Description

Description:

Garrison Capital (“GARS”) is a publically traded business development company. Unlike, its peers it has failed to recover from last year’s credit sell off. GARS trades ~75% of book value with an 11.7% dividend yield. The Wells Fargo BDC index trades at 1.07x of book and at a dividend yield of 9.25%. We believe that GARS can close this discount to its peers with some stability in its portfolio. Even if it does not – the current valuation, as well as dividend yield provide substantial downside protection.

Trade Return Profile:

If GARS can re-rate to 90% of book value, still a reasonably large discount to peers – the stock will return 28% over the next year inclusive of dividends.

In a reasonable downside case, if the NAV declines another 5%, and the stock rerates down to 70% of book value – the return including dividends will be -2-3%.

In a more bearish downside case – NAV declines 10%, and the stock trades as bad as FSC (at 62% of book) – will result in a 16% loss over a year. FSC has a variety of issues apart from a horrible portfolio, including governance (or lack thereof), lack of management and ownership conflicts. I view that valuation as a reasonable floor.

Garrison Investment Group:

GARS is managed by Garrison Investment Group – a relatively large asset manager ($4-5bn of AUM) founded in 2007 by former Fortress partners. Garrison manages a variety of lending funds, CLOs and other vehicles in addition to the BDC.

How did GARS get here?

After going public in 2011, GARS traded well all the way through late 2015 (in a range of 95%-105% of book value). In late 2015, the portfolio encountered several idiosyncratic issues that drove NAV/book value from~$15 to $12.42. Implicit in this recommendation is that these losses were a bad draw, and that overtime GARS will perform more in line with Garrison Investment Group’s good reputation and track record as a credit manager.

Specifically the losses were driven by:

Forest Park Medical – In this case the loss was driven by fraud. The loans were made to a series of doctor owned medical centers in Texas. It turned out that the medical center executives and doctors were engaging in a wide variety of kickback, and billing schemes. Numerous people at the centers have been indicted.

BFN Operations – This was a nursery business owned by Insight Equity that went bankrupt. Looks like a variety of factors were responsible.

Speed Commerce – This name was written up as a long on VIC in March 2015, and you can see the details of what happened there.

There aren’t a tremendous amount of errors, and one of them was outright fraud – but unfortunately they were chunky positions and in a BDC structure the leverage makes each error painful.

Haircutting the Portfolio:

2.5% of the portfolio is held on non-accrual (2 investments). If both are worth 0 that will lead to a roughly 5% decline in NAV. The two investments on non-accrual are the remnants of the aforementioned Forest Park Medical, and an energy name “Badlands Production”. They are already marked down, so recovery would have to be well below expectation for them to go all the way to 0.

Unfortunately most of the portfolio isn’t broadly syndicated and can’t be marked. The few names that can are all performing fine since 12/31.

Everyware Global Common: Marked at $7.50 per share. This was mid-market on 3/31 (trades by appointment on distressed desks as post reorg equity).

FRAM Group: Trades at 100.25; was marked at 99 on 12/31.

Sirva Worldwide: Trades at 99.75; was marked at 97.75 on 12/31

US Telepacific: Trades at 100; was marked at 100 on 12/31

Syncsort: Trades at 100.375; was marked at 99 on 12/31

Project Sunshine IV: Trades at 100.875; was marked at 99.35

Diamond Crystal: Trades at 100; was marked at par.

Aurora Diagnostics: Trades at 94.5; was marked at 100.

Phoenix Services: Trades at 98.5; was marked at 100.

AP Gaming I: Trades at 101; was marked at 100. (One of the top positions)

Inteva: Trades at 100; was marked at 100

Sears: trades at 99; was marked at 100

Sprint Industrial: Trades at 82.5; was marked at 72

Gruden Acquisition: Trades at 97; was marked at 95

Interest Rates:
The GARS portfolio is largely floating rate- and should see a significant boost in earnings as Libor rises (see item 7a in the 10k) for a sensitivity table.

Manager Fees:

GARS has a good fee structure relative to its peers. Management fee is 1.5% and the incentive fee is 20% over a 7% hurdle. Importantly GARS has a look back feature against capital losses (3 years); a feature that will prevent Garrison from earning an incentive this year given the losses that took place over the past year.

Other Notes:

GARS has an SBIC license, affording it attractive leverage – a privilege not all BDCs have been able to obtain.

There is a black box aspect to this trade – as with most BDCs/banks. However- at this discount to book value, yield, and level of non-accruals there is ample cushion for this trade to work.

Liquidity is mediocre – it’s a $155mm market cap, without a single large holder. Putting on a $2-4mm position should not be too difficult.

Catalyst

One or two quarters of NAV stability should re-rate the stock. Quarterly dividend provides attractive yield even if re-rating is delayed.