credit across the credit spectrum has mounted. With its multiplier effect, thanks to 8-10x built-in leverage, the CLO structure amplifies such issues.

HIGHER RATES HINDER

Then there's the Fed and the question of higher interest rates...As we all know, the Fed has begun to raise short-term rates. LIBOR is following. This might continue in some form through 2016 and beyond. Unfortunately for CLOs, the first stage of higher interest rates is a definite negative for their cash flows. Income does not rise with the first 1%+ of higher rates because of "floors" in the existing loan agreements with borrowers that protected the lenders for the past 8 years of lower rates. Now the Piper will be paid, as CLOs pay more for their LIBOR linked borrowing costs, while not benefiting from the increase in rates. For TICC, this will hit their CLO cash distributions (which the Company calls "distributable net investment income" because it adds together GAAP income and CLO distributions in excess of GAAP). We know this because if you read the 10-Q to the very bottom, there's a big reveal on page 89. We will quote at length to leave no doubts. The highlights are ours for those of you nodding off:

In addition, to illustrate the impact of a change in the underlying interest rate on our total estimated distributable net investment income as it pertains to our CLO equity investments, we have assumed a 1% increase in the underlying three-month LIBOR, and no other change in our CLO portfolio, or to any of the credit, spread, default rate or other factors, as of September 30, 2015. Under this analysis, the effect on estimated distributable net investment income would be a decrease of approximately $22.8 million on an annualized basis, reflecting the portfolio assets held within these CLO vehicles which have implied floors that would be unaffected by a 1% change in the underlying interest rate, compared to the debt carried by those CLO vehicles which are at variable rates and which would be affected by a change in three-month LIBOR. If the increase in three-month LIBOR was more significant, such as 5%, the net effect on estimated distributable net investment income would be a decrease of approximately $10.6 million. Although management believes that this analysis is indicative of our existing interest rate sensitivity, it does not adjust for changes in any of the other assumptions that effect the return on CLO equity investments, both positively and negatively (and which could accompany changes to the three-month LIBOR rate), such as default rates, recovery rates, prepayment rates and reinvestment rates, that could affect the net increase (or decrease) in net assets resulting from operations. Accordingly, no assurances can be given that actual results would not differ materially from the results under this hypothetical analysis.

BIG IMPACT ON EARNINGS

That $22.8mn of very hypothetical lower distributable net investment income just from CLO investments is equal to nearly 30% of TICC's annualized earnings performance at 9-30-2015 (see the TICC earnings release). Given that much of the loan portfolio will be sold off, and the remaining syndicated loan assets subject to floors as well, the medium term total drop in earnings from the Fed's desire for "normalization" could be substantial. We recognize that this rate hike has been telegraphed for months/years, and some of the drop in CLO values is already built into market pricing. However, with uncertainty about how much and over what period the Fed will raise rates, and the unknown impact on credit quality (much the more important known unknown), we find it hard to believe that TICC's CLO values will do anything but continue to drop in fair market value.

OUR GUESSWORK SPELLED OUT

For the sake of this analysis, we are assuming CLO values will drop - both through normal attrition (after all these are just discounted cash flows with finite lives and every quarter that life gets shorter) and because of market conditions - by 20% over the next 3-6 months. We admit this is a wild surmise, but with so little disclosure from TICC that's all we have to work with. If we are right, that will reduce CLO asset values by $50mn. If that's the case AND TICC want to keep their 230% asset coverage AND buy back stock as advertised, more assets will need to be sold off to keep to the leverage rules. For those of you keeping up with the math: a $50mn drop in CLO values would take TICC's adjusted asset values down to $570mn. To keep asset coverage in line, TICC would have to sell another $35mn-$40mn in assets and use the proceeds to pay down debt. Given that syndicated loan assets have to be sold off into an ever declining market for these kinds of assets (down 2.2% since 9-30-15), this suggests essentially all the $369mn in syndicated loan assets that were previously pledged to the Citi Revolver will have to be sold off.

GRIM

We know it sounds grim, but it's the natural result of over-leveraging and then facing declining asset values in the BDC format, and seeking to buy back shares, all at the same time. Many other companies face similar challenges in the BDC-space when asset values (stable for so many years) begin to slide. TICC Management had hoped to avoid all this by selling its investment advisory contract and getting out before the deluge. Unfortunately, the built-in economics involved and the delay in shifting strategies may be catching up with the Company.

TOTTING UP THE NUMBERS

In summary, if TICC seeks to do everything promised in recent days AND the value of CLOs do not arrest their decline, we expect to see the Company's total assets drop by 40%-50% over their September level by June 2016; debt to drop from $500mn to half as much and share count to drop from 60 million to below 50 million. Likewise, distributable net investment income, which has been very high of late, should greatly diminish. Our ballpark guess: a 50% drop in distributable net investment income per share is possible by June of 2016, notwithstanding the stock buyback. As of 9-30-15, DNII Per Share was $1.36 a share annualized ($0.72 on a GAAP basis). We expect DNII to drop to $0.60-$0.70 and GAAP Net Investment Income Per Share below $0.40. Likewise, we expect the Company's Net Asset Value to shrink, much in the same way that has occurred at KCAP Financial (NASDAQ:KCAP) - as we covered in a recent Seeking Alpha piece - to somewhere in the $6.0-$6.80 range.

THE PAIN WILL CONTINUE

Even then, TICC will be hardly out of the woods. Management will be distracted by the battle over the investment advisory contract, expenses to fight off lawsuits and contenders will eat away at remaining profits, leverage will still be high and the remaining CLO assets (still a large proportion of total assets) might continue to drop in value and in cash flow. If a new investment adviser with a different business strategy comes along (such as BSP offered up) assets will have to continue to be sold off, and financing arrangements unwound. That may be the Right Thing To Do in the long run, but in the short run will put additional pressure on costs and Net Asset Value.

HOW LOW CAN THE STOCK GO ?

That's why we decided to "short" TICC. With so much deterioration possible in earnings and equity value, and so much uncertainty remaining, we expect the stock price to slump further. Of course, we are just making a rough estimate, but we're projecting TICC's price to drop to somewhere between $3.0 and $6.0 over the next 6 months.

BOTH SIDES NOW

Readers often tell us that our views are too pessimistic. That may be the case here for all we know. Maybe the slide in CLO values will be arrested. Maybe TICC will be able to sell CLO assets at or near September 30 values. Or maybe - in a dramatic gesture - TICC Management will buy new CLOs at just the right moment. Maybe there will be a change of heart/strategy and TICC will not spend as much on buybacks, which will leave more assets on the books. Maybe a new manager will rally shareholders and lenders alike and come up with a sustainable business model in a hurry.

BLAME GAME

However, we will stick our necks out some more and say we believe the rush to buy back huge numbers of shares is misguided when TICC's leverage is already over the limit and asset values are in near free fall. Buying back shares at a discount to NAV is not the panacea advertised, if both earnings and NAV are headed downwards. For example, earlier in the year the Company bought back some shares at $7.56 a share. A few weeks later, those same number of shares could have been acquired at $6.10. See page 93 of the 10-Q.

TICC Management should have sold off its CLO assets when they first became concerned about the value of that asset class in the BDC format back at the beginning of 2015, but which was not reported to shareholders till 8 months later. Instead, TICC Management has wasted valuable time (thanks to our 20/20 hindsight) finding a new investment adviser who would meet their financial terms and in the struggle for control that has followed.

Likewise, TICC Management's decision to keep leverage maxed out through 2015 was misguided, especially as the increase in non-performing credits and drop in loan values began to show up in the second half of 2014. That has left whoever is at the helm of the Company with little in the way of options, besides downsizing. What was a billion dollar BDC might end up half that size. Or smaller.

Finally, we are disappointed that TICC Management suddenly got religion about how to account for CLO income in the IQ of 2015, just months before deciding to exit the business, which has resulted in very different GAAP accounting than was prevalent in the past.

These actions-plus the movement of the non-investment grade loan market-have created the conditions for TICC's abysmal state, and (in our view) the prospect that performance will continue to deteriorate.

CONCLUSION

The TICC saga is by no means over. The identity of the Company's Investment Adviser, the size of its investment portfolio, its business strategy and the level of its dividend are all unknowable. Down the road, the Company may find the right path out of all this confusion. However, in the months ahead, we project that poor decisions made over the past year will come home to roost, and with a non-investment credit market itself in turmoil, the result will be a massive drop in portfolio size, earnings per share and Net Asset Value Per Share, even if many shares are repurchased at a discount. That's why we are "shorting" TICC.

Disclosure: I am/we are short TICC.

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.