The BDC Reporter tracks the SEC filings of a number of Business Development Companies ("BDC") to keep apprised in almost real-time of some of the developments that may affect their prospects and stock price.
Mid-sized BDC Alcentra Capital (NASDAQ:ABDC) has been preparing to issue a new round of unsecured notes (called Inter Notes) and has been filing preliminary materials with the Securities and Exchange Commission ("SEC"), which are reflected on their website. Included therein are various updates on how the company's investment portfolio is performing in advance of the IVQ 2015 earnings release.
GROWTH IN MIND
We wrote an update on the BDC Reporter about the issue of the new Inter Notes, and about a number of additions and deletions to the portfolio. The activity in recent weeks, and the intention of raising new (albeit expensive) debt capital suggests the company seeks to continue to grow its balance sheet by leveraging itself up from a below average level for a BDC to one more in line with the industry average. (We are not big fans of financing high yielding debt investments with high costing debt borrowings as we explain in the attached article, but that's off today's topic).
Anyway, ABDC's investment portfolio appeared to be in good shape as the year closed, based on what we knew at the end of September from the 10-Q. On reviewing all the loans in portfolio, the BDC Reporter's Watch List was a very short one. This continued a trend that had continued all year, with Net Asset Value at 9-30-15 up on the number at year-end 2014, at a time when most BDCs have been recording lower equity.
Moreover, the Company had announced a few weeks ago, the impending sale of a couple of portfolio companies that were expected to result in Realized Gains and push the Company's aggregate record in this key metric north of the $169,623 recorded in September. Alcentra has only been public since the spring of 2014, but in its short history has a strong record of keeping credit losses low, booking some equity gains and turning over its portfolio as a BDC is expected to do. (Always worry about a lender whose loan portfolio never alters. Chances are the borrowers are not performing well enough to refinance).
FLY IN THE OINTMENT
There was one potential fly in the ointment: DRC Emergency Services. This portfolio company had been in trouble previously: barred from undertaking Federal contracting work for a period (the lifeblood of its business model). ABDC had also previously revealed DRC was also involved in litigation about a payment owed. Bad things happen in 3s, so ABDC more recently disclosed a new legal drama, in which a third-party company claimed to be owed (based upon an oral promise) 10% of DRC's stock. Apparently, DRC did not agree and litigation had followed in which Alcentra itself was named as a party.
GONE BUT AT WHAT PRICE?
The other day, Alcentra announced - as part of its updates to the Inter Note Prospectus - that DRC had been sold on January 19, 2016. As we said ruefully at the time in our article, the company did not reveal the price paid for the DRC-related loans, which had a cost of $12.2mn and a fair market value as of September 2015 of $10.3mn.
Now we know - from the February 1 filing - what management and a small circle of other participants - have known for 2 weeks: the price at which DRC was sold: just $2mn (and that includes a tax benefit !). That's quite a drop (i.e. $8.2mn in a few weeks since the September 30 mark) and suggests there has been great drama behind the scenes, which the dry filings can only hint at.
IMPACT ON EARNINGS
This is material news for ABDC investors, given that a $10,000,000 loss is going to contribute to a "2.5% to 4%" decrease in NAV in the IVQ of 2015. Not discussed but income will also be affected given the two DRC loans on the books were at a 10% interest rate, $5mn in cash and $7.2mn in PIK. That's annual income loss of $1.2mn or 3.5% of IIIQ 2015 Investment Income annualized.
Management is putting up a brave face on this reversal in its filing. After all, the other recent disposition (Health Fusion) did result in a $1.8mn realized gain. Likewise, the repayment of A2Z Wireless will result in a nice fat prepayment fee. (That loan has been redirected to the new buyer of the company as well, which will maintain income). However, these gains were already largely factored into the value of the portfolio at 9-30-15.
Most telling of all - albeit mysterious - Alcentra's filing states management expects realized gains from unspecified investment sales later in 2016 will recoup all that has been lost from the DRC fiasco:
Moreover, based on current information, our management believes that we will realize gains on our investment portfolio over the course of the year that may fully offset the loss associated with our investment in DRC.
We have mixed feelings about how Alcentra's investment adviser has handled this episode. On the one hand, the company has been making periodic disclosures about the ever-changing troubles at this borrower. On the other hand, the fair market valuation - with the benefit of hindsight - was clearly inadequate given the $8mn more than bargained for write-off in a matter of weeks.
WE MIND THE GAP
Moreover, we have no doubt Alcentra's adviser knew weeks ago that the amount to be received would be substantially lower than what was recorded on the books. There was a Conference Call on November 10th with investors, and the sale of the loans occurred on December 19th. Was a negotiation already underway when management last talked to investors? Moreover, why has it taken an additional 11 days for the company to reveal the final purchase price, even as other filings were made in the interim? There may be innocent answers to these questions (SEC regulations?).
This episode may hurt the stock in the short run (although we're guessing the institutional investor base was aware of the final value of DRC some time ago and the loss is already "in the price"). Over the longer term, gains elsewhere and the under-leveraged balance sheet should allow earnings to remain unchanged or continue to grow (as we projected in our earlier piece before learning about $10mn in net yield assets going away).
There are a couple of lessons here for BDC investors, which fit into themes we have pounding on about on Seeking Alpha and at the BDC Reporter:
1. Portfolio investment valuations can change very drastically in a short period of time, usually downward. DRC dropped 80% in a matter of weeks. In that regard, current valuations are just snapshots: worth a quick glance but not worth spending too much time on. Much more valuable is to try and determine what any BDC's portfolio might look like down the road after a little stress is injected into the system.
Vis-a-vis Alcentra we continue to rate the company relatively highly in that regard - DRC notwithstanding. Still, we expect loan assets equal to 10% of equity capital to get written off in the years ahead, net of any investment gains (see below).
2. Management will always seek to delay market moving news, if possible. As we've written elsewhere, there are inherent conflicts of interest between BDC managers and investors, regardless of catchphrases about being "shareholder friendly" and "aligned interests". Investors need to i) do their homework by keeping a close eye on what is going on at all times (which is very time consuming and still leaves big blanks of knowledge); ii) take management disclosures with an appropriate amount of salt. Their job is to "look on the bright side" to attract and retain capital, and yours to wonder what they're not telling you.
We happen to be invested in Alcentra, both in the stock and the existing Inter Notes. We had no special insight into what DRC might or might not be worth when we invested. We underwrite our BDC investments for the long term assuming that every lender will incur credit losses over time. In this case, we have a relatively rosy view of the company's long-term prospects: expecting "only" $20mn in realized losses over the next 5 years, and earnings per share to drop from $1.44 to $1.30, distributions from $1.36 to $1.12 and NAV to drop from $14.92 to closer to $13.50.
WHAT WE LIKE IN A FEW WORDS
We have appreciated management's relatively low risk approach, the adviser's major investment in the company and a business model that involves both debt and equity exposure, which can lead to the equity gains that reverse credit losses elsewhere in the portfolio which ABDC promises will be the case in 2016.
PRICE WAS RIGHT
Most of all, we bought into the Company at an average price of $10.34 (helped by "daring" to buy at $9.20 a share in the recent market meltdown). That's an 8.5x multiple of what we expect earnings to drop to in the years ahead, and 7.2x 2015 estimated earnings, and at a big discount to the latest (soon to be lower) NAV and even our post-recession NAV estimate. The current yield is 13.2%, but we expect that to drop in time to 11.8%. (We take the difference between current distributions and those expected down the road and dollar cost average our position at some point in the future in order to maintain that double-digit dividend).
In our Best Case (which involves no drop in earnings over the next 5 years and a reversion to a better stock price once Mr. Market regains confidence) ABDC earns us a 95% return over 5 years or 19% per annum in a mixture of current income and long-term capital appreciation.
In our Base Case, which assumes distributions drop to $1.12 from year two and remain there and that the stock will be worth 9X future earnings 5 years out, ABDC's total return would be 69%, or 14% per annum. The bulk of the gain (80%) will come from distributions received. Patience will be required.
In our Worst Case, ABDC's earnings per share dropped more than we'd anticipated as losses are higher. If we assume $1.0 a share in earnings/distribution and the stock trades only at an 8x multiple on exit, we would incur a long-term capital loss, offset by (lower) distributions. That's a total return of just 29%, or 5.8% per annum. That implies ABDC will have managed to lose 25% of its NAV in 5 years and 30% of its current net investment income per share.
In this case, we're sticking with our initial underwriting of the company's long-term prospects, but are not surprised that we are left some misgivings of who knew what when, and that shareholders have been left more in the dark than in the light. It's the nature of the BDC system.
Disclosure: I am/we are long ABDC.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: Also long Alcentra Inter Notes that don't have a ticker.