Tuesday, January 17, 2023

Vertical Capital Income: Carlyle Deal, Transitioning to CLO Equity Fund

Last week, Vertical Capital Income Fund (VCIF) ($98MM market cap) announced a proposed manager and strategy change, if approved, Carlyle Group (CG) will assume management of the closed end fund and transition the portfolio from residential whole loans to CLO equity and debt.  To encourage the proposal passing, Carlyle will make a one-time payment to VCIF holders of $10MM or $0.96/share.  Then to ensure alignment, Carlyle will tender for $25MM at NAV and invest an additional $25MM in the fund through a private placement done at NAV.  Following these transactions, Carlyle will own ~40% of the fund.

CLO stands for collateralized loan obligation, these are securitized pools of below-investment grade senior secured bank loans made to corporations (largely PE sponsored).  CLO equity sits at the bottom of the securitization's capital structure and receives the residual cash flow after all expenses and interest is paid to senior noteholders in the transaction.  CLO notes feature term financing with no mark-to-market, meaning CLOs can withstand volatility in the underlying bank loan market and often the manager can "build par" to offset any losses in the portfolio by purchasing loans at a discount and holding them through repayment at par.  CLO equity is generally underwritten to a mid-teens IRR.  There are several publicly traded CLO equity funds today, two prominent ones are Eagle Point Credit Company (ECC) and Oxford Lane Capital (OXLC), both trade roughly inline with NAV or slightly ahead (NAV is lagging, loans are up 1.80% to date, CLO equity values are likely up a bit).

Carlyle is one of the largest CLO managers, by taking over this fund, the PE giant will have a permanent source of equity capital for future CLOs.  This is important for future fund formation and why Carlyle is willing to pay $10MM to holders directly.  Fees to fund holders are going up in the transition as well (but roughly on par with similar funds/BDCs), VCIF currently pays 1.25% of assets, now will pay 1.75% of assets plus a 17.5% incentive fee above an 8% hurdle rate.  Carlyle does get to double dip a bit, they'll likely purchase Carlyle Group managed CLOs where they also earn a management fee.

VCIF currently trades for $9.38/share against a 12/31 NAV of $10.25/share, or an 8.5% discount (without factoring in the $0.96/share payment).  The vote is mostly secured at this point, 36% of shareholders have signed a support agreement.  I quickly sketched out what the return stream might look like in the next six months (the deal is set to close in the first half of 2023):

The biggest assumptions I'm making:
  • NAV is constant, the portfolio is marked monthly, the current holdings are mortgages with interest rate sensitivity, it'll move inversely with rate expectations (mortgage rates are flat-to-slightly down YTD).  As part of the transaction, current management has committed liquidating to cash at least 95% of the gross assets in the portfolio, thus reducing the NAV risk.
  • Only the January distribution is made and it doesn't erode NAV.  Additional interest income we'll assume goes to pay for any deal expenses the fund is expected to pay.
  • All holders participate at 100% in the tender offer.  If less than 100% participate, it improves the realized IRR.
  • Following the transition, the shares trade at a 15% discount to NAV.  In the last 12 months, the fund's shares have traded at an average discount of 12% and as mentioned earlier, the prominent CLO equity funds trade roughly in line with NAV.

I come up with a ~18% IRR for the 5+ months it'll take to close this deal (feels like it should happen sooner pushing the IRR above 20%) and might hold after closing when it will be rebranded as Carlyle Credit Income since CLO equity is reasonably cheap today.

Disclosure: I own shares of VCIF 

13 comments:

  1. Looks clean. Love a tender offer :)

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  2. Thanks for publishing. Was meaning to come back to this idea.

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  3. Hi - thanks for posting - could you explain your math behind the $2.41 tender offer estimate and the $6.67 post transition estimate ??

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    1. I probably should have made it a 100 share lot instead of 1 for clarity.

      Shares outstanding = 10,380,003
      NAV = $10.25

      If NAV stays constant (my assumption, make your own) then Carlyle will purchase 2,437,837 shares (25,000,000/10.25), or 23.48% of the shares. If everyone tenders, then you'd get $2.41 per share you own in the tender (23.48% * $10.25 NAV). Then on the remaining amount (my assumption), you take the amount of shares you have left 76.52% of your original amount, multiple that by the NAV and then apply a 15% discount (my assumption) (76.52%*10.25*85%= $6.67).

      I think that's the right way to think about the order of events here, but please check my work.

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    2. Are the tendered shares being retired? My assumption is that Carlyle will own ~40% of the shares and should still be included in any NAV calculation. In this way, either through share issuance or private placement, NAV/Share would not materially change.

      This leads to either of two options - A) One time payment ($0.96) + Tender (Approximately $10.25) or B) One time payment ($0.96) + Shares in a CLO fund that may trade with a lower/no discount to NAV.

      I could have missed something or be thinking of this incorrectly

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    3. No the tendered shares are not being retired. This is more of way for holders in the current fund strategy to get liquidity if they don't want to be part of a CLO equity fund.

      My assumption and math above is a combination of your two options. I'm assuming that everyone tenders and following proration, shares trade at a 15% discount. Just using that as a baseline, not everyone will fully tender, and it could trade tighter than 15% (or wider).

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  4. Will the dividend continue to be paid after this month?

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    1. I didn't see one way or another, but if the current manager has to liquidate the portfolio, my guess is there won't be another distribution following January. But I could be wrong, or missed it.

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  5. How do the fee structures at the CLO funds trading at NAV compare to the proforma structure to be implemented by Carlyle here?

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    1. Both of the other ones have higher fees. Oxford Lane has a 2/20 fee, Eagle Point is at 1.75/20.

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  6. Any idea how the special payment ($0.96/share) will be treated for tax purposes? The transaction agreement says: "Promptly following the Closing, Carlyle shall instruct the Payment Agent to promptly deliver to each holder of record of VCIF Eligible Shares the Shareholder Payment for each such VCIF Eligible Share held of record by such holder (subject to deduction for any required withholding Tax)"

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    1. I would assume it is taxable income, it is coming from Carlyle and not a return of capital from the fund. But I'm not an accountant and I'm not in the highest tax brackets.

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  7. https://www.prnewswire.com/news-releases/vertical-capital-income-fund-vcif-declares-february-2023-distribution-301738631.html

    Keeping the dividend thus far. NAV up slightly to $10.30, they haven't liquidated the portfolio yet, only $2.7MM of cash.

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