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The BDC Activist Unconvinced By TICC Capital's Loan Rotation Strategy.

|Includes: Oxford Square Capital Corp. (OXSQ), TSLX

The BDC Activist noticed that beleaguered TICC Capital (TICC) unexpectedly issued a press release today (July 19, 2016) providing an "update" on its "loan rotation strategy" for the quarter ended June 30, 2016. Apparently in the last quarter, the Company continued to divest itself of syndicated first and second lien loans, whose yield averaged just 6.89%, and at the slightest premium to par. To keep the home fires burning and income coming in, TICC turned around (thus "rotation") and re-invested some of the proceeds in higher yielding, less liquid loans and purchased at a discount to par. According to the press release, the "weighted average yield" on $36mn of these new positions is 11.6%. (We don't want to be Grinch-y but we have to point out that the footnote included in the press release-thanks to regulatory requirements when throwing around numbers-comes with a number of assumptions. A good portion of that yield will come from the ultimate redemption of the new loans purchased at par. The running rate yield-not disclosed-until the loan repays will probably be materially lower).


Unfortunately, this announcement creates more questions than answers. First of all, TICC has chosen to update shareholders only on loans pro-actively sold in the period. "Normal" amortization of the portfolio was not included. Nor is there any word about what has happened to the composition of the Company's CLO portfolio, which has both generated the highest Taxable/GAAP income in recent quarters and the greatest Unrealized Depreciation. What has happened to borrowing levels is also not addressed. As a result, we don't know how TICC is addressing leverage levels that were breaching the BDC 200% minimum asset coverage at March 31. By our count, and not including cash, TICC's asset coverage of its debt obligations was 178% at the end of the last reported quarter, usually an alarm bell for a BDC.


Nor are we clear why TICC is expecting shareholders to cheer a strategy of ridding itself of its "safest", most liquid loan assets and replacing them with less liquid and riskier loans. That 70% increase in the "average yield" comes with a far greater risk of eventual default. After all, we are late in the economic cycle, but TICC is making the argument that "risk-adjusted" returns are better in the more speculative segment of the non-investment grade credit market. Only time will tell if that's true.


However, we wonder how these new double digit loans were booked given that TICC has very little new deal origination capacity. We surmise from the press release that the BDC has been buying this loan paper in the secondary markets, going where others fear to tread. Unfortunately, with the huge sale of syndicated loans last year (read our article on the subject here) , and the announced continued shift towards lower credit grade paper, and with no new news on the CLO portfolio, everything suggests TICC Capital's credit risk profile is increasing sharply. The higher yields from these new assets may staunch some of the loss of income from de-leveraging the portfolio and from potential lower CLO income (if the last quarter's numbers in that area continue), but the risk of much higher credit losses over time has risen. Yet-even after selling more than they have invested-TICC probably remains over-leveraged by BDC standards. The BDC Activist asks the Board of the BDC (rhetorically) whether that seems wise or appropriate ?


Of course, this announcement has everything to do with the ongoing battle between the incumbent External Manager of TICC Capital and "activist" investor and fellow BDC TPG Specialty (NYSE:TSLX), which we mentioned recently in the BDC Activist. The press release refers to the Proxy contest underway. Presumably, TICC's current Manager wants to reassure shareholders, shortly about to vote for directors (including one backed by TSLX) and on a proposal to cancel the existing management agreement (amongst other subjects), slated for September 2. Unfortunately, the piecemeal information provided in the press release does not make anything clearer, but does worry the BDC Activist about rising credit risks at TICC. That won't show up in the short run, and TICC's External Manager is in a titanic battle in the here and now.


From the BDC Activist's perspective, the "loan rotation" announcement answers none of the questions shareholders have about what the manager is doing to tackle the over-leveraged nature of the balance sheet and what sustainable income is likely to be in the quarters ahead. We can't help feeling that the principal objective is a focus on maintaining income returns at a certain level in the short run, rather than a comprehensive strategy to achieve appropriate "risk-adjusted" returns over the long term.

However, we don't know how throwing out the External Manager and appointing one TSLX-favored director will necessarily lead to a better outcome either. The BDC Activist suggests that the best course of action-given that the credit markets have firmed substantially in recent months and even CLOs are back on investors Buy Lists-would be for the Board to sell off all the assets, pay off outstanding debt and return capital to shareholders, while the going is good.

After all, the strategies that the Company was employing for the last several years have not worked out. The External Manager has admitted as much by selling off the bulk of its syndicated loan portfolio, and putting its CLO portfolio into deep freeze. The Manager has no known sourcing capacity for originating new loans and can only acquire assets in the secondary markets. Even with the recently lowered management fees that's a very expensive way (1.5% on all assets AND an Incentive Fee) to invest in second hand non-investment grade debt. Sometimes you have to know when to "fold 'em" and this might be the time. If not-at the next credit shock-investors in TICC might find that the higher credit risks being added to the portfolio in recent months will bite them back. The Company has a new "independent" Chairman of the Board since March 1st in Steve Novak (albeit 13 years as a Director at TICC). Maybe we will witness a "re-think" ?

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.