Vertical Capital Income: NAV Slashed Ahead of Carlyle Closing

Another day with egg on my face.  Today, Vertical Capital Income (VCIP) announced that ahead of their pending closing with Carlyle, the fund had liquidated most of their portfolio of residential mortgage whole loans (which was a condition of closing) for a 17% discount to their last reported NAV on 6/30, a full 11 days ago.  In their own words:

Based upon the expected proceeds from this sale, which resulted in aggregate proceeds lower than the book value of the combined assets due to the significant  sale needed to facilitate the Transaction, the Fund has adjusted its net asset value per share ("NAV") from $9.96 as last reported on June 30, 2023, to $8.27 as of today.

Huh?  Seems like there must be a typo or a word was deleted between significant and sale as there's an extra space in there.

The portfolio assets are residential mortgages, most of them are fixed rate, rates have moved slightly up in recent weeks but not enough to justify that discount.  The old management, Oakline Advisors, is kind of an odd shell that is probably checked out at this point and the board of trustees barely own any stock (0.18% as a group).  The incentives to execute a full competitive auction to get best execution just probably weren't there, someone got a steal.  Carlyle doesn't care either, they just want to be handed a bank account with cash in it, doesn't matter to them how much is in the bank account, they're going to go through with their tender and subsequent investment at the value of the cash account.  Not sure how management or the board of trustees can get away with having a shareholder vote a month ago to approve the transaction based on such a faulty mark.  But that's above my head.

What does it look like from here? 

Based on the press release, looks like the deal will close by the end of the month, this will all happen pretty quickly.  Shortly after the deal closes, Carlyle (from the management company, not the fund) will pay $0.96/share in cash to shareholders and then will tender for $25MM at NAV.  If we assume the market is fully pricing in the $0.96/share payment, everyone tenders in full, my math comes up with a proforma price of $7.26/share or 88% of NAV.  Please check my math.

The other CLO equity funds trade above NAV.  It will take time (6-12 months?) for Carlyle to ramp the portfolio up from zero, add some leverage, etc., to get to the point where it looks like one of other CLO equity funds.  The world could change in the meantime.  But Carlyle should be incentivized to make this trade close to NAV, they're one of the largest CLO managers, they want the captive CLO equity vehicle to grow that business.  In its current size, VCIF is too small to accomplish that, if it trades at or above NAV, Carlyle will be able to issue shares accretively and everyone is happy.

Disclosure: I own shares of VCIF

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