KCAP Financial: A Year Later

INTRODUCTION

In preparation for writing this article about KCAP Financial (KCAP) , we re-read the BDC Reporter’s own prior postings about the Company. We’ve been writing episodically about KCAP for near on 10 years, with a Seeking Alpha article dating back as early as November 2007 . However, our homework focused more on a major piece written back on December 1st, 2015 for Seeking Alpha, which was published in their Pro section (and, as a result, the link may not provide the full text for readers) and several posts published in the BDC Reporter during 2015-2016.

Given the volume of analysis in the BDC space we undertake and the too many hours spent writing down our analysis, we don’t always remember our own thinking process until jogged by a re-read ! That’s one of the reasons we began putting digital pen to digital paper a decade ago: to keep track of our own evolving views. With the benefit of hindsight that review process sometimes can provide shocking evidence that we were on the wrong track and drew flawed conclusions. If hindsight is 20/20, we cannot claim to have had perfect vision of what the future held in many cases. We’re happy to point out where we were wrong as the occasion requires because there’s so much to be learned from that looking back process.

However, in the more recent case of KCAP, where we are just looking back a year or so most everything that we expected to happen has done so. There is one major exception-which we’ll get to in a little while. Let’s begin with where we were spot on, or very close to:

1. IGNORE THE ACTIVIST: Back on November 15, 2016 the BDC Reporter reviewed the attempt by a major KCAP shareholder (or “activist”) to encourage the Board and management to reverse the decline in the BDC’s fortunes by selling itself to another BDC, or disposing of a portion of its assets, or -at least-buy back stock in a major way. We won’t review all the details here. That’s what links are for. However, we did conclude that we had “no illusion” KCAP would listen to its self appointed activist.

Now nearly a year and a half after the activist began buying into the stock in a big way (all the way back in August 2015) nothing has happened. The BDC just ignored the activist’s critique and entreaties to make “shareholder friendly” changes.

2. CONTINUED INVESTMENT STRATEGY: The BDC Reporter’s view back in December 2015 was that one of the key weaknesses of KCAP’s business model was their insistence on investing directly and indirectly in CLOs. First, there is the substantial amount of capital tied up in CLO equity and debt tranches. Then there’s the BDC’s ownership in an investment management subsidiary whose sole business is sponsoring CLOs, and which requires KCAP investing in the most junior tranches to float new issues. We felt then that continuing with this CLO-centric business model-which has the benefit of generating very high investment income in the short run to pay distributions-is dooming the BDC to eventual failure. Here is our critique in a nutshell:

“In our view, the KCAP business model is flawed for a BDC format. Unfortunately, CLO equity investments and asset management assets tied to those very same investments do not create a “sustainable” financial model”.

We added the following:

“ Regardless of market prices, KCAP’s book of CLO investments is likely to reduce in aggregate value over the next several quarters. First, there are CLOs which liquidate (2 did last quarter much to the consternation of KCAP’s managers, and there are nearly a billion dollars worth of older vintage vehicles that could follow in those footsteps). Second, as CLOs reach ever closer to their maturity dates, their fair market value drops, everything else being equal. That’s because the value of the CLO is based on the discounting of future cash flows.

The Company values its CLO investments at $63mn at 9-30-2015. We could readily envisage that number dropping by $15-$30mn over the next three years. (We are talking in generalities like this because KCAP does not provide much in the way of guidance about such things).”

One year later-and despite a bounce back in loan and CLO values during a turbulent year for such things-KCAP’s CLO value has dropped to $45mn, or an $18mn drop.

Likewise-as we anticipated-the value of KCAP’s Asset Manager affiliate (Trimaran Advisors) has come down. A year ago, the value was $64mn.

This is what we projected last year : “Going forward, we assume a drop of value from today’s level of another third over three years, or $21mn”.

In fact, and to underscore that we are far from infallible, the value of the asset manager was $43mn at IIIQ 2016. In other words, that drop in value we expected to take 3 years has occurred in just 1.

STAYING THE COURSE

Of course, KCAP’s Board and management do not share our view that the CLO-centered strategy (which accounted for over 40% of investment income in the latest quarter). In 2016, they continued with their prior approach.

Because of a shortage of liquidity no CLO investments were added in the period. Moreover, a new Trimaran CLO was delayed by many months as market conditions were unfavorable. However just a few days ago, the subsidiary launched a new CLO , which KCAP had been funding the warehouse of to the tune of a $23mn advance. That loan will get repaid but KCAP has invested $11mn in the junior tranche.

UNCONVINCED

From our perspective the “getting away” of the new CLO only underscores that management is headed in the wrong direction, even if management fees and the value of the Investment Manager might temporarily increase. Over time, the economics of CLO investing will continue the secular trend of lower values and reduction in KCAP’s NAV.

3.PAYING DOWN DEBT . Towards the end of 2015, KCAP’s asset coverage ratio was reaching regulatory limits. Our not unreasonable guess was that the Company would avoid buying back stock and choose to pay down debt instead.

In brief, that’s just what has happened. The BDC’s entire Convertible Debt was paid off, and a portion of its Unsecured Notes were repaid in the past year: $19mn and $7mn respectively.

That was achieved by selling off $23mn of loan assets (at cost) from its investment portfolio and an equity investment. A year ago total loan assets at cost were $322mn but have dropped to $275mn, as KCAP has been gradually liquidating its loan portfolio. Some of the proceeds were earmarked as of September 2016 for the new CLO tranche (and have since been used for that purpose).

ASSET COVERAGE

The result is that on balance sheet asset coverage of the remaining debt still looks a little sparse. Between the $142mn in secured borrowings and the remaining $33mn in Unsecured Notes KCAP has $175mn in borrowings. At fair value, between debt and equity investments (excluding the CLO investments and the Investment Manager affiliate and deducting out the $11mn just committed) has $283mn in assets and cash. That’s asset coverage of 161%.

Investors in KCAP’s Unsecured Notes with the ticker KAP do not seem concerned, which makes sense. The ever smaller investment portfolio is performing pretty well from a credit standpoint. There is only one loan on non-accrual. We cast a wider net and count 7 loans on Watch List with a FMV of $16mn. However, even if you deduct out all the questionable loans, there is enough asset coverage to satisfy Note holders in the short term.

Looking ahead, though, with the continued need for capital to fund new CLOs, and regulatory asset coverage at 207% leaving no room for additional borrowing, chances are the gradual liquidation of the loan portfolio will continue. With $200mn of the loans and cash pledged to the senior debt, what KCAP can sell off is $83mn at most. Note Holders might begin to worry over time (and before the maturity in 2019) if their asset coverage erodes as assets are sold off and diverted into CLO investments.

AS EXPECTED

To sum up KCAP has performed pretty much as we expected in 2016. If anything, the reduction in the value of the CLO portfolio and the Investment Manager has been greater than we expected. We projected the distribution would be cut, and were not surprised by the reduction to $0.12 a quarter a few days ago. Realistically we expected management to avoid any change to the status quo as they are well compensated. In fact, we note that compensation expenses have only increased in 2016 versus 2015. Annualising the last quarter’s compensation suggests that expense is up by 20% over 2015. (Using the 9 months data the increase is more modest). However, given that assets, equity and earnings are all dropping the fact that compensation costs are up is eating into shareholder returns. A year ago 55% of all investment income went to shareholders. That’s now down to 50%, and we expect will drop more as income from the loan portfolio drops.

SURPRISE

Where we have been surprised is how the market has reacted over the past year. Please see the chart from December 1, 2015 to December 27 2016. When we wrote on December 1 , 2015 the stock price was at $4.62. For a while there was a sharp decline-which seemed appropriate given all what had come before and the deteriorating metrics. At February 12, 2016, the stock bottomed at $2.65.

That part we felt we had anticipated. Since then, though, KCAP’s stock price has greatly recovered. In early October, KCAP was at a YTD high of $4.80, and is still at $4.02 as of the close on December 27, 2016. That’s still 51% above the lowest low.

Of course, the BDC sector has been in rebound since February 2016 and this may be a matter of a rising tide lifting all boats.KCAP trades at 8.4x IIIQ 2016 Net Investment Income and distribution. Or, put another way, the yield is closing in on 12%. That may be enough to attract investors.

HUMBUG

For our part,though, we don’t see any change in the fundamental flaw in the business, where 30% (!) returns on CLO investments are offset by a continuous drop in the value of these time-limited investments, resulting in continuous pressure on the BDC’s NAV. We don’t see how such a trade-off can successfully exist in a BDC wrapper over the long term.

BDC REPORTER GETS OUT ITS CRYSTAL BALL-AGAIN

Looking forward, the BDC Reporter projects that this will result in lower NAV, lower earnings and a declining asset base as non-CLO assets are sold off to invest in CLO investments. Rightly or wrongly (time will tell) we don’t see how KCAP can maintain even its $0.12 a quarter distribution for more than a few quarters. NAV, too, will head downward. We’ll stick our necks out and project-based on what we’ve experienced in the last few years with this strange hybrid business strategy-that 3 years from now KCAP’s recurring earnings could be as much as a quarter lower. That’s earnings per share/dividend at $0.36 and NAV at $4.0. If the same multiple of earnings applies as today that would take the stock price to $3.0. Yes, there would be a distribution collected over that time frame (we calculate $1.26), but the Total Return would be 2% a year.

DIFFERENT STROKES

There’s no doubt that investors with a more speculative mind set can (and have) do remarkably well if they can time entry and exit into what has become a highly volatile BDC. If you’d bought on February 26 2016 and sold at the October 5, 2016 high, your return in price terms alone would have been 78% ! On the other hand, if you’d bought at that October high, a month later KCAP was down 24% as profit takers do what they do. Or, if you had a long term approach and bought in mid 2013 when all seemed well with the Company, but gave up at the February 2016 nadir, your price loss would have been 74%, only very partially offset by the distributions received in that less than 3 year period. Anybody invested or buying into KCAP today looking for a decent return will also have to accept that a 30%-75% loss is potentially possible. That’s not for us, as we’re more interested in situations where risk and reward are in a narrower range. We have no position in the common stock and have avoided even the Notes out of an abundance of caution.

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