Triangle Capital: Credit Issues

First in a series reviewing key issues in Triangle Capital's recently published annual filing. We begin with an analysis of the BDC's credit performance in recent years and delve into the current portfolio for clues about likely performance in the year ahead.

The post Triangle Capital: Credit Issues appeared first on BDC Reporter .

BACKGROUND: The BDC Reporter reviewed the Triangle Capital 10-K for the year and quarter ended December 31, 2016, as well as the transcript of the ensuing Conference Call. There are several issues worth reviewing, which we’re going to do over a series of articles. Starting out, we’ll be reviewing how the BDC’s credit performance stacks up, an issue that has been central for the past two years.

PARADISE LOST

From its inception as a public company in 2007 until 2014, Triangle Capital’s credit underwriting track record (including both loans and equity investments made) was superlative, even though the mid-market oriented BDC was principally a higher risk-higher return subordinated debt lender. At the end of 2013, with total assets at two-thirds of a billion dollars, the balance sheet had accumulated aggregate Realized and Unrealized Gains of $24mn.

However, in 2014 the Company began to recognize a series of credit issues in its portfolio,even while continuing to book Realized Gains on certain equity investments. In 2014, net Losses were ($30mn). In 2015, net Losses were ($22mn). In 2016 the streak continued with net Losses of ($24mn). That’s ($76mn) of losses in the last 3 years. Within those losses are ($45mn) of net Realized Losses, notwithstanding several successful offsetting equity exits.

NOT SO BAD ?

Management addressed the issue- amongst others-on the latest Conference Call, pointing out that over its 10 year history losses and gains fluctuate.

Realized gains and losses generated by any investment portfolio will fluctuate during calendar years, with some years resulting in a net loss and some years resulting in a net gain. We are certainly pleased that our realized gains have outpaced our realized losses by approximately $20 million in the 10 years since our IPO. And we continue to believe that our investment strategy of having equity upside and a high percentage of our portfolio companies will help protect shareholder capital over the longer term.

Later on the CEO added:

On an annual basis we have generated net realized gains during seven years and net realized losses during three years. During our first 40 quarters we have afforded non-accrual assets on a cost basis that were below 5% of our investment portfolios cost basis, 75% of the time. And which were above 5% of our investment portfolios cost basis 25% of the time.

ABOVE AVERAGE

Nonetheless, the 10-K suggests that despite many write-offs and write downs, the 88 company portfolio has an above average level of trouble spots, and is growing rather than shrinking, when measured at cost:

As of December 31, 2016 , the fair value of our non-accrual assets was $15.9 million , which comprised 1.5% of the total fair value of our portfolio, and the cost of our non-accrual assets was $38.4 million , which comprised 3.5% of the total cost of our portfolio. As of December 31, 2015 , the fair value of our non-accrual assets was $6.9 million , which comprised 0.7% of the total fair value of our portfolio, and the cost of our non-accrual assets was $20.4 million , which comprised 2.0% of the total cost of our portfolio.

In addition to our non-accrual assets, as of December 31, 2016 , we had a debt investment in one portfolio company (our subordinated note to Community Intervention Services, Inc. (7% Cash, 6% PIK)) that was on non-accrual only with respect to the PIK interest component of the loan. As of December 31, 2016 , the fair value of this PIK non-accrual asset was approximately $14.1 million , or 1.4% of the total fair value of our portfolio, and the cost of this PIK non-accrual asset was approximately $17.7 million , or 1.6% of the total cost of our portfolio.

In addition, as of December 31, 2016 , we had, on a fair value basis, approximately $131.8 million of debt investments, or 12.7% of the total fair value of our portfolio, which were current with respect to scheduled interest and principal payments, but which were carried at less than cost. In light of current economic conditions, certain of our portfolio companies may be unable to service our debt investments on a timely basis. These conditions may also decrease the value of collateral securing some of our debt investments, as well as the value of our equity investments. As a result, the number of non-performing assets in our portfolio may increase, and the overall value of our portfolio may decrease, which could lead to financial losses in our portfolio and a decrease in our investment income, net investment income, dividends and assets.

Page 48. Risks Disclosure.

MISERY MATH

Added together at fair market value these under-performing assets account for 16% of TCAP’s total portfolio. The Company did not offer up the cost basis for the debt investments that are not on non-accrual but are under-performing. However, when the BDC Reporter added up the cost of the non-accruing loans, made some conservative assumptions about the cost of the debt under-performers and threw in the cost of poorly performing equity investments (TCAP has a few of those as well) we came to the conclusion that at least a fifth of the $1.1bn portfolio is not performing to expectations.

Moreover, as long as we’re throwing out numbers, 6 loans out of 63 borrowers (there are 25 equity only investments in TCAP’s 88 portfolio companies) are on non-accrual, which is a significant percentage of the total. Here is the list and the status of each from the 10-K:

NAMING NAMES

Our non-accrual assets as of December 31, 2016 were as follows:

DCWV Acquisition Corporation

In September 2015, we placed our debt investments in DCWV Acquisition Corporation, or DCWV, on non-accrual status effective with the monthly payment due September 30, 2015. As a result, under U.S. GAAP, we no longer recognize interest income on our debt investments in DCWV for financial reporting purposes. In the year ended December 31, 2016 , we recognized unrealized depreciation on our debt investments in DCWV of $1.7 million . As of December 31, 2016 , the cost of our debt investments in DCWV was $8.4 million and the fair value of such investments was $1.6 million .

DPII Holdings, LLC

During the three months ended March 31, 2016, we placed our Tranche I & II subordinated debt investments in DPII Holdings, LLC, or Datapath, on PIK non-accrual status. During the three months ended June 30, 2016, we invested approximately $1.6 million in a Tranche III subordinated debt investment in order to provide liquidity to support Datapath. This Tranche III subordinated debt investment bears interest at a rate of 0% Cash and 19% PIK. In the three months ended June 30, 2016, we placed both our Tranche I & II subordinated debt investments and our Tranche III subordinated debt investment in Datapath on full non-accrual status. As a result, under U.S. GAAP, we no longer recognize interest income on our debt investments in Datapath for financial reporting purposes. In the three months ended December 31, 2016, we invested an additional $0.6 million in the Tranche III subordinated debt. In the year ended December 31, 2016 , we recognized unrealized depreciation on our debt investments in Datapath of $3.0 million . As of December 31, 2016 , the cost of our debt investments in Datapath was $5.4 million and the fair value of such investments was $2.4 million .

Gerli and Company

In November 2008, we placed our debt investments in Gerli and Company, or Gerli, on non-accrual status. As a result, under U.S. GAAP, we no longer recognize interest income on our debt investments in Gerli for financial reporting purposes. In the year ended December 31, 2016 , we recognized total unrealized depreciation on our debt investments in Gerli of $0.8 million . As of December 31, 2016 , the cost of our debt investments in Gerli was $3.4 million and the fair value was zero.

PowerDirect Marketing, LLC

In August 2014, we placed our debt investment in PowerDirect Marketing, LLC, or PowerDirect, on non-accrual status effective with the monthly payment due July 31, 2014. As a result, under U.S. GAAP, we no longer recognize interest income on our debt investment in PowerDirect for financial reporting purposes. During the year ended December 31, 2016 , we recorded unrealized depreciation of $0.3 million on our debt investment in PowerDirect. As of December 31, 2016 , the cost of our debt investment in PowerDirect was $5.1 million and the fair value of such investment was $0.9 million .

Women’s Marketing, Inc.

During the three months ended September 30, 2016, we placed our debt investment in Women’s Marketing, Inc., or Women’s Marketing, on PIK non-accrual status. In December 2016, we placed our debt investment in Women’s Marketing on non-accrual status effective with the monthly payment due November 30, 2016. As a result, under U.S. GAAP, we no longer recognize interest income on our debt investment in Women’s Marketing for financial reporting purposes. During the year ended December 31, 2016 , we recorded unrealized depreciation of $5.0 million on our debt investment in Women’s Marketing. As of December 31, 2016 , the cost of our debt investment in Women’s Market was $16.1 million and the fair value of such investment was $11.1 million .

PIK Non-Accrual Assets

In addition to our non-accrual assets, as of December 31, 2016 , we had a debt investment in one portfolio company (our subordinated note to Community Intervention Services, Inc. (7% Cash, 6% PIK)) that was on non-accrual only with respect to the PIK interest component of the loan. As of December 31, 2016 , the fair value of this debt investment was $14.1 million , or 1.4% of the total fair value of our portfolio and the cost of this debt investment was $17.7 million , or 1.6% of the total cost of our portfolio.

CONFIRMATION

The BDC Credit Reporter’s keeps its own Watch List. Our first cut look confirms that a good portion of TCAP’s investments are under-performing. From our perspective 23 of the 88 companies in the BDC’s portfolio are under-performing, based on valuations and other information at hand.

]Please note: Unlike TCAP-and most BDCs-our Watch List counts all exposure to any under-performing company, rather than just the facilities that have been marked down from par.

After all, from our perspective, where there’s smoke there’s likely to be fire and the damage may not limit itself to just some of the exposure over time].

With that clarification, the fair market value of the BDC Reporter’s Watch List totals nearly $180mn, or 17% the total portfolio, at fair market value.

UNEQUAL

Of course, not all under-performers are equally worrisome either to the BDC or its investors.

Some portfolio company investments are small in size, and whatever happens to them in the future will be Non Material to the BDC involved.

Others, such as many Non Accrual investments, have already been sharply written down.

Further step downs in credit quality may have little impact on Net Asset Value or on investment income.

The BDC Credit Reporter undertakes a sort of triage for every BDC portfolio looking for the Watch List companies that could-theoretically-cause more damage to earnings and book value down the road.

Moreover, not to get unnecessarily panicky about a Watch List company that may be having a bad quarter or two but will revert to “Performing” status, we differentiate between credits that appear to be in serious trouble (but are not yet on non-accrual) and those which are still more likely than not to recover.

BACK TO TRIANGLE

We don’t have a perfect picture as we’re still getting all the details we can about all of TCAP’s Watch List companies.

However, an initial snapshot for the IVQ 2016 (which we compared against a similar review last quarter) is not encouraging.

Outside of the 6 already identified non accruing loans and 6 other companies whose exposure is Non Material there remain 11 Watch List companies to whom TCAP has significant exposure.

All include material debt exposure and aggregate $140mn at current FMV.

If some of these 11 borrowers should fail to stay current on their obligations, TCAP’s list of non accruals could get longer and the 3 year trend of net Losses could continue in 2017.

RESCUE ME

Of late, the BDC has been successful-on an episodic basis-in selling off some equity stakes for bountiful gains and reducing the impact on NAV and on income from Realized Losses and Non Accruals.

Unfortunately, there are only so many “winners” in any portfolio and the best, most valuable investments are often those sold earliest by the equity sponsors that TCAP finances.

The BDC Reporter’s review of the 88 company portfolio identified only 3 significant potential equity upsides with an aggregate value of about $30mn.

Still, pro forma proceeds therefrom may (or may not) offset pro-forma losses from the 11 material Watch List names discussed above.

TCAP’s management makes the case that over time credit gains from equity investments will even out credit (and equity investment) losses in the portfolio.
We are not yet convinced and remain concerned that the deterioration in net Losses and the number of under-performing companies (using our measuring stick or theirs) may be a secular change in TCAP’s performance.
That may result in more non-accrual loans and a material drop in investment income, earnings per share and Net Assets.
Tracking credit performance in the next few quarters-always important-will be more important than ever.

COMING UP NEXT

The BDC Reporter will take a look at the long term changes in Triangle Capital’s revenue and expense trends and what that mean for the sustainability of the current $1.80 annual distribution.

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