Description

Fear on the Street can provide opportunity for thoughtful investors with a long time horizon.  Apollo Investment Corp (AINV) presents that kind of opportunity as it is uniquely situated among major BDCs, with existing liquidity for up to a year without resorting to new equity raises.

 

The Big Picture

 

With sub prime mortgage problems becoming more visible, markets are demanding more payment for risk.  Easy credit is withering as M&A bond deals are being pulled and a huge pipeline looms.  The turn has been quite abrupt.  For companies that require ongoing liquidity in the form of new capital as a fundamental part of the business model, these can be trying times.  But if capital is already in hand, then if your business is lending to other businesses, you are seeing rapidly improving pricing develop.

 

AINV is a Business Development Corporation (BDC).  BDCs are investment companies that specialize in middle market ‘subprime’ lending.  As a group, BDCs have done well since late 2002 following some well publicized short sale and propaganda attacks on ACAS and ALD.  But the BDC business model requires capital for growth.  It comes in the form of periodic equity raises, ultimately matched by an equal amount of borrowing.  By regulation, leverage can not exceed 50% of assets.  The BDC regulatory leverage test inverts that, requiring assets/debt to not be less than 200%.

 

Like much of the financial sector, large BDCs (AINV among them) have been pounded since early June.  Several are down 13-27% since the end of May.  AINV is off 14%.

 

 There is no real catalyst for a rapid price recovery, yet price matters, as BDC equity capital is raised through the sale of additional shares at market prices.  So, if the equity markets will only slowly recover, (and conceivably could be lower before recovery), the prime analysis for selecting in the sector is liquidity on the debt side.  In short, how long can the BDC run until either its credit lines, or the BDC regulatory debt limit stops it?

 

AINV’s Advantage

 

AINV is quite favorably positioned as it has been running net originations at a relatively conservative pace in the last year.  As a result, with an investment portfolio and cash of $2,357MM requiring only $492MM of debt, there is a great deal of liquidity remaining for taking advantage of opportunities that are now developing in their investment niche.

 

Here’s the analysis for AINV (all figures MMs):

 

At 3/31/07

Investments + Cash: 2357
Debt: 492
First Pass allowable borrowing based on BDC leverage test:
(2357/2) - 492 = 686 

In the above, half of assets = max debt, so that amount less present debt = possible allowable borrowing.

 

But in fact, in the leverage test, when you borrow for additional investments, both the numerator (assets) and denominator (debt) are increased.  This does converge, but the reality is that the ‘possible’ allowable borrowing suggested above is just half of what the regulations allow, so:

True allowable borrowing = 2x: 1372
Confirming leverage test: (2357+1372)/(492+1372) = 200%

 

So now we know AINV’s liquidity potential as of 3/31/07.

Adjustments post 3/31/07:

First, a Reality Check!  The leverage test is great for showing how much the SEC will let AINV borrow.  But the real test is what AINV can get from its existing lines of credit!   AINV credit availability 3/31 was 1208, based on borrowings of 492 against 1700 total availability.
In addition, there is a potential allowable credit ceiling expansion of 300 in
the existing documents.

Thus AINV has at least 1208 of credit and possibly 1508.
For our purposes, the range effectively is a minimum of 1208 of credit availability to a maximum of the 1372 BDC test ceiling.

But where do we stand today?  AINV has not just been sitting still since 3/31/07.  AINV made a major announcement with the going private transaction of Innkeepers USA.  This required a 200 equity investment from AINV for its direct part of funding the approximate 1500 deal.  This might be considered an extraordinary investment, so to be cautious, we should add something representing the underlying net origination rate.  In the last 4 quarters, net originations as measured by change in investment cost basis have been 179, 234, 179, and 133 in order.  I’ll use 180 as the underlying quarterly rate. 

 

So, a final adjustment for Q2 2007 originations is 380 and thus credit liquidity going forward ranges from 828 to 992.

 

Here’s the key implication.  If the run rate for net originations is 180, then AINV can operate on existing credit for 4.6 to 5.5 quarters, or over a year.  If there is a lot of opportunity coming for investments, then say net originations increase by 40% to about 250.  That still gives AINV between 3 and 4 quarters of unconstrained investing operations.

 

I ran similar analyses for ARCC and ACAS.  The results suggested ARCC had 386 to 482 of credit liquidity (but did not factor in existing commitments), and a net origination run rate of 175 (averaged over the trailing 4 quarters).  That’s good for at least 2 quarters going forward, but not more than 3. 

 

ACAS is more complicated with lots of moving parts, but a similar approach suggested 1885 - 2043 of credit liquidity, with a net run rate of 712MM.  That’s well over 2 quarters, but past 3 doesn’t look too easy.  One has to credit ACAS with excellent timing on raising capital of all forms in June.

 

I haven’t followed ALD for a couple of years, so I didn’t include it here as a comp.

 

I’m NOT saying any of these are going to have a serious liquidity problem!  But a margin of safety in the BDCs has to consider the possibility of waiting for higher equity prices before raising equity capital.  Clearly, AINV is best positioned in that regard.

 

Objections

 

I’m using net originations based on changes in portfolio cost figures.  In reality gross originations are higher, and are reduced by sales or redemptions of existing investments.  In this environment it isn’t difficult to imagine the sales component at the very least slowing down.  But if gross originations similarly slow, the net figures remain.  The logical move at the moment is to ease origination pace to allow pricing to further strengthen.  These are smart managements, and clearly AINV with its modest net pace in the last year has been waiting for this kind of event.  I don’t doubt they’ll manage through it well.

 

AINV still has a premium to NAV at 1.16x.  Considering ARCC (on an adjusted basis for its April equity offering) is under NAV one can ask if it can get cheaper.  Yes it could.  I’m not saying rush out and buy today.  But you can nibble, and depending on how markets move the next weeks and months, the knowledge that AINV is very well positioned to come through can give you the confidence to execute when you are ready.

 

Further, AINV is sitting on one of the better appreciated portfolios with net unrealized gains at 4.7% of cost.  Sure some of that has probably unwound on paper in the last few weeks, but it is one of the highest starting points among the comps.

 

One might suggest AINV holds a risky portfolio.  At 3/31/07, it was 28.4% senior debt, 61.7% subordinated debt, and 9.8% preferred and common equity and warrants (by cost).  More critically, the yield on the debt portfolio was 13.1%.  ARCC was about 11.7% on a significantly more ‘senior’ oriented portfolio, and ACAS came in at 12.2% on its debt securities with a somewhat similar risk profile to AINV.  These may not be exact comparisons, but clearly AINV has done well in maintaining a price for the risk it carries.

 

The dividend at present is not wholly paid out of net operating income.  However, there is over 84 on the 3/31/07 balance sheet in retained realized gains net of excess NOI distributed.  This is about $.81/share.  NOI in the most recent quarter was reduced by an unusual incentive fee on a significant realized gain.  The run rate of NOI is well above $.40 per outstanding share.  Clearly there is substantial padding already on the books to support a $.51/share dividend rate.  With increased investments on a fixed share base the logical outcome of the scenario outlined above, it stands to reason NOI will grow even as realized gains may fall off for now.  Here’s proof:

 

For this, we'll assume the 380 in net investments made in calendar Q2 '07, and add 400 in new investments, a midpoint of the bottom liquidity range.  Total new investments from 3/31 is 780.

 

Debt goes from 492 to 1272.  Libor + 100bps margin is ~6.5%.  Quarterly interest is 20.7.

 

Portfolio fair value goes from 2349 to 3129 (assumes no appreciation or depreciation).  An average portfolio value during a quarter would be about 3039, reduced by half the 180 run rate for net originations.  Thus the 0.5% quarterly management fee is 15.2 

 

We'll use the present portfolio mix for yields.  Thus the debt portfolio is increased by 90% of the new originations (360 of 400) and the non Innkeepers originations in Q2 (160 of 180), or ~520.  Yielding AINV portfolio debt currently is 2022, so with 520 added the debt portfolio is 2542, at 13.1%.  Quarterly interest is 83.3.

 

Dividends to AINV have been ~5 per quarter.  The Innkeepers deal is all equity, and we know the REIT structure will remain intact.  It will pay cash.  We also have about 60 in other new equity originations implied if our portfolio ratios remain constant.  Very conservatively, it's easy to support 6.7 in quarterly dividends.  We make no allowance for 'other' income.  So:

 

+90.0 gross revenue

-20.7 interest expense

-15.2 base management fee

-_2.0 other expense (increased to 8 vs TTM 7 annual rate)

 

+52.1 Net operating income.  But this is right on the incentive fee rate of 1.75% return, so incentive fee is not a factor, absent realized gains.

 

52.1 / 103.5 shares is $.503/share, clearly backing the $.51/qtr dividend rate with NOI.  Even absent substantial near term realized gains, NOI will easily ramp to support the existing dividend rate.

 

Finally, Isn’t AINV just like a subprime mortgage originator for businesses, having been way too loose?  No.  AINV, like all the BDCs does extensive DD on candidate deals.  No liar loans involved.  They do not run a revolving door where their income is fee driven on origination and turnover of underwritten risk.  They are not repackaging and selling these investments as CDOs.  [Even the BDCs that have securitized retain the bottom tranche(s).  Thus they are not about shifting risk, but financing a block of held loans.]  AINV cannot exceed 1:1 D/E and has stable credit lines, so even if impairments show up in the portfolio they are a long way from a wipeout compared to much more highly leveraged entities.  They are active managers of their investments, not passive paper holders.  AINV conducts a much different business than the headline events you’re reading.  They are being impacted with the subprime fallout, but are much stronger than the market thinks.

 

Outlook

 

This too shall pass, but not in a hurry.  Liquidity is power when it dries up elsewhere.  AINV is going to be able to take advantage of a much better pricing environment in its lending space.  It has greater staying power to do so.  We saw excellent BDC recoveries from post 2002.  This will be the same in the long run.  But it’s nice to have that extra bit of safety in built-in liquidity!  And there’s nothing wrong with a 10% cash yield either when it looks secure.

Catalyst

None immediate – this is a long term investment.
Superior internal returns on better pricing in middle market lending on coming originations due to present repricing of risk.
Buy on any weakness.

Disclosure: the author may buy, hold or sell any of the securities mentioned in this review at any time.