Tuesday, March 22, 2016

KCAP Financial: Another Busted BDC, Potential M&A Candidate

We've seen a pretty incredible rally the last 5-6 weeks in the market, especially in junk debt and lower quality equities which basically describe business development companies perfectly.  I currently own too much American Capital (ACAS) for my own good, but they've been selling assets above their book value and plowing that money into buying back stock below book value as they stage the house for a sale.  I might have gotten the path to closing the NAV discount wrong in the case of ACAS, but value will still be unlocked as the assets are worth more in someone else's hands than they are with Malon Wilkus and team.

A similar situation is likely to play out in what I'm calling a mini-ACAS in KCAP Financial (KCAP).  KCAP is a small ($130MM market cap) internally managed BDC that invests about 70% of their assets in vanilla middle market leveraged loans and the other 30% in a CLO asset manager and their manager's related CLO equity book.  Similarly to ACAS, it also trades at a significant discount to NAV and its doubtful it will return to NAV in its current form.

Collateral Loan Obligations (CLOs) are securitization vehicles that own diversified pools of bank loans, many of which are made to leveraged buyouts or as a result of other M&A activity.  The equity portion of a CLO is typically levered 8-10x and captures the excess spread between what their bank loan assets pay and the interest due on their rated notes/liabilities.  During good times, CLO equity IRRs can be in the high teens to low twenties and were a favorite among BDCs as a way to pay the high dividends that investors demanded in a low interest rate world.  Now that the market as stumbled a bit in the past year, many of the companies whose debt is included in CLOs are facing financial trouble (such as Valeant which is about ~1% of CLO assets across the industry), and as the first loss tranche, CLO equity values have taken a significant haircut.  Fewer investors are currently willing to step in to buy the equity of new deals and as a result CLO issuance has slowed (additional reasons are contributing as well).

KCAP Financial's CLO asset manager, Trimaran Advisors (technically they also own Katonah Debt Advisors, but since the financial crisis they've only issued deals under the Trimaran banner) manages $2.7B in assets across their CLO platform.  But with current economic concerns and soon to be implemented risk retention rules taking effect later this year, many smaller CLO managers are having difficulty issuing new deals (to grow and replace ones that are running off) and have put themselves up for sale.  In KCAP's 2015 10-K, they slipped in language suggesting they're shopping their CLO manager platform that wasn't present in the 2014 10-K:
Asset Manager Affiliates.   We expect to receive recurring cash distributions and seek to generate capital appreciation from our investment in our Asset Manager Affiliates. We may also seek to monetize our investment the Asset Manager Affiliates if and when business conditions warrant. As a manager of the CLO Funds, our Asset Manager Affiliates receive contractual and recurring management fees from the CLO Funds for their management and advisory services. In addition, our Asset Manager Affiliates may also earn income related to net interest on assets accumulated for future CLO issuances on which they have provided a first loss guaranty in connection with loan warehouse arrangements for their CLO Funds.
Asset-Backed Alert, a weekly securitization industry publication, also reported in their March 4th edition (sorry, I only have a physical copy) that KCAP is actively selling Trimaran Advisors and presumably their retained CLO equity holdings in Trimaran's CLOs to potential buyers.
KCAP Financial's CLOs have been a headache for the company, its financial statements (they had to restate their financials recently due to incorrect CLO equity accounting), and as a result the stock price as investors have shunned BDCs with any significant exposure to CLO equity.  Removing that business and the related securities would leave a diversified portfolio of fairly straight forward middle market loans with minimal oil & gas, or mining exposure.

The net asset value at 12/31/2015 was $5.82 per share, given the rally in leveraged loans (bank loan returns are generally positive YTD) that NAV should be fairly steady if recast today.  KCAP is internally managed with a cost structure a little over 2% of assets - above the typical base management fee for an externally managed BDC of 1.5 to 2.0% - there's no incentive fee and management owns 12% of the shares, incentives should be fairly aligned.  The stock currently trades for $3.40, or 60% of NAV, if they're able to sell the CLO manager and equity for something close to their marked values, any number of strategic or financial buyers should be knocking down the door to buy the rest of the company as it would be incredibly accretive for any BDC trading above NAV.  Said another way, an investor today is essentially paying a small discount for the bank loan portfolio and getting a cheap option on the CLO manager and CLO equity.  With KCAP's leverage and distressed stock price, they can't increase assets to reach a size where it makes sense to be internally managed, selling to a larger BDC is best option for them and removing the CLO overhang will allow that.

  • Leverage - KCAP is just about maxed out on the BDC asset coverage ratio of 200%, selling the CLO platform would obviously solve that issue completely, but in the meantime mark to market losses in their portfolio will force them to sell assets in order to cure the asset coverage ratio failure.  In the current environment they should be able to sell their more liquid loans to reduce leverage, but during the financial crisis, many BDCs ran into trouble as they created a forced selling environment when they liquidated assets at lower and lower prices to meet their asset coverage ratio.  Their leverage has also limited their ability to repurchase shares which has irked analysts on recent conference calls.
  • CLO Equity - The market has comeback for bank loans in recent weeks, but at certain points, and maybe still today on certain deals, if the CLOs were liquidated using current market prices it would leave nothing for the CLO equity.  But CLOs are cash flow deals, only when a loan gets downgraded near default territory do market prices get applied.  All of KCAP's CLOs are currently passing their coverage tests meaning funds won't get diverted from the equity to pay down senior notes. The accounting treatment for CLO equity is also murky and requires many assumptions that are subject to management's discretion.
  • CLO Warehouse - Trimaran is in the process of raising funds for a new CLO, traction has been slow on it, but they do risk the CLO never coming to fruition and being stuck with the loans already purchased and any resulting losses associated with liquidating the partial portfolio.
Disclosure: I own shares of KCAP