We've been a little behind in analyzing Alcentra Capital's ( ABDC ) common stock offering and sale of stock due to the press of other activity and the need to review the several hundred pages of the Prospectus and other related documents. Admittedly, much of the paperwork is duplicative: typically, copies of prior financial statements. Nonetheless, we like to scan for nuggets of information in the thickets of the filings that are not brought to shareholders' attention in the short and sweet press releases - whether innocently or not. Anyway, the BDC Reporter - after our initial review - is disconcerted by developments at ABDC. For the reasons why, read on:
First, a little background: ABDC was formed in 2013, acquiring the portfolio assets of clumsily titled "BNY Mellon Alcentra Mezzanine III (GP) L.P.", which itself was launched in 2010 to invest in middle market assets. ABDC, through a couple of links, is owned by Bank Of New York and managed by an affiliate thereof. The BDC went public in May 2014 at $15.00 a share, raising $100mn in equity from the public but leaving Bank Of New York with a significant minority interest. From the outset, the BDC's CEO and president was Paul Echausse.
So Far, So Good
Over the past three years, ABDC has performed relatively well, with a strategy of targeting "growth oriented" lower middle market companies. In general terms, the BDC's portfolio risk profile is relatively high, with a goodly portion of capital in the junior tranches of company structures and an average portfolio yield of 11.7% and spread over a relatively small number of borrowers. However, the Investment Advisor successfully navigated the BDC towards a much lower percentage of equity investments in the portfolio, from a third of the total at inception to 7% currently; managed to keep credit losses de minimis over the period and consistently earned and paid a $0.34 quarterly distribution.
When IQ 2017 results were recently unveiled, Net Investment Income Per Share was $0.34, and ditto for the distribution, and Net Asset Value was $13.43, down from $14.76 in the first full quarter after going public. In the interim, what was over $4mn in Unrealized Appreciation has become ($18mn) in Unrealized Depreciation and Realized Losses are up to ($2.2mn). However, the Investment Advisor has been under-distributing Net Investment Income for years, causing that item to bulk up net assets by nearly $5mn and causing the need for a Special Distribution recently. Over a three-year period, that's a pretty good performance and has earned the BDC a mighty boost in its stock price since its all-time low on February 15, 2016, of $9.03 to a high of $14.48 very recently.
In the last few weeks, there have been a number of changes, which may or may not be related. First of all, the BDC made a determined effort to reduce its equity investments, which was highlighted prominently in the IIIQ 2016 earnings release :
"We made a strategic decision to reduce our equity portfolio via a secondary sale of select equity investments (Tunnel Hill, Media Storm and Dentistry for Children), thus positioning the portfolio favorably to maintain or grow net investment income going forward; as well as reduce some of the volatility in the equity portfolio.
The reduction of equity exposure in our portfolio positions us favorably to redeploy capital into new debt investments. Including the value of our warrant in DBI, we will have redeemed approximately $24 million of equity, which can be redeployed into approximately $48 million of debt investments. While the secondary sale came at the cost of a slight discount to our June FMV, it positions the portfolio favorably for the future."
So Long Goodbye
Then, CEO and President Paul Echausse resigned as CEO and president and became chairman but will no longer be involved in the day-to-day management. Instead, David Scopelliti - who joined the Alcentra Group only in 2014 - will become president/CEO from June 2017. The latest conference call was Mr. Echausse's last hurrah at the helm, but reassurances were made that the existing strategy would continue, when the new CEO was asked directly. Nonetheless, we note that there have been a series of managerial changes in the past few weeks, including a new CFO and a new EVP:
Other management changes include the promotion of Ellida McMillan, who has been instrumental in the launch and management of the Company, to Chief Financial Officer and Chief Operating Officer of the Company and Branko Krmpotic, who co-founded the U.S. middle market strategy with Mr. Echausse in 1998, as the Executive Vice President of the Company.
Selling Or Selling Out?
Then, the BDC announced its intention to raise additional equity in a secondary offering, although leverage has consistently remained lower than at its BDC peers. At the end of the IQ 2017, the Net Debt To Equity metric was 0.5 to 1.0.
More controversial - from existing shareholders point of view - the Investment Advisor and other BNY-Alcentra funds holding ABDC's common stock opted to use the recent boost in the stock price to sell their holdings. Almost all their holdings. As page S-40 of the Prospectus shows Alcentra NY, LLC and Alcentra Ltd. have sold 1.7mn shares they own, piggybacking on the secondary. (To their credit, and as the notes to the table below show, the selling shareholders are absorbing some of the costs to ensure no decrease in ABDC's NAV):
Less Is More?
The BDC's Investment Advisor (Alcentra NY, LLC) will be left - like so many other asset managers of public and private BDCs - with only a minimal shareholding in the business that it is the stewards of. By itself, that's not an encouraging sign for ABDC's remaining shareholders and just when the BDC is undergoing a passing of the baton. We leave it to individual investors - whether existing shareholders or those watching from the sidelines considering making the plunge - what to make of the confluence of these events.
Also worth considering is that the BDC Credit Reporter - the sister publication of the BDC Reporter - has some reservations about what's happening to credit quality at ABDC. Of course, just a glance at the balance sheet shows Unrealized Depreciation on the portfolio has increased to ($18.4mn) or 6.3% of the cost value of the portfolio. However, the BDC Credit Reporter tends to dig much deeper and looks at every portfolio company in great detail. For today's purposes, we'll share BDCR's latest assessment of ABDC's portfolio quality completed a few days ago. This is long but instructive:
Portfolio Credit Snapshot
IQ 2017: ABDC has 31 portfolio companies, 7 of which are on our Watch List. Right at the bottom, with a Corporate Credit Rating of 5 is Show Media , which has been on the Watch List since the IQ of 2016 and non-accrual since the IVQ 2016. $7.7mn of First Lien debt and common equity has been written down to $1.1mn by the end of the first quarter. Of course, the loss of income is already impacting ABDC and we expect a complete write-off, given the trends.
More disturbing for ABDC are the 3 companies in Category 4, our Worry List, where we anticipate that the likelihood of an eventual loss is greater than that of full recovery. Oil services company Black Diamond Rentals has been a borrower since the IIQ of 2014, with a $13.9mn First Lien Loan due 2018. However, the Company went on our Watch List at the CCR 3 level from the IQ 2016 when the debt was written down (23%), or ($3.1mn). In the next quarter the debt was restructured into a Senior Note and a Subordinated Note, and the rating changed to the CCR 4 or Worry List. The $5.9mn of the former was valued at par but the Sub Note was valued at 50% of cost of $8mn. Since then both tranches have been written down further but an additional advance by ABDC made in the IQ 2017 of $1.3mn is carried at par. Yet another advance was made in April 2017. The Subordinated Debt carries a bargain basement 4% rate, which is already eating into the income ABDC used to generate pre-restructuring of 12.0% on $12.9mn. The rest is at 12% cash pay and 2% PIK.. Both interest rates suggest Black Diamond Rentals is a special situation. In the IQ of 2017, the original two tranches continue to be written down further. We get the impression ABDC is funding the Company on the hopes of a turnaround. The Company generates $2.2mn in annual investment income even now.
Xpress Global Systems is a logistics company, which ABDC has been a lender and investor in since IVQ 2015, with $5.5mn invested. By the IQ 2016, the equity investment in the Company was sharply written down so we added Xpress to our Watch List. That was confirmed the next quarter when the Second Lien debt too was written down by a third, and is nearly (40%) discounted as of the IQ 2017. The Company generates $0.9mn of annual investment income.
Last but not least is My Alarm Center LLC, which just went on the Worry List straight from Performing in the IQ 2017. This is a large syndicated loan which several BDCs are invested in. Total exposure at IVQ 2016 from BDCs was $164mn. ABDC carried its Second Lien loan of $12.6mn at par in the IVQ of 2016. A quarter later the amount involved has increased and the value written down (24%). The equity stake ABDC owned in the business has gone from a premium to nil value. The security company has been growing by debt financed acquisitions and must have hit a speed bump. Even in April, ABDC advanced additional funds, but did admit on its Conference Call that the Company was on its Watch List. At an interest rate of LIBOR + 11.0%, My Alarm Center, LLC generates $1.6mn of annual income. The second lien status is worrying if the Company is facing financial troubles.
At the Watch List level there are another 3 companies: Conisus, LLC, Southern Technical Institute and FST Technical Services. We won't get into the details of each, but in aggregate these 3 companies are valued at over $45mn, equal to 25% of the latest equity. Income-wise too these companies are major contributors.
In toto, there is around $70mn of ABDC's $180mn of IQ 2017 in net assets up in the air, or nearly 40%. Just the possible investment income loss from the 3 CCR 4 credits could result in a loss of 15% or more of current Net Investment Income. While we have a Long Term rating of C for ABDC -which means we expect average annual NAV erosion of 2%-4%- the amounts of income and capital at risk are on the high side. Of course, these are only possible losses and the BDC maintains several options, including the ability to convert debt to equity or continue to deficit fund if necessary. We are not changing our long term rating, but can't help noting the nominal risk is on the high side. [Extracted from the BDC Credit Reporter]
On ABDC's Conference Call, the Investment Advisor declined to discuss what's happening - or not - at My Alarm Center. Of course, that's its right but does tend to ring alarm bells at the BDC Credit Reporter's headquarters.
Today, just before we began this opus, we heard on Saratoga Investment's ( SAR ) Conference Call that My Alarm Center will not be paying its contractual interest and will go on non-accrual. Here's the full quote:
Second is a $9.4 million second lien investment called My Alarm Center that currently carries $2.3 million of unrealized depreciation also reflecting declining business fundamentals. Subsequent to quarter end, we were notified by management and the sponsor that they will postpone the payment of interest from March onwards and we'll put this on non-accrual in Q1. There are currently various restructuring and sale options being pursued.
Whatever that means for Alcentra's Second Lien valuation in My Alarm Center (same as Saratoga's), this means over $13.6mn in debt with a yield of 12.0% (as confirmed by Advantage Data's records) will be going on non accrual. That's $400,000 a quarter of Investment Income temporarily or permanently going away from the IIQ of 2017. That's equal to 4% of ABDC's Investment Income and 8.7% of Net Investment Income, less any benefits for shareholders to be incurred from lower management or incentive fees.
If we are very strict and subtract from last quarter's Net Investment Income both the probable My Alarm Center income and the non-cash income ABDC is booking, Net Investment Income Per Share drops from $0.34 to $0.24.
Nothing is preordained. ABDC does have the ability to grow the portfolio by tapping its under-used leverage. The Investment Advisor could waive some fees in the future for a while. The troubled investments highlighted by the BDC Credit Reporter could all get resolved favorably. We expect the Investment Advisor will do all in its power to maintain its stellar stable dividend paying record.
Which Way To Go?
Nonetheless, investors may want to worry both about the sale of ABDC's stocks by its Investment Advisor; the uncertainty surrounding any change in leadership and the BDC Credit Reporter's warning that the credit trend is headed downward. As we said at the outset, for the BDC Reporter, the combination of the above as well as the absence of any explanation by the Investment Advisor for its stock sale and the continued absence from the BDC's financial statements of a risk rating of the portfolio (which most BDCs offer up) - leaves us disconcerted.
Dividend Sustainability Rated
We track our expectations for the sustainability of all 45 BDCs in our coverage universe, and we're rating the chances of ABDC maintaining its payout unchanged through this time next year as UNLIKELY.
We Are The Contrarian
We should stress that the market does not (yet?) agree. The stock is trading at a premium to NAV even after the disruption of the equity raise.
Stark Choices To Make
Investors who've read this far have a clear choice that they can make. There are no certainties involved on either side, but given that ABDC is trading at a high price (just before the equity sale ABDC was at the highest level since July 2014), the possible downside is substantial, while the upside (barring multiple expansion) is probably limited to continuing to capture the 10.0% yield and a march up in the price towards the $15.00 all-time high.
Who Are We To Tell You What To Do?
The BDC Reporter does not know enough about each investor's individual risk-return parameters; their tax situation; the availability of other investment alternatives, etc. to be bold enough to suggest what anyone should do. We see our role as providing News, Views, and Analysis. Pushing the Buy, Sell, or Hold button is up to you.
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The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.