Gladstone Investment's Updated Dividend Sustainability Analysis (Impacts From Very Large Deemed Distribution)

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About: Gladstone Investment (GAIN), Includes: AINV, ARCC, BDCL, BDCS, BIZD, BLK, FSK, GBDC, MAIN, MCC, MDLY, NEWT, OAK, OCSI, OCSL, PFLT, PSEC, SLRC, TCPC, TSLX
by: Scott Kennedy
Summary

On 4/9/2019, GAIN declared a monthly dividend of $0.068 per common share for April-June 2019 and a semi-annual special periodic dividend of $0.09 per common share.

Last quarter, I provided a GAIN dividend sustainability analysis that correctly projected the company would declare a stable monthly dividend while increasing its special periodic dividend.

However, due to an extremely large cumulative UTI balance, GAIN also declared a deemed distribution of $1.52 per common share. This unique strategy/event directly impacts GAIN’s taxation metrics.

As such, this article performs an updated GAIN dividend sustainability analysis by incorporating all impacts from the company’s extremely large deemed distribution.

Updated results from the three tests performed, including a projection of GAIN’s monthly dividend for July-December 2019 and its next special periodic dividend, are stated within the “Conclusions Drawn” section.

Focus of Article:

In light of a recent rare event, the focus of this article is to provide an updated analysis, with supporting documentation (via three tests), on the dividend sustainability of Gladstone Investment Corp. (GAIN) through calendar year 2019. This analysis will be provided after a discussion of GAIN’s deemed distribution and the direct impacts this event has on the company’s Internal Revenue Code (“IRC”)/taxation metrics. The first two tests will focus on GAIN’s net investment company taxable income (“ICTI”) and the company’s undistributed taxable income (“UTI”). These two tests will be termed “TEST 1” and “TEST 2.” The third test will focus on GAIN’s unrealized appreciation (depreciation) on investments account and be termed “TEST 3.”

I have performed this analysis due to the number of readers who have specifically requested such an analysis be performed on GAIN as a direct result of the company’s deemed distribution. Understanding the tax and dividend payout characteristics of GAIN will provide investors with an overall better understanding of the business development company (“BDC”) sector as a whole. From reading this article, investors will better understand how a Regulated Investment Company (“RIC”) per the IRC comes up with the company’s current dividend per share rate and specific signs when an impending increase or decrease should occur. In the past, I have covered a handful of sector peers’ IRC metrics via similar articles (ultimately based on reader requests).

At the end of this article, there will be a conclusion based on the updated results obtained from TEST 1, TEST 2, and TEST 3 about the dividend sustainability of GAIN. I will also provide my projection regarding GAIN’s monthly dividend per share rate for July-December 2019 and my projection regarding the company’s special periodic dividend for the second half of calendar year 2019 (first half of fiscal year 2020). My Buy, Sell, or Hold recommendation and current price target for GAIN are also stated in the “Conclusions Drawn” section near the end of the article.

Side Note: It should be noted GAIN’s fiscal year-end, based on Generally Accepted Accounting Principles (“GAAP”), is March 31st of a given year. GAIN’s tax year-end, based on IRC methodologies, is also March 31st of a given year. Readers should understand this point as the analysis is presented below.

Discussion of GAIN’s RIC Classification per the IRC:

For new readers of my articles, or existing readers who need a “refresher” on this topic, please see the following article:

Gladstone Investment's Dividend Sustainability Analysis (Includes April-December 2019 And Fiscal 2020 Special Periodic Dividend Projections)

Discussion of GAIN’s Deemed Distribution and its Impact on IRC Metrics:

On 4/9/2019, along with GAIN declaring a monthly dividend of $0.068 per common share for April-June 2019 and a semi-annual special periodic dividend of $0.09 per common share, due to an extremely large cumulative undistributed taxable income (“UTI”) balance that had rapidly built up during calendar year 2018, the company decided it was the best option to declare a deemed distribution of $1.52 per common share which was accrued for in March 2019 (prior to the 2019 fiscal and tax year-end). Simply put, this is a very unique strategy/event which directly impacts GAIN’s taxation metrics. As such, I believe it is highly useful/valuable to provide readers an updated dividend sustainability analysis on GAIN.

Last quarter, I provided a GAIN dividend sustainability analysis (see link provided above) that correctly projected the company would declare a stable monthly dividend per common share rate while increasing its special periodic dividend. I also provided the following commentary/thoughts in reference to the potential that GAIN could declare a deemed distribution in the near future and the reason why I was against such a strategy:

As a quick ‘refresher’, under the spillback provision, a RIC per the IRC must distribute the company’s remaining net ICTI for a given tax year through declared dividends prior to the filing of its tax return for that applicable year. If GAIN fails to comply with this provision, the company will be declassified as a RIC per the IRC. If this were to occur, all of GAIN’s net ICTI would be subject to taxation at regular corporate tax rates at the company level. Now, there is one extraordinary measure that could be taken by a RIC for relief of this provision but that is a scenario I believe shareholders would strongly be against. In a nutshell, a RIC would pay corporate taxes on the undistributed capital gain at the BDC level. In my professional opinion, it would make much more sense to ‘pass-through’ the company’s capital gains to shareholders versus GAIN paying taxes on such gains (which would be a notable amount) …”

Using the above quote as a reference, I was in direct opposition of GAIN declaring a deemed distribution. This mainly centers around two factors. First, as will be shown later in the article, a deemed distribution directly lowers GAIN’s cumulative UTI balance without the direct benefit of actually receiving taxable income which would be classified as long-term capital gains treatment to most shareholders (subject to a 20% tax rate). Instead, GAIN shareholders basically have a “deferred” benefit from this event by increasing one’s cost basis by the amount of the deemed distribution less the payment of taxes paid by the company for its shareholders. For example, if a GAIN shareholder has a weighted average purchase price of $10.00 per common share, this particular investor would increase their GAIN cost basis by $1.20 per common share which calculates to $11.20 per common share ($1.52 – ($1.52 x 21%) = $1.20 per share). So, simply put, shareholders do not receive an actual cash (or stock) dividend distribution from this event.

While shareholders are entitled to a current period tax credit regarding the amount of taxes paid on behalf of shareholders by GAIN ($1.52 x 21% = $0.32 per share), the vast majority of this benefit is still deferred until one’s position in the company (as of the ex-dividend date; near the end of March 2019) is closed out (which in itself can get very complicated if one increases their investment in GAIN after March 2019; dependent upon the methodology used to record partial lot sales [LIFO, FIFO, weighted average, or specific identification]). Regarding shares held in a retirement account, shareholders will typically have to contact their financial advisor as they will need to submit an IRS form to the government. I believe it is fair to say the matter is more complicated versus a typical cash distribution over time.

Second, GAIN has to pay federal (and possibly state) corporate taxes on the total amount of the deemed distribution. GAIN’s deemed distribution totaled $1.52 per common share or $50.0 million. As such, GAIN had to pay a federal corporate level tax of $10.5 million during the company’s fiscal fourth quarter of 2019 (calendar first quarter of 2019). Along with a state corporate tax accrual of $3.0 million, this directly reduced GAIN’s earnings per share (“EPS”) and net asset value (“NAV”) by ($0.41) per common share last quarter with no direct benefit to the company, other than to retain some capital.

Simply put, I do not believe this was the most efficient/useful way of dealing with GAIN’s built-up cumulative UTI balance. As such, I was disappointed/not in agreement with GAIN’s decision to declare such a large deemed distribution in March 2019. With that being said, now let us now determine how GAIN’s large deemed distribution has impacted the company’s IRC/taxation metrics and ultimately its future dividend sustainability.

GAIN’s Primary Factor Regarding Setting an Appropriate Dividend Per Share Rate - Intend to Cover the Company’s ADR with Net ICTI:

To fully understand and accurately project a BDC’s dividend sustainability, readers must understand the subtle differences between a company’s net investment income (“NII”) and net ICTI figures/cumulative UTI balances. Due to the fact GAIN continues to not have a capital loss carryforward balance, this is an extremely important concept to understand. Simply put, not having this balance continues to “de-couple” GAIN’s quarterly NII and net ICTI and notably widens the gap between the company’s cumulative overdistributed NII (including GAAP net realized gains) and cumulative UTI balances. As such, readers/contributors not considering IRC methodologies greatly lower the probability of providing accurate projections over a prolonged period of time. Since this is such an important concept to understand, let us briefly discuss this distinction.

NII is a GAAP figure which is based on the accrual method of accounting. ICTI and net ICTI are IRC figures which are “generally” based on the cash method of accounting (some exceptions to this notion [for instance payment-in-kind income and differing depreciation/amortization time tables] but I am keeping it simple for this discussion). Income and expense recognition of certain accounting transactions differ between GAAP and the IRC (book versus tax accounting treatments). A majority of GAIN’s book to tax differences (either temporary or permanent in nature) consist of the following: 1) deferred financing fees on loans and deferred offering costs in relation to equity raises; 2) pre-tax book income (losses) related to certain subsidiaries; 3) expenses not currently deductible; and 4) income tax (provision) benefit of certain subsidiaries. Let us now move on to GAIN’s dividend sustainability analysis.

To test GAIN’s primary factor, I believe it is necessary to analyze and discuss the company’s historical net ICTI figures to see if the company’s quarterly/annual dividend distributions were being covered. This will lead to a better understanding of the overall trends regarding this particular metric and possible pitfalls that may arise in the future. This includes GAIN using the company’s cumulative UTI balance on any quarterly/annual net ICTI overpayments.

By using this methodology, I have consistently provided highly accurate projections within the BDC sector over multiple years (including the most accurate projections on Seeking Alpha).Table 1 below shows GAIN’s annual net ICTI for fiscal 2016, 2017, and 2018. Table 1 also shows GAIN’s net ICTI for the fiscal first, second, third, and fourth quarters of 2019.

Table 1 - GAIN Net ICTI and Cumulative UTI Analysis (IRC Methodologies Based on Quarterly/Annual Timeframes)

GAIN Net ICTI and Cumulative UTI Analysis (Source: Table created entirely by myself, partially using GAIN data obtained from the SEC’s EDGAR Database)

All ACTUAL figures within Table 1 above are checked and verified, either directly or through reconciliations, to various spreadsheets and data from GAIN's supporting documentation (excludes all ratios). Table 1 will be the main source of information as TEST 1 and TEST 2 are analyzed below.

TEST 1 - Net ICTI Versus Distributions Analysis:

  • See Red References “E, F, G, (F / E)” in Table 1 Above Next to the March 31, 2019, Column

Using Table 1 above as a reference, I take GAIN's quarterly/annual "net ICTI" figure (see red reference "E") and subtract this amount by the quarterly/annual "distributions from net ICTI" figure (see red reference "F"). If red reference "E" is greater than red reference "F," then GAIN technically had enough quarterly/annual net ICTI to pay out the company’s dividend distributions for that particular period of time (both monthly and special periodic dividends when applicable). Any excess net ICTI left over, after accounting for GAIN’s dividend distributions, is added to the company’s cumulative UTI balance. This particular balance will be analyzed within TEST 2 later in the article. If red reference "E" is less than red reference "F," then GAIN technically did not have enough quarterly/annual net ICTI to pay out the company’s dividend distributions for a particular period and must use a portion of the cumulative UTI balance to help with the overpayment.

TEST 1 – Analysis and Results:

Still using Table 1 above as a reference, GAIN had annual net ICTI of $25.6, $26.4, and $28.9 million for fiscal 2016, 2017, and 2018, respectively. In comparison, GAIN had annual common stock dividend distributions of ($22.7), ($22.7), and ($28.9) million, respectively. When calculated, GAIN had an annual underpayment of net ICTI of $2.9, $3.6, and less than $0.1 million (rounded) for fiscal 2016, 2017, and 2018, respectively (see red reference “(E – F) = G”). This calculates to an annual dividend distributions payout ratio of 89%, 86%, and 100%, respectively (see red reference “(F / E)”). When combined, GAIN had an underpayment of net ICTI of $6.5 million during fiscal 2016-2018 which calculates to a three-year dividend distributions payout ratio of 92%. In my opinion, most readers would view this as a minor underpayment of net ICTI.

Side Note: GAIN currently has two series of preferred stock with a “mandatorily redeemable” characteristic. Simply put, these two series of preferred stock have a set maturity/redeemable date. Due to this more unique characteristic, GAAP methodologies dictate GAIN should expense all preferred stock dividend distributions within the company’s interest expense account. This is due to the fact GAIN’s preferred stock has characteristics more similar to a typical fixed-rate bond/outstanding borrowing. Within Table 1 above, I did not include such preferred stock dividend distributions within reference “G” above. This is due to the fact such distributions are already accounted for/expensed within GAIN’s income statement (hence represented within the company’s NII/EPS figures). If one were to include such preferred stock dividend distributions within the common stock dividend distributions figure within Table 1, one would also have to increase GAIN’s NII/EPS by an equal amount. Since this is merely a classification scenario (net effect of $0), including the notion to reduce an additional “layer” of reconciliations, I have not reclassified such preferred stock dividend distributions within Table 1 above. If one were to reclassify such amounts, currently reference G would increase by approximately $2.1 million quarterly while net ICTI would increase by this same amount. This also has no impact on TEST 2’s cumulative UTI results discussed later in the article.

Moving to fiscal 2019, GAIN had net ICTI of $14.2, ($8.5), $82.8, and $10.7 million for the fiscal first, second, third, and fourth quarters of 2019, respectively. In comparison, GAIN had common stock dividend distributions (excluding the deemed distribution of $1.52 per common share which was “non-cash” in nature; accounted for in TEST 2 later) of ($8.6), ($6.6), ($8.7), and ($6.7) million, respectively. When calculated, GAIN had an underpayment (overpayment) of net ICTI of $5.6, ($15.1), $74.2, and $4.0 million for the fiscal first, second, third, and fourth quarters of 2019, respectively. This calculates to an annual dividend distributions payout ratio of only 31% for fiscal year 2019. Simply put, this is an extremely low payout ratio. In addition, this includes accounting for both of GAIN’s special periodic dividends totaling $0.12 per common share for fiscal 2019.

In comparison, within my prior quarter’s dividend sustainability analysis (see linked article above), I projected GAIN would have an annual payout ratio of 35% for fiscal year 2019. As such, GAIN had some additional book-to-tax adjustments for tax year 2019 that were slightly above my previous projections. However, as noted earlier, this payout ratio excludes GAIN’s deemed distribution which is accounted for in TEST 2 (was a non-cash distribution).

The modestly above average net ICTI for the fiscal first quarter of 2019 was mainly due to the realized/capital gain within Drew Foam Companies, Inc. (Drew Foam). GAIN reported a net realized gain of $13.8 million during the fiscal first quarter of 2019. The notably below average net ICTI for the fiscal second quarter of 2019 was mainly due to realized/capital losses within NDLI, Inc. (“NDLI”). This portfolio company was previously written-down and this was merely an unrealized to realized loss reclassification (“cleaning up” the balance sheet).

As I previously correctly projected, GAIN’s net ICTI for the fiscal third quarter of 2019 had a massive “bounce back.” The extremely above average net ICTI was mainly due to realized/capital gains within Cambridge Sound Management, Inc. (Cambridge) and Logo Sportswear, Inc. (Logo Sportswear). When combined, GAIN reported a net realized gain of $76.8 million during the fiscal third quarter of 2019. The average net ICTI for the fiscal fourth quarter of 2019 was mainly due to realized/capital losses within SOG Specialty Knives & Tools, LLC (SOG Knives) and The Mountain Corp. (The Mountain). When combined, GAIN reported a net realized loss of ($19.5) million during the fiscal fourth quarter of 2019. However, these net realized/capital losses were offset by the reversal of the $13.5 million of taxes paid on behalf of common shareholders by GAIN in relation to the company’s aforementioned deemed distribution and several other book-to-tax adjustments.

When looking at TEST 1 on a “standalone” basis, I believe GAIN’s massive realized/capital gain in regards to Cambridge and Logo Sportswear previously had secured the company’s dividend sustainability through at least calendar year 2019 (most of fiscal year 2020). This even considered the possibility of GAIN incurring some realized/capital losses on several of the company’s underperforming portfolio investments over the foreseeable future (for instance the recent restructuring of SOG Knives and The Mountain). However, GAIN’s recent $50.0 million deemed distribution could put this previous assumption in jeopardy. As such, to take this dividend sustainability analysis a step further, let us now perform TEST 2.

TEST 2 – Cumulative UTI Coverage of Outstanding Shares of Common Stock Ratio Analysis:

  • See Red References “H, I, K, (I / K)” in Table 1 Above Next to the March 31, 2019, Column

Once again using Table 1 above as a reference, after accounting for GAIN’s deemed distribution (broken out to highlight/isolate this event’s impact; see red reference “H”), I take the company's "cumulative UTI” figure (see red reference “I") and divide this amount by the company’s "outstanding shares of common stock" figure (see red reference "K"). From this calculation, GAIN's "cumulative UTI coverage of outstanding shares of common stock ratio” is obtained (see red reference "(I / K)"). The higher this ratio is, the more positive the results regarding GAIN's future dividend sustainability. Simply put, this ratio shows the amount of cumulative UTI covering the number of outstanding shares of common stock for that specified point in time.

TEST 2 - Analysis and Results:

Still using Table 1 above as a reference, GAIN had a cumulative UTI balance of $6.9, $10.5, and $10.5 million at the end of the fiscal fourth quarter of 2016, 2017, and 2018, respectively. Due to GAIN's three-year minor underpayment of net ICTI (as discussed in TEST 1 earlier), the company’s cumulative UTI balance increased from $4.0 million as of 3/31/2015 to $10.5 million as of 3/31/2018. GAIN had 30.2, 30.2, and 32.7 million outstanding shares of common stock, respectively. When calculated, GAIN had a cumulative UTI coverage of outstanding shares of common stock ratio of 0.23, 0.35, and 0.32 at the end of the fiscal fourth quarter of 2016, 2017, and 2018, respectively. In my opinion, GAIN's cumulative UTI balance as of 3/31/2018 was at a fairly attractive level (was near the mean of the fifteen BDC peers I currently cover). In addition, it should be noted GAIN distributed special periodic dividends totaling $0.12 per common share during fiscal year 2018 (which most BDC peers did not declare).

Moving to fiscal year 2019, in last quarter’s dividend sustainability analysis (see link provided above), I projected GAIN would have a cumulative UTI balance of $66.5 million at the end of the fiscal fourth quarter of 2019. This projection assumed GAIN would not declare a deemed distribution and would have eventually paid out the company’s cumulative UTI in subsequent quarters during its tax year 2020. When accounting for GAIN’s ($50.0) million deemed distribution and subsequent reversal of the company’s $13.5 million federal and state corporate taxes in relation to this event, I would have projected GAIN would have a cumulative UTI balance of $30.0 million as of 3/31/2019.

In comparison, GAIN had a cumulative UTI balance of $29.2 million at the end of the fiscal fourth quarter of 2019. As such, I believe my previous projection was very accurate when excluding GAIN’s deemed distribution and the direct impacts from such an event. Getting back to Table 1, GAIN had 32.8 million outstanding shares of common stock. When calculated, GAIN had a cumulative UTI coverage of outstanding shares of common stock ratio of 0.89 at the end of the fiscal fourth quarter of 2019 (as of 3/31/2019).

I believe there is a one main positive and one main negative factor/trend to consider as a direct result of GAIN’s recent large deemed distribution when it comes to the company’s dividend sustainability. Let us first discuss the positive factor/trend. GAIN’s management team could have declared an even larger deemed distribution to common shareholders (larger than $1.52 per share) which would have further reduced the company’s cumulative UTI ratio as of 3/31/2019. In other words, GAIN’s cumulative UTI coverage of outstanding shares of common stock ratio of 0.89 as of 3/31/2019 was still at a very attractive level and was still the third highest ratio out of the fifteen BDC peers I currently cover.

However, I also believe it needs to be stated GAIN’s cumulative UTI coverage of outstanding shares of common stock ratio notably decreased as a direct result of the company’s $1.52 per common share deemed distribution. As of 12/31/2018, GAIN’s cumulative UTI balance and coverage ratio was $75.2 and 2.29, respectively. As stated above, as of 3/31/2019, this balance and ratio notably decreased to just $29.2 and 0.89, respectively. Simply put, this notable decrease has now directly lowered my previously projected special periodic dividend range for the second half of calendar year 2019 (specific range provided near the end of the article).

Still, compared to what occurred with some BDC peers like Apollo Investment Corp. (OTC:AINV), FS KKR Capital Corp. (FSK) (formerly FS Investment Corp.; FSIC), Oaktree Strategic Income Corp. (OCSI), Oaktree Specialty Lending Corp. (OCSL), Medley Capital Corp. (MCC), and Prospect Capital Corp. (PSEC) who had material dividend per share reductions over the past several years,GAIN has continued to have sufficient net ICTI for the company’s dividend distributions (with an attractive surplus; even after accounting for the extremely large deemed distribution). This includes accounting for GAIN’s special periodic dividends.

In my opinion, considering TEST 2 on a standalone basis, the evidence provided above helps support GAIN’s steady–slightly increasing monthly dividend per share rate over the past several years and over the foreseeable future. TEST 2 also supports GAIN’s special periodic dividends that were/are projected to be distributed during fiscal year 2018-2020.

The following were the 3/31/2019 cumulative UTI coverage of outstanding shares of common stock ratios for GAIN and fourteen of the BDC stocks I currently cover (very good comparison tool/metric):

1) TPG Specialty Lending Inc. (TSLX): 1.12 (1.22 as of 12/31/2018)

2) Ares Capital Corp. (ARCC): 0.94 (0.76 as of 12/31/2018)

3) GAIN: 0.89* (2.29 as of 12/31/2018)

4) Main Street Capital Corp. (MAIN): 0.77 (0.68 as of 12/31/2018)

5) FSK: 0.36 (0.36 as of 12/31/2018)

6) Solar Capital Ltd. (SLRC): 0.34 (0.31 as of 12/31/2018)

7) PennantPark Floating Rate Capital Ltd. (PFLT): 0.33 (0.31 as of 12/31/2018)

8) NEWTEK Business Services Corp. (NEWT): 0.25 (0.15 as of 12/31/2018)

9) PSEC: 0.07** (0.05 as of 12/31/2018)

10) BlackRock TCP Capital Corp. (TCPC): 0.06 (0.03 as of 12/31/2018)

11) OCSL: 0.05 (0.04 as of 12/31/2018)

12) Golub Capital BDC Inc. (GBDC): 0.04 (0.06 as of 12/31/2018)

13) OCSI: 0.01 (0.01 as of 12/31/2018)

14) AINV: 0.00; No cumulative UTI (0.00 as of 12/31/2018)

14) MCC: 0.00; No cumulative UTI (0.00 as of 12/31/2018)

* = As indicated earlier, declared a $1.52 per common share deemed distribution during the calendar first quarter of 2019

**= Based on an Internal Revenue Code (“IRC”) tax year-end of August 31st (tax year 2019 began 9/1/2018)

As readers can see, some BDC peers like to be cautious when it comes to distributing out its cumulative UTI (for instance TSLX, ARCC, and even some could argue MAIN and FSK) while some companies like to distribute most of its “built-up” cumulative UTI annually; whether it is through a special periodic dividend twice a year (for instance GAIN), at the end of the calendar year (for instance GBDC), or through an increased dividend towards the second half of the year (for instance NEWT).This is a good segway in transitioning to another “forward-looking” sustainability analysis regarding GAIN’s semi-annual special periodic dividend.

TEST 3 – Cumulative Unrealized Appreciation Coverage of Outstanding Shares of Common Stock Ratio Analysis:

  • See Red References “L, K, (L / K)” in Table 2 Below Next to the March 31, 2019, Column

To begin TEST 3, let us first take a look at the information provided in Table 2 below.

Table 2 - GAIN Cumulative Unrealized Appreciation Coverage of Outstanding Shares of Common Stock Ratio Analysis (Based on Quarterly/Annual Timeframes)

GAIN Cumulative Unrealized Appreciation Coverage Analysis (Source: Table created by me, partially using GAIN data obtained from the SEC’s EDGAR Database [link provided below Table 1])

Using Table 2 above as a reference, I take GAIN's "cumulative unrealized appreciation (depreciation) on investments” figure (see red reference “L") and divides this amount by the company’s "outstanding shares of common stock" figure (see red reference "K"). From this calculation, GAIN's "cumulative unrealized appreciation (depreciation) coverage of outstanding shares of common stock ratio” is obtained (see red reference "(L / K)"). The higher this ratio is, the more positive the results regarding GAIN continuing to declare future special periodic dividends beyond fiscal year 2020. Basically, this ratio shows the amount of cumulative unrealized appreciation covering the number of outstanding shares of common stock for a specified point in time. Since GAIN has continued to gradually increase the company’s investment portfolio, through borrowings and periodic equity offerings, this ratio shows if the company has been able to/will be able to increase its cumulative unrealized appreciation balance by a similar proportion.

I believe this is a good test to perform because GAIN’s unrealized investment appreciation (depreciation) will eventually become a realized event. However, one unknown variable is time. It cannot be determined if GAIN will realize a particular investment gain (loss) during the next quarter, next year, or further out on the time horizon. However, it is a general “rule of thumb” that the larger a company’s cumulative unrealized appreciation balance becomes, the greater the probability of realized gains occurring at some point in the future. In the end, management has the ultimate decision when to realize/“monetize” certain investments within GAIN’s portfolio. As such, I believe TEST 3 is a good indicator of possible future realized/capital gains which directly leads to GAIN being able to continue to pay special periodic dividends beyond fiscal year 2020 (forward-looking metric).

TEST 3 - Analysis and Results:

Still using Table 2 above as a reference, GAIN had a cumulative unrealized appreciation (depreciation) balance of ($30.5), ($23.6), and $13.8 million at the end of the fiscal fourth quarter of 2016, 2017, and 2018, respectively. GAIN had 30.3, 30.3, and 32.7 million outstanding shares of common stock, respectively. When calculated, GAIN had a cumulative unrealized appreciation coverage of outstanding shares of common stock ratio of (1.01), (0.78), and 0.42 at the end of the fiscal fourth quarter of 2016, 2017, and 2018, respectively. As such, over the span of three fiscal years, GAIN’s ratio went from being notably negative as of 3/31/2016 to fairly attractive as of 3/31/2018 (especially when compared to most sector peers who had deficit balances).

Moving to fiscal year 2019, GAIN had a cumulative unrealized appreciation balance of $34.5 million at the end of the fiscal fourth quarter of 2019. GAIN had 32.8 million outstanding shares of common stock. When calculated, GAIN had a cumulative unrealized appreciation coverage of outstanding shares of common stock ratio of 1.05 at the end of the fiscal fourth quarter of 2019. I believe this ratio as of 3/31/2019 is at a very attractive level.

This increase is directly related, in part, to passage of the Tax Cuts and Jobs Act (“TCJA”) and continued strong operating performance by some portfolio companies. Most of GAIN’s underlying portfolio companies recently had a reduced effective tax rate (or pass-through rate; dependent upon entity status) regarding their “earnings and profit” (E&P) statement (an IRC methodology) due to the recent passage of the TCJA. This positively impacts GAIN’s equity investments within these applicable portfolio companies (lower taxes typically equate to higher enterprise value [EV]).

Using a baseball analogy in reference to GAIN’s investment portfolio over the past several years, the company has had a handful of “strikeouts” (non-accrual debt investments; worthless equity investments) while also having a handful of “grand slams” (consistently performing debt investments at an attractive interest rate along with notable equity appreciation). Per a monetary standpoint, GAIN’s gland slams have “trumped” the company’s strikeouts. Even if GAIN’s cumulative unrealized appreciation balance once again turned negative over the foreseeable future (possible in an economic recession), the company still has its very attractive cumulative UTI surplus discussed earlier. As such, I would not be surprised if management went ahead and continued to “clean up” GAIN’s balance sheet during the remainder of calendar year 2019 regarding several of the company’s non-accrual debt investments and worthless equity investments which are already completely written down. I am not stating this will happen. However, I am stating management has this option if/when needed.

Conclusions Drawn:

To sum up the information in this article, a discussion in relation to GAIN’s March 2019 deemed distribution was provided. This included GAAP and IRC impacts regarding this unique event. Personally, I was disappointed when GAIN announced this type of distribution/event. I preferred GAIN to have distributed the company’s extremely large cumulative UTI balance during its fiscal/tax year 2020. Instead, GAIN retained $50.0 million of long-term capital gains and paid a corporate federal tax of $10.0 million while also accruing a corporate state tax of $3.5 million on behalf of common shareholders. Simply put, I believe this was the “less complicated/efficient” option.

This article then performed three dividend sustainability tests on GAIN to analyze the impacts from the company’s deemed distribution of $50 million or $1.52 per common share. The first two tests were based on GAIN’s net ICTI and cumulative UTI which are based on IRC methodologies. TEST 1 provided the following information in regards to GAIN’s annual net ICTI payout ratio for fiscal 2016, 2017, 2018, and 2019, respectively (excluding the deemed distribution of $1.52 per common share which was non-cash in nature; accounted for in TEST 2):

GAIN’s Fiscal 2016, 2017, 2018, and 2019 Net ICTI Payout Ratio: 89%, 86%, 100%, and 31%

My Previously Projected GAIN 2019 Net ICTI Payout Ratio: 35%

When looking at TEST 1 on a standalone basis, I believe GAIN’s massive realized/capital gain in regards to Cambridge and Logo Sportswear previously had secured the company’s dividend sustainability through at least calendar year 2019 (most of fiscal year 2020). This even considered the possibility of GAIN incurring some realized/capital losses on several of the company’s underperforming portfolio investments over the foreseeable future (for instance the recent restructuring of SOG Knives and The Mountain). However, GAIN’s recent $50.0 million deemed distribution could have put this previous assumption in jeopardy.

As such, to gain further clarity, TEST 2 was then performed which analyzed GAIN’s cumulative UTI balance. TEST 2 provided the following information in regards to GAIN’s cumulative UTI coverage of outstanding shares of common stock ratio at the end of fiscal 2016, 2017, 2018, and 2019, respectively (including the March 2019 deemed distribution of $1.52 per common share):

GAIN’s Cumulative UTI Coverage of Outstanding Shares of Common Stock Ratio as of 3/31/2016, 3/31/2017, 3/31/2018, and 3/31/2019: 0.23, 0.35, 0.32, and 0.89

GAIN’s Cumulative UTI Coverage of Outstanding Shares of Common Stock Ratio as of 3/31/2019 if no Deemed Distribution was Declared: 2.00

My Previously Projected GAIN’s Cumulative UTI Coverage of Outstanding Shares of Common Stock Ratio as of 3/31/2019 (Assumed no Deemed Distribution Would be Declared): 2.03

In my opinion, considering TEST 2 on a standalone basis, the evidence provided above helps support GAIN’s steady–slightly increasing monthly dividend per share rate over the past several years and over the foreseeable future. TEST 2 also supports GAIN’s special periodic dividends that were/are projected to be distributed during fiscal year 2018-2020.

When looking at the results from TEST 1 and TEST 2, I have concluded the probability of GAIN being able to maintain-slightly increase the company’s monthly dividend per share rate in its next several sets of dividend declarations remains very high (90%). As such, I am projecting GAIN will declare the following monthly dividends:

Dividend for July-September 2019: $0.068-0.072 per common share

Dividend for October-December 2019: $0.069-0.073 per common share

Next, TEST 3 provided the following information in regards to GAIN’s cumulative unrealized appreciation (depreciation) coverage of outstanding shares of common stock ratio at the end of fiscal 2016, 2017, 2018, and 2019, respectively:

GAIN’s Cumulative Unrealized Appreciation (Depreciation) Coverage of Outstanding Shares of Common Stock Ratio as of 3/31/2016, 3/31/2017, 3/31/2018, and 3/31/2019: (1.01), (0.78), 0.42, and 1.05

When looking at the results from TEST 2 and TEST 3, I have concluded the probability of GAIN being able to declare a semi-annual special periodic dividend through at least the second half of fiscal 2020 remains very high (90%). However, when compared to last quarter’s sustainability analysis, the projected per share amount of GAIN’s future special periodic dividend is modestly-notably lower versus my previous projection as a direct result of a notably lower cumulative UTI balance as of 3/31/2019 (due to the deemed distribution). Still, GAIN’s cumulative UTI ratio was still very attractive when compared to most BDC peers I currently cover which is a positive catalyst/trend. As such, I am projecting GAIN will declare the following special periodic dividend during the second half of fiscal 2020:

My Updated Projection of GAIN’s Special Periodic Dividend for the Second Half of Fiscal 2020 (Likely to Be Distributed December 2019): $0.06-0.12 per common share

My Previous Projection of GAIN’s Special Periodic Dividend for the Second Half of Fiscal 2020 (Likely to Be Distributed December 2019): $0.10-0.30 per common share

A prior BDC comparison article I wrote provided some recent, more generalized dividend sustainability metrics regarding fifteen BDC peers that I cover (including GAIN). For additional analysis related to this topic, I refer readers to the following article:

Ares Capital's Dividend, NAV, And Valuation Vs. 14 BDC Peers - Part 2 (Indications Of An Undervalued Stock)

PART 2 of my BDC sector comparison article for the current quarter should be available to readers in the near future.

My Buy, Sell, or Hold Recommendation:

From the analysis provided above, including additional factors not discussed within this article, I currently rate GAIN as a Sell when the company’s stock price is trading at or greater than a 5.0% premium to the mean of my projected NAV as of 6/30/2019 range ($12.25 per share), a Hold when trading at less than a 5.0% premium but less than a (5.0%) discount to the mean of my projected NAV as of 6/30/2019 range, and a Buy when trading at or greater than a (5.0%) discount to the mean of my projected NAV as of 6/30/2019 range. These ranges are a minor decrease when compared to my last GAIN article (approximately three months ago). This minor decrease is mainly due to GAIN’s recent $1.52 per common share deemed distribution (and all direct impacts) which directly reduced the company’s cumulative UTI balance (thus lowering the per share amount of special periodic dividends versus my previous projections; see above).

Therefore, I currently rate GAIN as a Buy. As such, even with the slight decrease to my recommendation ranges (relative to NAV but considers numerous factors/metrics), I currently believe GAIN is undervalued. My current price target for GAIN is approximately $12.85 per share. This is currently the price where my recommendation would change to a Sell. The current price where my recommendation would change to a Hold is approximately $11.65 per share. Long-term holders of GAIN should gain comfort that I currently believe the company’s dividend sustainability, through at least fiscal 2020, remains very high.

Final Note: Each investor's Buy, Sell, or Hold decision is based on one's risk tolerance, time horizon, and dividend income goals. My personal recommendation will not fit each reader’s current investing strategy. The factual information provided within this article is intended to help assist readers when it comes to investing strategies/decisions.

Recent/Current BDC Sector Stock Disclosures:

On 3/13/2019, I initiated a position in GAIN at a weighted average purchase price of $11.625 per share. On 6/6/2019, I increased my position in GAIN at a weighted average purchase price of $11.085 per share. When combined, my GAIN position has a weighted average purchase price of $11.257 per share. This weighted average per share price excludes all dividends received/reinvested. Each GAIN trade was disclosed to readers in real time (that day) via the StockTalks feature of Seeking Alpha.

On 9/6/2017, I re-entered a position in PSEC at a weighted average purchase price of $6.765 per share. On 10/16/2017 and 11/6/2017, I increased my position in PSEC at a weighted average purchase price of $6.285 and $5.66 per share, respectively. When combined, my PSEC position has a weighted average purchase price of $6.077 per share. This weighted average per share price excludes all dividends received/reinvested. Each PSEC trade was disclosed to readers in real time (that day) via the StockTalks feature of Seeking Alpha. I currently have a Buy recommendation on PSEC.

On 2/2/2018, I re-entered a position in MAIN at a weighted average purchase price of $37.425 per share. On 2/5/2018, 3/1/2018, 10/4/2018, 10/23/2018, 12/18/2018, and 12/21/2018, I increased my position in MAIN at a weighted average purchase price of $35.345, $35.365, $37.645, $36.674, $35.305, and $33.045 per share, respectively. When combined, my MAIN position has a weighted average purchase price of $34.713 per share. This weighted average per share price excludes all dividends received/reinvested. Each MAIN trade was disclosed to readers in real time (that day) via the StockTalks feature of Seeking Alpha. I currently have a Hold recommendation on MAIN.

On 6/5/2018, I initiated a position in TSLX at a weighted average purchase price of $18.502 per share. On 6/14/2018, I increased my position in TSLX at a weighted average purchase price of $17.855 per share. My second purchase was approximately double the monetary amount of my initial purchase. When combined, my TSLX position has a weighted average purchase price of $18.071 per share. This weighted average per share price excludes all dividends received/reinvested. Each TSLX trade was disclosed to readers in real time (that day) via the StockTalks feature of Seeking Alpha. I currently have a Hold recommendation on TSLX.

On 10/12/2018, I initiated a position in ARCC at a weighted average purchase price of $16.40 per share. On 12/10/2018, 12/18/2018, and 12/21/2018, I increased my position in ARCC at a weighted average purchase price of $16.195, $15.305, and $14.924 per share, respectively. When combined, my ARCC position has a weighted average purchase price of $15.293 per share. This weighted average per share price excludes all dividends received/reinvested. Each ARCC trade was disclosed to readers in real time (that day) via the StockTalks feature of Seeking Alpha. I currently have a Buy recommendation on ARCC.

On 10/12/2018, I re-entered a position in NEWT at a weighted average purchase price of $18.355 per share. On 12/21/2018, I increased my position in NEWT at a weighted average purchase price of $15.705 per share, respectively. When combined, my NEWT position had a weighted average purchase price of $16.462 per share. This weighted average per share price excluded all dividends received/reinvested. On 4/8/2019 and 4/11/2019, I sold my entire position in NEWT at a weighted average sales price of $21.157 per share as my price target, at the time, of $21.10 per share was met. This calculates to a non-annualized realized gain of 28.5% and a non-annualized total return (when including weighted average dividends received) of 34.0%. These NEWT trades were disclosed to readers in real time (that day) via the StockTalks feature of Seeking Alpha.

On 10/12/2018, I initiated a position in SLRC at a weighted average purchase price of $20.655 per share. On 12/18/2018, I increased my position in SLRC at a weighted average purchase price of $19.66 per share, respectively. When combined, my SLRC position has a weighted average purchase price of $19.909 per share. This weighted average per share price excludes all dividends received/reinvested. Each SLRC trade was disclosed to readers in real time (that day) via the StockTalks feature of Seeking Alpha. I currently have a Buy recommendation on SLRC.

All trades/investments I have performed over the past several years have been disclosed to readers in real time (that day at the latest) via the StockTalks feature of Seeking Alpha (which cannot be changed/altered). Through this resource, readers can look up all my prior disclosures (buys/sells) regarding all companies I cover here at Seeking Alpha (see my profile page for a list of all stocks covered). Through StockTalk disclosures, at the end of May 2019 I had an unrealized/realized gain “success rate” of 87.5% and a total return (includes dividends received) success rate of 100% out of 40 total positions (updated monthly; multiple purchases/sales in one stock count as one overall position until fully closed out [no realized total losses]). I encourage other Seeking Alpha contributors to provide real time buy and sell updates for their readers which would ultimately lead to greater transparency/credibility.

Disclosure: I am/we are long GAIN, ARCC, BLK, MAIN, PSEC, SLRC, TSLX. 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.

Additional disclosure: I currently have no position in AINV, BDCL, BDCS, BIZD, FSK, GBDC, MCC, MDLY, NEWT, OAK, OCSI, OCSL, PFLT, or TCPC.