To DRIP or Not to DRIP (Seeking Alpha Article)

I just posted a Seeking Alpha article over here that outlines BDCs and whether or not reinvesting your dividends is worthwhile.

The companies to be examined for this article will be American Capital (ACAS), Apollo Investments (AINV), Ares Capital Corp (ARCC), Blackrock Kelso Capital Corp (BKCC), Kohlberg Capital (KCAP), Main Street Capital Corporation (MAIN), PennantPark (PNNT), Prospect Capital (PSEC), Solar Capital (SLRC) and Triangle Capital Corp (TCAP).

A Look at Dividend Coverage

Overview
The Dividend Coverage Ratio is a way to measure how "safe" a dividend is for a firm. For a BDC with a required minimum payout (to avoid taxes), this ratio becomes a little more meaningful. As you can see below, some BDCs will pay out more in dividends than they earned in their current quarter's Net Investment Income.

There are many formulas out there, but this site will use these formulas:

DCR  = Net Investment Income / Current Quarterly Dividend.

DC = Net Investment Income - Current Quarterly Dividend

I am using Net Investment Income because a BDC is required to have at least 70% of their holdings in qualified securities / cash. These investments are the life-blood of a BDC and while many firms generate fee income from structuring deals, these are more volatile. One other note, if a firm pays out dividends on a Monthly basis, I am adding together the past three months of dividends to get the amount. The second formula is useful because it shows you how much room a firm has to pay out its dividend

In the below chart, I have pulled the NII from the BDCR Index and compared that value with their current dividend payouts. In cases where NII is negative, the DCR will also be negative, this allows us to sort the results.


Results

Discussion of Table


As you can see, a large number of the firms are operating at the razor's edge when it comes to their payout ratio. While this is nice for fixed income investors, it may mean that a company is actually paying out their dividends at the expense of the firm. If a company cannot cover the dividend with investment income, it needs to generate the proceeds from another source(s).

• The first source would be from capital gains on the sales of a firm's assets. This dividend is good for a tax-paying investor in the short-term as it will be classified as a return of capital and taxed (in the US) at the long-term capital gains tax-rate (15% for most people, for the IRS view, please click this link). Return of capital dividends do require you to adjust your cost basis for your position though and that may not be desired from a book-keeping standpoint. For a BDC, this type of dividend payment may be bad as the firm has presumably sold off an income generating asset to meet a payout requirement. 
• A second source would be from the company tapping their Revolving Credit Facility (Revolver) to get the cash to payout to their investors. Again this may be a bad sign for the firm as they are increasing their interest expense and leverage without any offsetting gain.
• The final source is when a firm actually goes "Ponzi" and will begin issuing new shares to pay-off old shares. This does not happen on a large scale for long; most firms will cut their dividend or violate a lender covenant if they are in this situation. But, a good example would be AINV for 2008, you can see that their asset values and net investment income were tumbling, but the firm maintained its dividend and partially funded this dividend with proceeds from selling shares. AINV was not the only BDC to do this, but they are an easy target as they are still one of the largest.

A firm that has a DCR over 1 or a DC > 0 is a firm that is currently covering its dividend with its investment proceeds and that may be a sign of a responsible management team. There are some firms that are close to their ideal payout (KCAP for example) that may be correcting their balance sheets, but you should take a look at their dividend and NII history to come to your own conclusions. The best firms in terms of dividend coverage are KFN (which is not a BDC) and MVC. The worst are the firms that have already cancelled their dividend.

TPG Special Situations - New Guy on the Block

On January 14th, TPG Specialty Lending, Inc., the Special Situations division of Private Equity giant TPG Capital filed a 10-12G (Initial Form for General Registration of Securities, aka IPO overview) with the SEC. Judging by available tickers and what other companies have been doing, I assume they are going to go with "TPGM" (TPG Management, there already exists a TPG Capital, the parent) and for the sake of brevity I will refer to them as that for the rest of this post.

Organization
The company will use TSL Advisers (affiliate of TPG Capital) as the investment adviser and enter into an "Administration Agreement" with them. This means TPGM will essentially outsource all functions to them. TSL will provide the new firm with investment professionals, investment decisions, facilities and reporting functions. The new firm will operate very much like other externally managed BDC's such as Ares Capital (ARCC) and Apollo Investment (AINV).

People in Charge
The investment decisions will be led by Co-CIOs Alan Waxman and Joshua Easterly, both former Goldman Sachs employees. Mr. Waxman was the co-founder of the Goldman Sachs Specialty Lending Group (GSSLG) and Mr. Easterly is a former co-head of that group. The statement also stipulates that they have a team of over 20 dedicated professionals. The Board of Directors will be at the time of IPO only 5 people, where at least 3 people cannot be "interested persons" of the Company. The document states that the firm does not intend to ever have any direct employees.

Fees
This is where the filing gets interesting. An externally managed BDC is usually setup by the external manager as a way of increasing fee income. In a way, it is a publicly-traded CLO where the equity can be held by anyone. The manager collects a management fee + a performance fee. TPG Capital will collect a 1.5% management fee of the Company's average total gross assets of of the end of the quarter. Until the IPO, TPGC will not collect a fee and for the first two quarters the fee will be based on the quarter-end gross assets.
The performance fee will have two components. It is best to copy/paste directly from the filing on this one. "(i) Following an IPO, the first component of the Incentive Fee will equal 100% of the excess (if any) of pre-Incentive Fee net investment income over a 1.5% quarterly (6% annualized) hurdle rate, until the Adviser has received 17.5% of total net investment income for that quarter, and 17.5% of all remaining pre-Incentive Fee net investment income for that quarter. No Incentive Fee will be payable under this component for any quarter in which pre-Incentive Fee net investment income does not exceed the hurdle rate for that quarter. Prior to an IPO, the first component of the Incentive Fee payable by the Company will be subject to a reduced rate.

     “Pre-Incentive Fee net investment income” means dividends (whether or not reinvested), interest and fee income less operating expenses, calculated on an accrual basis.

     (ii) Following an IPO, the second component, payable at the end of each fiscal year in arrears, will equal a percentage, which we refer to as the “Weighted Percentage,” of the cumulative capital gains from the inception of the Company to the end of such fiscal year, minus the aggregate amount of any previously paid capital gain Incentive Fees for prior periods; but in no event will be less than zero. The Weighted Percentage will be calculated at the end of each fiscal year of the Company that occurs following an IPO and is intended to ensure that the portion of the Company’s capital gains that accrued following an IPO will be subject to an incentive fee rate of 17.5% and the portion of the Company’s capital gains that accrued prior to an IPO will be subject to a reduced rate. The Weighted Percentage will be calculated in the manner set forth in the Advisory Agreement, the form of which is filed as Exhibit 10.1 of this Registration Statement. Prior to an IPO, the second component of the Incentive Fee payable by the Company will be subject to a reduced rate.

“Cumulative capital gains” means, on any relevant date, cumulative realized capital gains, less the sum of (a) realized capital losses and (b) unrealized capital depreciation on investments, in each case as of such date. "

In normal person terms - this means they will collect 1.5/17.5 (kind of like a hedge fund 2/20 standard), with a quarterly high water mark of 1.5% on the NII + they get a kicker at the end of the year based on Capital Gains.

Portfolio Composition

Like most of the other BDC companies, TPGM will focus on senior secured loans, first and second lien, some unitranche loans (this post does a nice job of explaining), some mezzanine loans, structured equity and even straight equity/warrants.  Most of the equity instruments will be hand in hand with another more senior investment.

Private Offering
Prior to the IPO, the company will have private offering with a number of investors that provided seed capital. The company will structure the private offering like a Private Equity fund where investors will make an initial capital commitment and drawdowns (capital calls) will take place. These initial shareholders will not be able to sell their stock until the restrictions are lifted. The release condition would be for TPGM to have an IPO that results in the Company having a common stock float of at least $75 million or for the fourth anniversary of the private closing to have passed. TPGM has also reserved the right to offer a board seat to a member of the initial private subscription group.

Stated Risks
This could easily be another post, but I will list the main bullet points here

• We are a newly-formed company with no operating history
• We will be dependent on upon management personnel of the Advisor for our future success
• The Adviser and its management have no prior experience managing a BDC
• Regulations governing our operation as a BDC affect our ability to, and the way in which we, raise additional capital.
• We may borrow money, which may magnify the potential for gain or loss and may increase the risk of investing in us.
• We will operate in a highly competitive market for investment opportunities
• Even in the event the value of your investment declines, the Management Fee and, in certain circumstances, the Incentive Fee will still be payable (No matter what, TPG will get paid)
• We will be subject to corporate-level income tax if we are unable to qualify as a RIC under Subchapter M of the Code.
• There is a risk that you may not receive dividends or that our dividends may not grow over time. 
• You may be subject to filing requirements under the 1934 Act as a result of your investment in the Company.
• You may be subject to the short-swing profits rules under the 1934 Act as a result of your investment in the Company.
• Potential conflicts of interest could impact our investment returns.
• Our Board may change our investment objective, operating policies and strategies without prior notice or stockholder approval.
• Changes in laws or regulations governing our operations may adversely affect our business.
• The Adviser can resign on 60 days' notice. We may not be able to find a suitable replacement within that time, resulting in a disruption in our operations that could adversely affect our financial condition, business and results of operations. 
• To the extent that we do not realize income or choose not to retain after-tax realized capital gains, we will have a greater need for additional capital to fund our investments and operating expenses.

So there you have it. I encourage anyone who would like to know more about a BDC to read as many 10-12G filings as possible as this provides you with a great look into how the firm was organized (most of these filings have some copy/paste to them) and it provides a number of definitions in it.