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BlackRock Capital And The Problem With BDC Revolvers

Posted by Nicholas Marshi, BDC Reporter on Jun 8, 2017 12:46:31 PM

On June 5, 2017 BlackRock Capital Investment (BKCC) filed an 8-K regarding an amendment to the BDC's principal financing arrangement - to which all non-SBIC pledged assets are secured : the Second Amended and Restated Senior Secured Revolving Credit Facility, or Revolver for short. The BDC Reporter reviewed the routine change made to the Revolver, which is discussed below. However, we also used the opportunity to scan through some of the critical terms of BKCC's loan agreement. The goal was to determine what institutional lenders to a BDC like BKCC are looking out for and seeking to protect themselves against, which can be instructive for the shareholders of this or any other BDC:

The only material amendment - and a positive for BKCC and its shareholders given that the BDC has not performed well in recent years - is that the lending group agreed to extend the maturity of the Revolver by an above average period. The existing maturity was February 19, 2021 and was extended to June 5, 2022.

LONG TERM PLANNING

Generally speaking, the BDC Reporter - whose background includes stints as institutional borrower and lender - knows that locking up renewed commitments from lenders well in advance is good liability risk management.  If we were in a financial crisis right now and the Revolver was coming up for renewal there would be a substantial possibility there would be many lender defections and the prospect that the Revolver would not be renewed. BKCC - run by an investment Advisor from one of the world's largest asset managers - are planning ahead and ensuring financing certainty while the sun is shining.

REST OF THE AGREEMENT

The BDC Reporter refreshed its familiarity with the Revolver - which we'd first read ages ago - with a view to remembering how the lending group approaches portfolio valuation issues, which can be instructive for shareholders as well.

CONSTANT SNAPSHOTS

The key concept that runs through the Loan Agreement is that the lenders want to ensure the portfolio investments are constantly re-valued to reflect  their "real" value, and are not satisfied with a valuation based on the original funds advanced at cost.

This might seem innocuous enough but can have very dangerous consequences for the BDC borrower, as we shall see.

The Loan Agreement requires BKCC to engage a third party appraiser and value no less than 90% of all portfolio investments every quarter.

That's only the beginning.

If the investment is publicly quoted (which draws a higher advance rate from the lender as we shall see), the instrument is re-valued once a month.

Under certain circumstances the frequency can be upped to once a week ! See page 90.

REVIEW AND REVIEW AGAIN

The Loan Agreement further requires BKCC to undertake no less than 40 internal reviews/ re-appraisals of all its investments through the year.

The objective is to ensure that any changes that may have occurred to the credit quality of the investments get reflected in their valuation, providing the lenders with a clear perspective on true value, and replacing whatever stale number had been used previously. Here's a brief illustrative extract:

Such internal reviews shall take into account any material events of which the Borrower has knowledge that affect the value of the Portfolio Investments. If the value of any Portfolio Investment as most recently determined by the Borrower pursuant to this Section 5.12(b)(ii)(C) is lower than the value of such Portfolio Investment as most recently determined pursuant to Section 5.12(b)(ii)(A) or (B), such lower value shall be deemed to be the “Value” of such Portfolio Investment for purposes hereof.

If BKCC fails to properly value any portfolio investment, the value from the lenders perspective is zero.

SPOT CHECK

Even then, the lenders are not fully at ease and have an additional requirement requiring an independent appraising firm hired by them to test the value of certain portfolio assets on a quarterly basis.

If there is a discrepancy between the BDC's value on an investment and the lenders value - as determined by this third party valuation firm - the Revolver has a complex methodology for ascribing what dollar value to ascribe.

Even that is not sufficient protection to the lenders who also reserve the right - at any time and with no limit - to require their independent valuation firm conduct reviews of any portfolio investment.

(You can understand why so many BDCs have turned to Baby Bonds and their almost covenant-free terms as a primary source of funding).

TOTTING UP

Unfortunately for shareholders in BKCC, according to the terms of the Revolver the lenders may come up with substantially different valuations for portfolio investments than those carried on the books of the BDC but BKCC has no obligation to use the banks numbers.

Effectively that means there could be two sets of valuations going on: what you see on the balance sheet every quarter and those that the lenders are using as their starting point for deciding advances.

The unfortunate aspect for BKCC shareholders is that what those discrepancies might be - and which could affect the BDC's liquidity in a crisis - are not made publicly available at any time.

As a result - during the once-in-a-decade periods when credit markets go into panic mode, BKCC shareholders will have no idea what valuation is being placed on the assets being funded by the BDC's lenders.

Thankfully we are about as far away from that type of crisis as possible at the present.

EVERY INVESTMENT IS DIFFERENT

Also instructive for BKCC shareholders are the different advance rates that lenders make available to portfolio investments, which reflect the lenders perception of risk.

All portfolio assets are broken down into two main categories: Quoted and Unquoted. (Of course most BDCs have the greater proportion of their portfolio in the latter category).

Then there are a multitude of sub-classifications as this chart below - taken from page 94 of the Loan Agreement - illustrates. Readers should note how lenders are warier (i.e. advance less) on portfolio investments that involve Pay In Kind interest payments.

 

Portfolio Investment

   Quoted     Unquoted  

 

Cash, Cash Equivalents and Short-Term U.S. Government Securities

     100     n.a.  

 

Long-Term U.S. Government Securities

     95     n.a.  

 

Performing First Lien Bank Loans

     85     75

 

Performing Second Lien Bank Loans

     75     65

 

Performing Cash Pay High Yield Securities

     70     60

 

Performing Cash Pay Mezzanine Investments

     65     55

 

Performing Non-Cash Pay High Yield Securities

     60     50

 

Performing Non-Cash Pay Mezzanine Investments

     55     45

 

Non-Performing First Lien Bank Loans

     45     45

 

Non-Performing Second Lien Bank Loans

     40     30

 

Non-Performing High Yield Securities

     30     30
 

Non-Performing Mezzanine Investments

     30     25

 

Performing Common Equity

     30     20

 

Non-Performing Common Equity

     0     0

 

Structured Finance Obligations and Finance Leases

     0     0

 

Unsecured Bank Loans

     0     0

Generally speaking, the advance rates offered by this banking group are generous. Other facilities will not allow any advance against non-performing loans or even "performing common equity".

THE SOLUTION CAUSES THE PROBLEM

However, the problem with these myriad categories, each with their specific advance rate and lenders who want to keep constantly up-to-date on the "real" value of the portfolio (more illusion than anything else during a crisis, all the above notwithstanding) is that the BDC's availability can change drastically in a very short period of time, as many BDCs experienced during the Great Recession.  Thanks to the lenders drive to have as "true" a reading as possible, BKCC's portfolio is essentially being constantly "marked to market".  When the value of portfolio assets are dropping 10%, 20% or even 30% that can be a very dangerous falling knife.

Every day portfolio loans are getting added, or repaid or shifting from one category to another as they move to PIK or non-performing. As a result, a BDC's gross availability is constantly shifting, and nobody -and that includes both the BDC managers and the lenders - knows what the availability under the Revolver will be from day to day, week to week.

HUNKERING DOWN

As we saw during the Great Recession when in doubt the BDC managers understandably seek to build a wide cushion of availability, just when that is hardest to do, to ensure their liquidity. In one of those ironies which lending is famous for, that tends to create its own liquidity crisis as BDCs pull back from new lending and encourage borrowers to repay them and sell whatever investments they can, just when borrower need is greatest.

YOU MUST REMEMBER THIS

What BDC shareholders should keep in mind is that any BDC which leans heavily on its Revolver for financing itself is at great risk if the facility has been pushed close to its limits before whatever crisis comes along because availability can melt away faster than the debt can be reduced in an orderly fashion.

We recognize that most investors prefer to look at earnings metrics and 36,000 feet numbers such as debt to equity and asset coverage when assessing a BDC.   All of that is very valid when the machinery of finance is working well.

ALL BETS WILL BE OFF

However, when the value of financial assets drastically drops the BDCs which are over-reliant on capital advanced by lenders who are concerned about the current value of their collateral,  are at risk of having to take drastic actions which can cause both immediate losses and  impairment to their business which will last long after the crisis has ended.  Knowing the earnings per share or the prior quarter's asset coverage ratio will not provide much guidance as to which BDC will muddle through and which will stumble.

PRESENT COMPANY

BKCC itself has had its own encounters with these drastic changes in portfolio valuations.

We refer anyone interested to what the BDC's balance sheet looked like in March 2017, when the portfolio was valued slightly above cost and NAV was $14.95.

Now roll forward to the 10-Q for March 2009, just 2 years later. The value of BKCC's assets has dropped by almost a third and NAV has fallen to $9.04.

This was no fly-by-night BDC, but an entity managed by not one but two famous financial names. Yet book value, thanks to the financial crisis dropped by 40%.

The BDC has never fully recovered.  If we flash forward to the latest 10-Q, we see that the BDC's total assets have not materially moved since 2009 and NAV is $8.22.

No wonder, perhaps, that the current Investment Advisor manages the BDC with an above average margin of safety, and has dialed down the BDC's reliance on Revolver borrowings.

ALL ALONG THE WATCHTOWER

For what it's worth, the BDC Reporter worries about such dull things as balance sheet construction and liability management (we're falling asleep just typing the terms)  and evaluates each BDC accordingly.

It's an assessment which has had very little real-life application in recent years, but is likely to be valuable again in the future.

Unfortunately.

-Nicholas Marshi, BDC Reporter

Topics: BDC

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