July 31, 2013: A busier day in the BDC and Leveraged Debt space: We reviewed new CLO data from Oxford Lane Corporation, as well as the American Capital IIQ 2013 earnings and the Gladstone Investment Fiscal IQ 2014 earnings. Finally, we did a little investigating of MVC Capital's new portfolio investment.
1. Oxford Lane Capital Corporation (NASDAQ:OXLC) provided their quarterly report card on the performance and metrics of the 32 Collateralized Loan Obligations ("CLO") in which they invest. As an investment OXLC is, to the best of our knowledge, the only pure-play way to invest in the equity and subordinated portions of CLOs. The stock is thinly traded, the market cap small (but growing), the price volatile, and the datastream opaque (this is a highly complex area given all the different rules by which each CLO operates). We have a position in OXLC.
WHY WE READ THE REPORT AND YOU SHOULD TOO: The monthly data report is a useful summary of how the Company is performing. Of course, we are looking for any deterioration in the credit performance or value of the underlying loans in the portfolio to determine if there's any near and present danger of the subordinated/equity portions distributions being stopped to protect the more senior tranches. That occurred in many cases in the Great Recession, and is the great risk of investing in CLOs. We also look at what the junior tranches are getting paid for taking the risk of being in the nether regions of an 8x leveraged structured finance vehicle.
The report is useful both to OXLC shareholders and Noteholders (OXLCP-we own that too), and to investors who own many of the Business Development Companies out there with CLO exposure, who can get an idea of how the market is performing. For Leveraged Debt investors generally, the data is an insight into the performance of non-investment grade loans generally, given the thousands of loans in the report's purview (with an average credit rating of B1-B2, using the Moody's nomenclature).
The main take-away from the June report is that the CLO market (or at least OXLC's portion thereof) is in fine shape:
As of June 30, 2013, each of the CLO vehicles was in compliance with all of its respective collateral and coverage tests that were necessary for full payment to be made to the Company by each CLO vehicle.4 The weighted average over-collateralization ("OC") cushion for the Company's CLO equity and debt investments was approximately 3.0% and 8.0%, respectively, as of June 30, 2013 (compared to 2.7% and 7.8%, respectively, as of March 31, 2013).
Also, defaulted loan percentages are very low (0.7%), and down from 0.9% in the prior quarter. Something called a WARF score (we are always learning) was up in the period, indicating better average loan quality.
PRICING: If you needed to be reminded how good things are for borrowers in a low yield environment, just look at the average loan yield: LIBOR + 4.3% (presumably an all-in rate well under 5.0%). The CLOs own average cost of senior loan capital is also ridiculously low: 1.4% above LIBOR. That gives the risk takers in these structures (before CLO expenses) a 2.9% spread to feast on, up from 2.7% a quarter ago.
The weighted average period till the portfolio of CLOs ends their re-investment stage, and the vehicles begin to self liquidate with every loan repayment, is February 2016. That implies OXLC has plenty of time to reap the CLO spread, assuming loan conditions remain positive. Of course, a 3% over-collaterilization for the equity is no wide moat, but that's another subject.
Anyway, looking as we are all the time for evidence of deteriorating credit quality, the CLO report for the IIQ was very encouraging. At the moment the CLO model is working...
2. AMERICAN CAPITAL EARNINGS: The second quarter 2013 earnings of former BDC behemoth American Capital were released after-hours last night, and as Zacks says, they were "dismal". We read the release and the shareholder presentation, and are waiting on the Conference Call transcript.
Here's the Zacks summary:
American Capital Ltd. (ACAS) reported second-quarter 2013 operating income of 16 cents per share, lagging the Zacks Consensus Estimate by 9 cents. Moreover, the results compared unfavorably with the prior-year quarter's earnings of 58 cents per share.
Lower-than-expected results were attributable to lower top line, followed by a rise in non-accrual loans. Further, the low interest environment during the quarter was a negative. However, new investments and reduction of debt acted as the positives.
Net operating income for the quarter came in at $49 million, substantially down from $194 million reported in the prior-year quarter. Net earnings were reported at $21 million, or 7 cents per share, against $237 million or 71 cents per share in the prior-year quarter.
You'd expect that with such poor results, the stock would sell off, but the market has been anticipating poor performance for months. That caused the stock to drop from a high of $15.13 in April to a low of $11.86 on June 24th (the lowest point for every type of Leveraged Debt it seems, and a 22% drop !), before rebounding in recent weeks to $13.48 at yesterday's pre-release close: a 14% increase in a month. We have a big position in American Capital, and sold half at the open, just in case. In fact, the stock shot up initially but has now dropped (1 hour in) below the prior day close.
The sad thing about American Capital is the waste of potential. We are not bothered by the drop in the asset value of their mortgage REIT investments (you have to take the rough with the smooth), which has been in the works for weeks. In fact, the stock price of American Agency (NASDAQ:AGNC) has bottomed (for the moment) and is trending up since the sector's July 5th low.
CREDIT PERFORMANCE: However, we were disappointed by the increase in the number and cost of American Capital's non-accruing loans in the period (following a similar pattern in the IQ). So far into the economic recovery investors have a right to expect better credit metrics, as is almost universally the case across the Leveraged Debt space. Go to Page 61 of today's Investor Presentation for a vivid illustration: 20% of $1.8bn of loans at cost are on non-accrual. That's up from 12.9% at year-end 2012.
ACAS would answer that the write-down to Fair Value of those loans is only 30%, but that's still $104mn in estimated losses. Still, lending represents 36% of the Company's revenues, and interest income has dropped 30% in three months (admittedly as one time and unusual adjustments play into the numbers).
Related to the above, we are disappointed by the Company's inability to make use of it's balance sheet. Everyone is delighted ACAS dodged a bullet back in the Great Recession and successfully de-leveraged. Now,though, the Company has effectively no debt, continues to generate more cash, and increases the Net Asset Value, but seems incapable of making loans and growing income. That's doubly a shame given the Company's tax loss carry-forward.
WAIT AND SEE: Maybe the Conference Call will change our mind, but we are in a wait-and-see mode with ACAS. Waiting to see how the changing rate environment affects it's Mortgage REITs, how the European economy affects subsidiary ECAS, and waiting to see what management does with the structure of The Company and it's strategic direction. When, and if, ACAS gets the right formula here, the stock price (which has already boomed 35% in the past 12 months) could jump again. We have a Realizable Value of $18.0, but we may have to wait longer than we had hoped.
3. Gladstone Investment (NASDAQ:GAIN) Earnings and Conference Call.
SUMMARY: There wasn't much new at the Company. Earnings were lower than the prior quarter, but only because of a one-time income item last quarter.
The decrease in Net Investment Income for the quarter ended June 30, 2013, as compared to the prior quarter, was primarily due to the conversion of $8.2 million of Galaxy Tool Holdings Corp. preferred stock and its related $4.1 million in accrued dividends into a new $12.3 million senior subordinated debt investment through a non-cash transaction recognizing $4.1 million in dividend income related to the recapitalization in the prior quarter. This was partially offset by a decrease in the incentive fee expense by $2.4 million when compared to the prior quarter.
Liquidity remains adequate to grow the Company, and on decent terms. Net Asset Value,though, dropped, as we discuss below. The dividend was maintained at $0.05 a month.
CREDIT QUALITY: As always, the key item at Gladstone Investment is the performance of the portfolio. With a quarter of assets invested in the equity portion of buy-outs, the values can swing widely from period to period. This quarter a couple of companies recent results were lower than previously, so Unrealized Depreciation was up. Management argues that there's nothing to worry about (or much to cheer about). Nothing we heard caused us to want to run for the exits (we have a position in both the common stock and debt) or mortgage the house to buy more. Gladstone still needs to demonstrate that their hands on, long term approach to curing the ills of their troubled investments will yield results over time. No wonder the stock trades at a 14% discount to NAV despite the growth in earning assets in recent quarters. The stock has dropped down 2% in the last few days.
4. MVC Capital's (NYSE:MVC)) New Investment: Smaller, entrepeneurial MVC Capital has money to spend and a new income-oriented strategy to implement.
Yesterday, the Company announced an invested in Biogenic Reagents, "a producer of high-performance carbon products made from renewable resources". The investment is in the form of a senior loan (MVC seeking regular income), with a convertible feature (looking for an equity upside).
Further details about the deal are minimal. We looked at Bionic's website and came away with the conclusion that this is a somewhat speculative investment in a new technology. The borrower's plant was only built in 2012. The amount at risk is not huge as a portion of MVC's total investments.