Wednesday, October 27, 2010

Capital Structure

Before continuing on the ACAS company dive, I wanted to have a quick post that discusses some of the key terms used when describing a BDC's portfolio companies. A hyper-link on the term means I am sending you to a site with a good definition that expands on the item.

Capital Structure 
This term refers to how a company finances its assets and business through various combinations of Debt and Equity. There are many different variations of Debt and Equity and each one represents a trade-off between security and agency within the company.

Debt Financing
There are two main types of financing extended to a Company - Asset-Backed and Cash Flow. Asset-backed loans for everyday people would be equivalent to a mortgage or car loan. There is some form of collateral that is backing the loan. If the borrower defaults on the loan, the lender can take possession of the physical (or in some industries - take the Intellectual Property (IP)/patents) asset. A Cash Flow loan is equivalent to a Credit Card. These loans are based on the company's earning power and ability to pay back the loan with its Earnings.

Asset-Backed Loan
In terms of corporate finance, a typical asset-backed loan is a fixed term loan of about 3-5 years (as opposed to a 30 year mortgage). The main reason a company looks for an ABL is to fund an expansion of the firm (leveraged buyouts will be discussed later). These loans have many flavors and names such as "Term Loan", "Senior", "Subordinated", "Jr.," "Mezzanine" and "Tranche". The name is very important in an ABL, it tells you the claim priority of the loan (who gets paid first in case of bankruptcy) as well as what guarantees are attached to the loan. The amount a company can receive in an ABL is tied to the company's assets.

Term Loan A, B, C
It is very common for a BDC to hold a Term Loan B or C on its Balance Sheet. Most ABLs are extended by a primary lender (bank) that will hold the most senior tranche of the loan (Term Loan A - TLA). The bank will typically hold this loan on its balance sheet until maturity. Sometimes if the desired amount of credit the company desires is more than what the primary lender wants to extend, the loan is offered by the lender to other institutions. This is known as syndicating a loan and these investors typically invest in a slightly different tranche called the Term Loan B or C. TLAs typically have a fixed amortization schedule and the lowest pricing for a loan. A Term Loan B/C is different than the TLA. These loans have the same seniority "pari passu" as the TLA, but their amortization is usually a token amount followed by a balloon payment at maturity (think ARMs). TLB/C may have a longer maturity date than the TLA and will have a higher price than a TLA (L+500 versus L+300). For a lender to extend loans to a company, they typically attach a number of covenants to the loan. These covenants help ensure that the borrowers stays in a position that will allow them to pay for the interest and amortization over the course of the loan.

Cash Flow Loan
A CFL is called a Revolver in the corporate world. A revolver is typical for many companies that have seasonal cash flows (think retailers/construction) that need to fund their need for working capital during these times. A Revolver is a special type of loan in that it is a Line of Credit extended to a company (like a credit card) but it carries a maturity date and two interest rates. The first interest rate is the funded rate - this is like your APR on your credit card. The second rate is for the unfunded/unused portion of the Revolver. This rate is typically very small (25-75 bps) but when you have a $100m Revolver, the interest expense does add up!

Basis Points (BPS) "bips"
A basis point is equal to 1% of 1% as a rate. So, 100 basis points = 1% interest.  It may take awhile to get used to this, but after reading enough documents or talking with enough people about finance, it will become second nature.

A loan's "price" often refers to the interest rate on the loan. This is different from Bonds, since most bonds are quoted on their yield to maturity (a 5% coupon yielding 5% is priced at par, where as a 4% YTM means the bond is above par). Since most loans in corporate finance are floating rate (they have an underlying index such as LIBOR, PRIME or EURIBOR), it is very common to hear of a loan priced as "Libor plus 500".

This is the loan's remaining years until maturity, although it will sometimes be quoted in months. For example, a 5 year loan that was originated in 2008 has a tenor in 2010 of 3.

Loan Seniority List / Hierarchy of Creditors
When you hear about a company going bankrupt / loan pricing, the order of seniority and pricing generally have an inverse relationship (more senior you are, the lower the price). Here is the order of seniority in a firm's capital structure.
Revolver - Secured, little influence on management
Term Loan A - Secured
Term Loan B - Secured
Term Loan C - Secured
Mezzanine Loan - Unsecured
Bond Holders - May be secured, mostly unsecured
Preferred Equity - No security, but have influence on management
Common Equity - No security, but have influence on management

There you go, now when you read a firm's 10-K and you see they have "Senior Secured" notes, you know they most likely have a TLA/B/C.

Monday, October 25, 2010

American Capital NASDAQ: ACAS

American Capital (stock price of 6.57 as of 10/25/2010) will be the first BDC that I am reviewing. They are one of the oldest and largest of the BDCs. Of note, they are also in a form of zombie status due to certain issues that arose during the financial crisis starting in 2008. Most of the material presented below was taken from the company's webpage, SEC filings and news articles found on Google.

Directly lifted from the webpage - American Capital (Nasdaq:ACAS), with $15 billion in capital resources under management, is a publicly traded private equity firm and global asset manager. American Capital, both directly and through its global asset management business, originates, underwrites and manages investments in middle market private equity, leveraged finance, real estate and structured products. American Capital and its affiliates invest from $5 million to $100 million per company in North America and €5 million to €25 million per company in Europe. 

The company is headquartered in Bethesda, Maryland and has offices in Boston, Chicago, Dallas, New York in the US and international offices in Hong Kong, London and Paris. Judging by headcount, it appears the main offices in the US are its headquarters and the Dallas office. The company used to have a Pittsburgh office, but that office appears to have been closed over the summer in 2000. Also, it appears that office in Los Angeles and Philadelphia were also closed sometime within the past two years. It was founded in 1986 and taken public in August 1997. The IPO consisted of 7 million shares, up to 645,161 shares offered to the directors, officers and other employees of the company and up to 364,606 shares issued as warrants to the underwriters. An interesting note is that the company currently has over 340million shares outstanding The managers who took the company public (as per the Form N-2) were David Gladstone, Malon Wilkus and Adam Blumenthal. The company had a very successful run up until the end of 2008 when the company's stock price was crushed due to portfolio markdowns that triggered various credit events. If someone was fortunate enough to get out at that time, they would have recognized a Total Return of about 200%. Just in case you were curious, Total Return is equal to the actual rate of return of an investment over a given period of time including interest, capital gains, dividends and any distributions.

Originally this post was going to discuss the investments, management, loan issues (zombie company) and other major factors, but as I was writing them up, I realized it was a small novel to complete all of that information. So, I will space out the posts and add more meat to each section. The first section I will cover is the ACAS Investment mix and changing strategies. The firm's portfolio has changed quite substantially since the IPO in '97, so there will be some interesting charts.

Wednesday, October 20, 2010

What is a BDC?

If you have stumbled onto this blog via Google or some other link, then most likely you have a basic idea of what a Business Development Company (BDC) is. Just in case you do not, here is a quick overview of a BDC.

A BDC is a closed-end, may or may not be diversified investment management company that has a class of its shares registered under the Securities Exchange Act of 1934. BDCs were established as a part of the Investment Company Act of 1940 Section 54 (page 105 on that link if you are curious).  They were established in part to spur investment in smaller business after the Great Depression that banks were not willing to provide. The main points of the law establish what a BDC may and may not do.

Some key examples - a BDC must maintain an asset coverage ratio of 200%. Most other publicly traded funds (mutual funds) must maintain a coverage ratio of 300%. What is an asset coverage ratio? Typically it is defined as a ratio of debt to total assets. This means if all of the firm's debt/liabilities came due at this exact time, would they be able to cover them? So, if a firm issued $10m in Equity, they could also issue $10m in Debt. This is also referred to as their debt to equity ratio.

Investment Restrictions - A BDC must have at least 70% of its portfolio invested in eligible portfolio companies. What is an eligible portfolio company? One, it must be a company that is organized and has its principal place of business in the USA, sorry foreign issuers. Two, it must be a non-investment company unless it is a SBIC (small business investment company) that is wholly-owned by the BDC. Finally, it must be a company that does not have a class of publicly traded securities. In plainer English, an eligible portfolio company is a small to medium-sized (rarely large) non-public business.

Investment Types - Most likely a BDC will extend some form of debt financing to a portfolio company. This financing comes in all shapes and colors, from a Senior Secured Loan all the way down to Common Equity. If you do not know what those are, Investopedia may be a decent help or you can wait for my next post.

Managerial Assistance - A BDC is expected to offer significant managerial assistance to a portfolio company. The reason for this is because a BDC is there to help a company thrive. The managerial assistance may take the place of balance sheet restructuring, recruiting and hiring a managerial team and exploring mergers and acquisitions (or divestitures) for the company.

Taxation - A major reason for a company to be organized as a BDC is to be classified as a “regulated investment company” (RIC). As a RIC, the company avoids having to pay corporate taxes on capital gains and investment income that is distributed to shareholders.  To be a qualified RIC, the BDC must distribute at least 90% of the above to shareholders in the form of dividends. If at any time a BDC fails to comply as an RIC for the year, they will be subject to corporate taxes as a regular "C corporation" under US Tax Code.

Dividends - Due to the Taxation treatment above, BDCs will tend to pay out most of their Net Investment Income in dividends to shareholders. The reason why NII is used is because it represents the money that a BDC is taking in from interest payments, capital gains or dividends (from a portfolio company). If a BDC overpays their dividend (shortfall - Dividend Amount > NII per Share), that means the company had to either sell assets, issue equity, take on more debt or some combination of the three. Other times a BDC will underpay their dividend. The reasons for underpaying are varied, but include times when a BDC is anticipating a dividend shortfall in the future or making a significant asset purchase.

There you have it, the quick overview of what a BDC company is. In my next posts I will expand on these topics and then begin an analysis of each BDC company. I plan on going in alphabetical order by ticker symbol so anyone hoping for a TCAP review may have to wait awhile.

Saturday, October 9, 2010

Welcome to the BDC Review Blog

Welcome to the BDC Review blog - home to reviews of publicly traded Business Development Companies. This blog will take shape over the next few weeks and months. The main purpose of this blog? To provide more people insight into the BDC world.