Trying to solve the enigma of BDC valuation - Middle Market Memo

30 November 2017

Underperformance shouldn’t be an excuse to not test the market in today’s frothy environment, just ask Triangle Capital and Medley Capital. In the past 24 months, both business development companies cut their respective dividends. In recent weeks, they also effectively hit the auction block, likely buoyed by the returns that another struggling BDC manager Fifth Street Asset Management got after it sold off its management contracts to Oaktree Capital Management for USD 320m earlier this fall.

 

Getting a maximum valuation for these assets is hardly an easy exercise as people have to view these asset managers based on the value of the underlying loan portfolios, how those target vehicles are structured and how those buyers plan to execute their transactions.

 

Medley Management, the external manager for Medley Capital, a private BDC and other lending vehicles, is the entity officially on the auction block. Like Fifth Street, it owns fee-generating management contracts for two BDCs, so those types of trades could be valued as multiples of historic or expected earnings.

 

Triangle Capital, on the other hand, is internally managed, meaning the management contract is essentially owned by shareholders. In a deal for Triangle, buyers could compensate shareholders to relinquish that contract. Buyers could also acquire the BDC as an entire portfolio valued as either a premium or discount to NAV and merge that portfolio into an existing BDC. A precedent for the latter type of transaction is Ares Capital Corporation’s takeover of American Capital last year.

 

“If you're looking at the management contract then it's a multiple of EBITDA or fee stream,” a financial services banker said. “If you're looking at a portfolio, its net asset value (NAV), which is driven by return on equity. That's the real thing.”

 

Triangle Capital has posted a negative 6.83% return on equity over the last 12 months through 30 September. Ares Capital Corporation, the largest public BDC by market capitalization, produced an 8.1% return on equity over the same period.

 

 

Acquisition multiple

 

The value in BDC managers lies in the recurring fees they command from the funds they manage. Those fees can be as high as 2 percent of assets under management and 20 percent of profits earned.

 

In the case of Fifth Street, Oaktree’s USD 320m paid for FSAM represented roughly 4.5x its USD 71.9m in TTM revenue through 30 June (the sale was announced on 14 July). Oaktree also reduced management fees on FSAM’s contracts from 1.75% of assets under management to 1.5% and from 20% of earnings to 17.5%.

 

At the same multiple of revenue, Medley Management would receive USD 294.3m, based on TTM revenue of USD 65.4m through 30 September, according to SEC filings. Medley manages a pair of BDCs--Medley Capital Corporation and Sierra Income Corporation--and several private credit vehicles.

 

The management contracts also serve as an entryway for asset managers to expand their presence in middle market leveraged finance, as was the case with Oaktree. The new manager ends up responsible for sorting out a slew of non-performing loans.

 

Oaktree Specialty Lending Corporation CEO Edgar Lee touted his firm’s ability “to leverage our restructuring experience and expertise in managing troubled credits in the portfolio,” on the first earnings call held yesterday for the BDC following the close of the Fifth Street transaction.

 

Given that over 6% of Medley Capital’s portfolio—on a fair value basis--was on non-accrual as of 30 June, any acquirer would also have to have a stomach for workouts. Medley reports 3Q earnings next Thursday (7 December). The problems were less severe at Sierra Income, a privately held BDC also run by Medley, as only 2.88% of its loans were on non-accrual as of 30 September, and had been reduced from 3.56% as of the end of 2016.

 

“The platforms are somewhat similar,” a sellside research analyst said. “So what happened with Fifth Street and Oaktree could also occur at Medley.”

 

Net asset value

 

In the case of Triangle Capital and its internal management structure, value may be harder to extrapolate than with the buyers of an external contract.

 

Externalization can be a difficult sell for shareholders, however, as they are loathe to relinquish fee income to a third party. Hercules Capital management attempted an externalization this year but subsequently abandoned the plan.

 

Oaktree paid a 24% premium to the NAV on Fifth Street’s BDCs, according to a 2 November research note from Wells Fargo. Using that same multiple, Triangle Capital could fetch a valuation of USD 781.2m or a 24% premium to its NAV of USD 630m as of 30 September.

 

Some agree with that valuation method, while others don’t.

 

“You can externalize and create your own fee stream and back into that. Or look at a percentage of NAV and merge into an existing portfolio. I think you can look at it both ways.”” said one BDC executive.

 

“Internal versus external is an important legal structure, but it’s not an impediment to doing a deal. It depends if portfolio is well managed…Everything is on the table if you’re an underperformer,” added the BDC executive.

 

Shareholders in the internally managed American Capital received USD 17.40 per share in the Ares buyout which represented a discount to NAV at the time of the deal.

 

And if a fund manager were to acquire a portfolio of assets like Triangle Capital’s—with significant holdings in non-performing subordinated loans to middle market companies--- they would also have to analyze how much they believe the quarterly marks-to-market of those illiquid credits if valuing the BDC on a per-share basis.

 

“There is the bid/ask spread,” the analyst said. “The (perceived) fair value of the portfolio… (And) how much value it adds to the acquiring party.”