Last week, the BDC Reporter initiated coverage of TCG BDC (ticker: CGBD), the latest public Business Development Company (“BDC”). In order to delve into the details, we have broken the analysis into multiple parts. We began with CGBD’s History/Formation, and reviewed Strategy. Now we turn to Compensation. This is not just a matter of listing out what the fees charged are, but involves placing compensation in the context of the business overall, and ascertaining how incentives shape how the BDC is run. In this case, Carlyle is doing much that is a copycat of other BDCs, and not in a way that’s necessarily good for shareholders. However, there is a noteworthy exception to that statement which we’ll review below. We end,though, by pointing out some of the ways the compensation scheme may have unfavorable consequences over the long term for those who hold the stock. (By the way, the Prospectus show that Carlyle insiders own very little of the stock t the moment: 0.5%).
OVERTURE
Outside of interest expense, the compensation of a BDC’s managers is its largest expense and its most contentious. After all, the rate of interest paid is negotiated at arm’s length with third party lenders and both the managers and shareholders are on the same side, both wanting the BDC to have the best terms possible. However, management compensation agreements – as many Prospectuses will remind you – are not negotiated at arm’s length, but are set by the sponsoring asset management organization at the outset. As we’ll see when we discuss Corporate Governance, a BDC’s Directors do not see their role as involving negotiating compensation terms with the asset management group who invited them to a directorship. Despite nominal annual or bi-annual compensation reviews, the BDC Reporter is not aware of any instance where a BDC’s Directors re-negotiated at their own volition any material element of its managers compensation. (However, the asset managers themselves have – at times – reduced compensation in order to maintain access to the public markets, typically after major set-backs and on terms that they have offered up).
ONLY SO MUCH TO GO ROUND
Still, how compensation agreements are structured is a key determinant of shareholder returns because a finite number of income dollars are being pre-allocated between managers and shareholders. There are a wide variety of different variations in the BDC space, most of them based on a hedge fund or private equity model. For external management (like CGBD) there are 3 main potential fees payable: a Management Fee based on total assets (not a BDC’s equity like many hedge funds – but that’s another story); an Incentive Fee based on Net Investment Income achieved over a threshold, typically a return on fair market book value; and a Capital Gains fee, based on net Realized Gains achieved and with a “high water mark” concept built-in. Moreover, most external managers charge the BDCs they manage for a pro-rata share of their office and certain personnel expenses.
FEE NUMBER ONE
In the case of CGBD, the largest compensation cost is the Management Fee, which has been set at 1.5% of gross assets, net of cash. That amounts to nearly 20% of total investment income. For the last several years Carlyle has been waiving a third of the Management Fee, but that ends with the new public status of the BDC. As a concession to its new shareholders, the Investment Advisor has agreed to continue the fee waiver “until the completion of the first full quarter after the consummation of this offering”. As a result shareholders will need to get out their pencils and calculate the “real” Management Fee after the third quarter of 2017. Here’s what we came up with: with total assets likely to reach over $1.7bn, the 0.5% annual difference will benefit the Advisor/cost the shareholders $8.5mn annually. That’s about $0.14 a share.
FEE NUMBER TWO
The Income Incentive Fee includes a hurdle return rate of 6.0% annually, with a standard 100% catch-up provision calculated when the limit has been reached and maxing out at 20% of the entire recurring net earnings. Then, Carlyle has included a “shareholder friendly” provision that defers payment of the incentive fee (including the capital gain portion we’ll discuss below) if “the sum of the aggregate distributions to our stockholders and the change in our net assets is less than 6% of our net assets at the beginning of such period”. However, deferred compensation will “be carried over for payment in subsequent calculation periods when such test is met”. That’s the old adage: “You’ll pay be now, or you’ll pay me later, either way you’re going to pay me”. More on that below.
Carlyle has offered shareholders to waive 2.5% of the 20% Income Incentive Fee AND the deferral provision if that is approved by the shareholders in an upcoming vote on the subject. The BDC Reporter – jaded by reviewing too many sided compensation arrangements – cannot find fault with this “concession” from the Investment Advisor, nor any reason why shareholders would not consent. The deferral is even more valuable than the 2.5% reduction. For CBGD shareholders this provision means that if there is a precipitous drop in the BDC’s net asset value, presumably from Unrealized Depreciation or Realized Losses, the Incentive Fee will not be charged. On paper, and if we properly understand how the calculations will work, the BDC’s shareholders could see the Incentive Fee drop to zero if things are going badly.
FEE NUMBER THREE.
Finally, there is a standard 20% of net Realized Gains (after taking into account Unrealized capital depreciation and fees already paid on a cumulative basis). Given – as we saw in Pari I – that CGBD’s strategy is to be almost exclusively a lender, and there to be very few equity opportunities that might create a Realized Gain of any sort and the losses already incurred, we doubt that there will be any fees paid out under the provision.
OUR ASSESSMENT
As always, there’s a mixture of positive and negative elements in the compensation arrangements which Carlyle has offered up. Given the relatively low investment yield which the BDC is targeting – just over 8.0% – the 1.5% Management Fee (ignoring the one quarter bonus offer shareholders will be receiving) is on the high side. Yes, Goldman Sachs BDC (GSBD) and market leader Ares Capital (ARCC) also charge 1.5% (we would argue that this is no coincidence as all these big name asset managers are comparing themselves to their peers), but their business model is different than CGBD’s. Instead, the new player is closer to Solar Senior Capital (SUNS) or PennantPark Floating Rate (PFLT), both of whom charge a 1.0% Management Fee.
PUBLIC VS PRIVATE
What’s more, it’s galling to see public shareholders being charged effectively 50% more than the institutional private investors that have been in the Carlyle Fund in prior years. The BDC Reporter will give you a heads up and guess that the Investment Advisor’s stated rationale for the higher fee will be the heavy costs associated with being a public company versus a private fund. This does not wash given that all those undeniable additional costs are paid for by the BDC directly, or allocated to its shareholders through the administrative cost allocation provisions. Unfortunately for public shareholders, the higher fees reflect what they are prepared to bear and a top asset management firm like Carlyle knows just what will will be borne. The BDC Reporter has seen this pattern many times as private BDC funds make the transition to public: the key terms offered to the public are worse than those negotiated by the initial institutional investors. Which is why the Prospectus spends as little time as legally possible on the current – private – arrangements.
EVERY 12.5% COUNTS
The BDC Reporter is a little more impressed with the better than average but not unique reduction of the Incentive Fee to 17.5% (assuming shareholder approval). The 2.5% reduction (and shareholders must learn to be grateful for a 12.5% reduction over what has become a BDC standard) will result in a greater return than would have been the case otherwise.
WE ARE GIDDY
Furthermore, what seems to be a potential full credit of the Incentive Fee if the BDC under-performs is a breakthrough in BDC terms. (We continue to wonder if we’ve misunderstood the carefully constructed language involved). It appears that if CGBD is having a bad few quarters or even years the Incentive Fee will not be charged. When you consider that in the most recent quarterly numbers of the fund (see page F-3) the Incentive Fee amounted to more than a quarter of total expenses, and 14% of Investment Income, the importance of the potential credit is evident. Given the increasing size of the BDC the potential “savings” from a shareholder’s standpoint could be well over $20mn a year that in some other BDCs (in fact, most of them) would still be paid to the Investment Advisor.
BACK TO EARTH
However (isn’t there always a however where the BDC Reporter is concerned ? ) it’s also worth noting that the Incentive Fee will only be going away, and only for a period of time, if and when CGBD seriously under-performs. Until such a time (and who’s looking forward to that ? ) the Investment Advisor’s Incentive Fee compensation will be high, even with the reduction to 17.5%. New shareholders may gain on the Incentive Fee roundabout but will lose more on the Management Fee swings. We analyzed the IQ 2017 numbers with the new compensation arrangements in mind and found that the half a million dollars in lower Incentive Fees will be well offset by $1.7mn in higher management fees.
Total adjusted compensation (leaving out any allocations) in the IQ 2017 would have been 27% of investment income, and 57% of total adjusted expenses.
TWO FOR YOU AND ONE FOR ME
The bottom line and roughly speaking Carlyle is taking home one third of all net Investment Income generated and shareholders the other two thirds when things are going well. Again, we’re not including the hard to quantify benefit to the Investment Advisor of having CGBD pay some of its overhead costs.
OLD THEME
As always the BDC Reporter will ask: why is there an Incentive Fee at all ? What’s more, why have that incentive tied to achieving higher yields (aka higher risk). Investors may shrug their shoulders at such questions but the form of the compensation affects the BDC’s investment approach. We could not help noticing that Carlyle was bulking up the fund with investments (a quarter of which were second lien) yielding 8.7% (see page 12) in recent weeks, as per its own disclosures. Yet at the end of 2016 (see page F-68) only 12% of the portfolio was in Second Lien. Also at the end of 2016, the average portfolio yield was 8.2%. In 2015, the yield was 7.9%. We would suggest that Carlyle is increasing return ( and risk) just as the BDC goes through this transition and to suggest that the Incentive Fee is unrelated to the change seems disingenuous.
ONLY JUST BEGUN
Moreover, Carlyle is highly committed to growing the “much-more-leveraged-than-a-
BIGGER AND BIGGER
That’s already bigger than most BDCs, but CGBD and You-Don’t-Know-Who have committed to invest $800mn between them in the venture. Simple math suggests (and we’re assuming CGBD’s capital commitment includes its share of mezzanine loans they are advancing) the size of the BDC’s investment could triple in the years ahead. Seeing the bank lenders seem willing to advance $2 for every $1 of equity, subordinated and mezzanine capital provided by the JV partners, total assets could go to $2.4bn, and match or exceed on balance sheet assets. (By the way, this is very similar to what Goldman Sachs BDC has been carefully constructing , and another example of how asset managers copy mercilessly from one another).
We mention all this to point out that the Investment Advisor expects the Credit Fund (thanks to its use of turbo-charged leverage) to be highly profitable on a return on capital basis, which will boost Net Investment Income, and the Incentive Fee.
ROUGH WITH THE SMOOTH
However, the BDC Reporter has to point out that there is no free lunch (and no article without its cliches) and the JV will be substantially riskier than “regular” CGBD because of the high leverage. The type of loans in the Credit Fund portfolio are similar to those CGBD owns on its own balance sheet. However, given the high leverage credit losses will resonate louder. Moreover, the third party lenders – given that they are already over their skis from an exposure standpoint by lending at 2/3rds of portfolio cost – may be quicker to take action and more lethal in what they do should we get a new Financial Crisis or Recession, or both. Only then will shareholders be able to evaluate if the slightly higher Net Investment Income generated overall from this scheme (but which will greatly benefit the Investment Advisor if the earnings lift the BDC’s results over the threshold) was worth the higher credit risk involved from abandoning the maximum 1:1 debt to equity BDC standard.
CONCLUSION
Overall, the new BDC’s compensation arrangements are higher than the BDC Reporter might have expected given the supposedly “safer” investment strategy being touted (the first loss unitranche, second lien and highly leveraged Credit Fund notwithstanding). Moreover, we’re not surprised, but disappointed, to see that overall compensation costs will be higher going forward than in the past given the the Management Fee is effectively being raised by 50% and the lower Incentive Fee is only part compensation. That will keep the Investment Advisor earning one dollar in three of recurring income. That seems unduly high to the BDC Reporter but not to the market at large, as Carlyle has sussed out. However, shareholders may take some solace from the Incentive Fee going away for a period should the BDC under-perform in the future, which is a progressive measure. If we really understand what’s being proposed.
However, the compensation scheme – as is the case almost universally across the BDC space – continues to incentivize (as every Prospectus and 10-K toothlessly reminds us) the Investment Advisor to take on more risk, and seek to stretch the standard BDC rules more, to maximize their return. (One day we’ll write an article that shows how these marginal, higher risk transactions add greatly to a BDC’s risk profile – and credit losses that only the shareholders will absorb – but most of the financial benefit inures to the Investment Advisor, which is why we are not fans). That process is already underway even as CGBD makes the transition to public status, and will bear watching.
By Nicholas Marshi, BDC Reporter
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