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.

Net Investment Income Addendum

Someone pointed out to me that I failed to mention what the below line represents:

Interest income from cash and cash equivalent investments

 

This line item for most companies will include true Cash that is sitting in an account and assets that are readily convertible into cash. This second category is more fluid than Cash. For most firms, CE will be money market holdings, short-term government bonds (DEVELOPED countries), US Treasury Bills and Notes, highly liquid securities and commercial paper with Investment Grade Ratings. For example, MSFT commercial paper may be considered Cash Equivalent while Lehman CP would not. Some firms like to get more exotic in their cash equivalent definition by including duration (bonds), time to maturity, if the issuer of the debt (bond/loan) is a GSE and the list goes on and on.

Thank you for reading and welcome to all new readers!

Net Investment Income Overview

Net Investment Income (NII) is one of the most important factors when evaluating a BDC. NII as a definition is a measure of the income received from investment assets (bonds, stocks, funds, loans and other investments) minus equivalent investment expenses. For a BDC, this number measures how well their investments are performing. As a simple way of breaking this information down, I am pulling in the balance sheet from TCAP's Q3 earnings release to illustrate.

Investment income:
Loan interest, fee and dividend income:
Non—Control / Non—Affiliate investments	6,654,541
Affiliate investments	1,044,088
Control investments	333,993
Total loan interest, fee and dividend income	8,032,622
Payment—in—kind interest income:
Non—Control / Non—Affiliate investments	1,338,018
Affiliate investments	231,525
Control investments	117,419
Total payment—in—kind interest income	1,686,962
Interest income from cash and cash equivalent investments	67,501
Total investment income	9,787,085
Expenses:
Interest expense	1,864,442
Amortization of deferred financing fees	469,394
General and administrative expenses	1,840,794
Total expenses	4,174,630
Net investment income	5,612,455

Basic line by line breakdown:

Non-Control / Non-Affiliate Investments - These represent the bread and butter investments of a BDC - extending capital (most of the time in the form of term loans) to firms to collect interest. You would expect the majority of a firm's NII to come from this line.

Affiliate Investments - This means that TCAP has some type of influence or relation to these companies. Such situations could be: a person in TCAP sits on the board of the company (or if an officer), holds either directly or indirectly 5% or more of the outstanding voting securities or if the affiliated company is an investment company, TCAP has seeded the company.

Control Investments - Will let the 1940 take it from here - "Control" means the power to exercise a controlling influence over the management or policies of a company, unless such power is solely the result of an official position with such company. From what I have seen, a BDC likes to avoid controlling a firm as that is not the specialty of the BDC. Also, it tends to take considerable personnel power to both manage another company as well as your entire portfolio.

Payment in Kind Interest Income - Quick sub-note on this. http://en.wikipedia.org/wiki/PIK_loan

Interest Expense - This is the expense that the company pays on the leverage it issues (loans/bonds) to make investments. A BDC will take out a Loan (most likely a Revolver) because they make money off of the spread. If a BDC pays interest at LIBOR+200 and can lend that money out at LIBOR+500, it is doing OK. This is the same principal on how a traditional bank makes money. Take in deposits and pay a certain rate and lend money out at a higher rate. Remember, a BDC must be in compliance with a max 1:2 Leverage to Assets ratio (200% test).

Amortization of deferred financing fees - These are the costs incurred with issuing debt such as commissions paid to investment banks, auditors, lawyers, etc. These fees are amortized because of accounting reasons which you can easily lookup online.

General and administrative expenses - The incredible catch all which includes costs of doing business. For example, if a business professional is evaluating a potential portfolio company, they can expense (within limits) travel costs and acquisition costs.

What does this all mean?

Well, from looking at those lines, we see that TCAP has a positive NII and if you divide that by the number of outstanding shares, you get to a NII of 0.46 per share. This is important because that means TCAP is currently covering their dividend of 41 cents (now 42 cents) with their NII. This is important when you look at a BDC. There are a number of BDCs that currently have a dividend shortfall (future post). If a BDC is not covering their dividend with NII, then you have a problem with a BDC selling assets to make payments or even going Ponzi by paying out dividends from equity and leverage raises.