Description

Kayne Anderson Development Co (KED) is a BDC specializing in ‘midstream’ energy investments, principally in the form of private limited partnerships.  Selling at a 7.1% discount to NAV, KED provides a margin of safety for new purchases, an implied cash yield of 5% at present, and the potential for 20% compounded total returns.

Description:

KED intends to invest at least 80% of total assets in the energy industry, specifically, ‘Midstream’ energy companies, which are businesses that operate assets used to gather, transport, process, treat, terminal and store natural gas, natural gas liquids, propane, crude oil or refined petroleum products.  Other candidate investments are ‘Upstream’ E&P companies and ‘Other’ energy companies, including coal, tankers or bulk carriers, refiners, or distributors.  Any E&P investments will be debt securities only.

The key focus however, will be equity and debt investments in Midstream energy companies structured as limited partnerships.  Initially, investment size will be in the 10-60MM range.  Midstream companies tend to have less commodity price risk.  In addition, they fit other investment criteria listed by KED:  stable cash flows, more consistent and predictable demand, and the potential for increasing cash flow from internal growth.   (KED views E&P funding as 1) quite competitive, and 2) subject to less need by E&P companies due to high commodity prices…the slow pace of investment at NGPC was specifically cited in a conversation with the IR.)

KED will participate in private MLPs through common units, subordinated debt and warrants.  While these investments won’t include equity in the General Partnership units (GPs), they will include incentive distribution rights ( IDRs), which receive a disproportionate share of the cash distributions above stated levels.  KED will work with companies that have midstream assets better suited to a LP format, and through joint ventures will establish and invest in those structures, in part, monetizing those assets while still permitting original owner control.  KED will invest in private GPs of MLPs.  Other investments will be typical mezzanine financing, second lien bank loans, and greenfield development loans with PIK terms as a construction phase feature. When participating with private equity, KED will tend to have a preferred equity position.   Initially up to 30% of assets may be in publicly traded MLPs, though this will reduce as private investments are identified and funded.

The investment manager is KA Fund Advisors, LLC, an affiliate of Kayne Anderson Capital Advisors, L.P. (or “KACALP”), a leading investor in both public and private Energy Companies with energy AUM of $4.4 B.  KACALP manages two public CEFs, KYN and KYE, with over 2.6B in energy assets.  KYN specializes in MLP energy investments.  This structuring is similar to what KED will pursue, though for KED the emphasis will be on private MLPs, a category which is limited for KYN, and which is why KED has been launched.   KYN IPO’d at $25 in September 2004.  Since then it has paid $3.24 in dividends and appreciated $6.94 to today’s price of $31.94.  This represents a 2 year total return of $9.70, or just over 40%.  Since November 2004, KYN and KYE have, in aggregate, invested over $1.1 billion in 20 transactions that involved the purchase of securities that were unregistered or otherwise restricted, which Kayne refers to as “Private Transactions.” Thus there is substantial experience and contacts in the target investment industry.  KED is not starting from standstill.

The investment manager will be compensated with a 1.75% base management fee on average total assets.  Through 9/24/07, 0.5% will be waived or reimbursed to KED.  An incentive fee (20%) will be paid on 1)  net investment income (NII) amounts above 1.875% (7.5% annualized), and 2) net realized gains (adjusted for unrealized losses).

Officers and Directors own just under 2% of the company.  KED’s fiscal year ends November 30.

Operating Performance:

KED will follow the typical BDC pattern of first investing its initial net capital, in this case $233MM.  This is expected to be completed by mid calendar year 2007. At 11/30 approximately 44% of assets are invested in targeted investments.  About 25% is in public MLPs, and over time this may decline as more private MLP investments are originated.  The balance of funds is in repurchase agreements yielding 5.2%.  NAV had increased to $24.21/share from the post IPO NAV of $23.32.  After the initial capital is invested, leveraging should go as high as 60% in the early phase of the company, and subsequently may reach the BDC maximum of 100% D/E.

Structuring the investments as MLPs is a different approach within a BDC entity and has some ramifications for expected performance compared to the ‘traditional’ BDC:

1)   NII will tend to be lower since MLP distributions are substantially classified as returns of capital.  In fact the company anticipates it will seldom achieve the NII incentive hurdle rate, because the distributions received from MLP units will be substantially deemed returns of capital (ROC) rather than income.

2)  Realized capital gains (when they occur) will tend to be higher because of the cost basis reduction due to ROC.

3)  In the traditional BDC, to move cash upstream from a portfolio company there is an advantage to skew the capital structure more towards debt, and less in equity.  Because MLPs pass through their cash flows, the need for debt heavy structures is lessened, but the result is less high yield debt in the portfolio, and more lower yield partnership units, which in part are upstreaming cash not considered to be income at KED’s level.  The cash is there, but to meet the BDC test of distributing nearly all income, KED will probably have a dividend yield near KYN’s 6% and/or there will be some ROC element in KED’s dividends to shareholders.

4)  MLPs may have a bias to grow internal cash flows, thus KED expects to receive growing cash flows from its portfolio, another function of less fixed debt structuring.  This organic growth may raise the dividend KED shareholders receive while there are somewhat fewer follow-ons driving dividend growth compared to the traditional BDC.  This is also tied up with the bias to ROC from the portfolio structure, and whether or not all of that goes to the dividend.  However, that said, KED does understand that substantial expansion of the portfolio, assuming abundant qualified opportunities, will require additional equity capital, and that would require the typical BDC follow on.

The 11/30 investment status report illustrates some of these effects.  Of the $106MM in targeted investments, 60% are in MLP units or MLP affiliates yielding 6.4%, with 40% in fixed income securities yielding 11.4%.  While the company indicates overall yield will increase, as full investment is reached, this clearly is not the typical mix of debt and ‘equity’ securities, because the ‘equity’ is a different animal.

Expectations:

As the IPO cash is fully invested, the 7.1% discount to NAV should be closed as is typical for BDCs.  After 2 years, KYN trades at a 1.103x premium to NAV….but NAV has increased to $28.99 from an initial NAV of about $23.75.

By late summer 2007, assuming KED is fully invested (and using only the yields announced to date on a similar ratio of equity and debt investment),  KED will be able to yield up to 6.2% on its IPO cash after all expenses, or a dividend run rate of $.36/share.

A year from now, if KED achieves only a 5% premium to present NAV, then the stock will have a price of $25.42.

The 1 year total return should be $2.93 in appreciation and at least $1.26 in dividends for an 18.6% total return on a $22.49 investment.  This is conservative as I do not allow for: 1) further NAV appreciation, 2) cash flow growth in portfolio assets, 3) a shift to somewhat more debt securities as the ratio of private to public investments increases, or 4) typical BDC premium valuation (NGPC is at 1.165x NAV as it only now approaches full investment).  Thus I think this is a minimum reasonable expectation for KED 1 year returns.

For a longer time frame, I need only point to KYN.  It is doing what is intended for KED to do, and has returned over 40% in 2 years.  The distinction is that KYN primarily investments in public MLPs, while KED will primarily invest in private MLPs.  The risks there will be higher of course, but the returns will be commensurate with the risk.  The management company has proven its abilities in the sector with the KYN track record.  Thus compounded 20% total returns seem a reasonable long term expectation for KED.

Catalyst