Description

Investment Overview

Portman Ridge Finance Corporation (“Portman”) (ticker: PTMN) offers discounted valuation and high current income—difficult to find in the Fed-fueled COVID rebound. Combined with improving portfolio fundamentals and the platform’s proven ability to scale, PTMN should provide a compelling total return for investors. 

Significant NAV build

KCAP Financial

Portman Ridge began with the acquisition of the management contract of the formerly internally managed public business development company (BDC), KCAP Financial. In April 2019, legacy KCAP externalized its management contract and transferred ownership to Sierra Crest Investment Management, an affiliate of BC Partners; the company then adopted the new Portman Ridge name.

KCAP shareholders received a cash payment of $25 million ($0.67 per share) as part of the transaction. Additionally, BC Partners committed to waiving incentive fees (if necessary) to enable the BDC to generate net investment income (NII) of $0.40 per share for the first year. Further, BC Partners agreed to deploy up to $10 million of incentive income (earned during the first two years) to acquire/issue shares of the BDC at NAV.

Given BC Partners’ scale (with ~$21BN in private equity and ~$4.0bn of credit assets), the deal has provided shareholders with significantly greater institutional heft. PTMN now enjoys greater sourcing capabilities and the ability to participate in larger deals; they can also leverage the industry expertise and insights of the entire BC Partners’ platform.

Under new management, PTMN has also adopted a more conservative portfolio allocation—increasing the portfolio’s exposure to directly originated senior secured debt and reducing its CLO equity positions.  

• The portfolio composition of PTMN at 3/31/2020 compared to KCAP at 3/31/2019 demonstrates the rapid transition of the legacy KCAP assets:

Source: SEC filings

Oak Hill Acquisition

Scale is paramount in private credit and Portman Ridge is getting bigger, fast. On the heels of the KCAP deal, in August 2019, Portman Ridge acquired OHA Investment Corp. (OHAI), a small BDC (portfolio $62mn FV at September 30, 2019) associated with Oak Hill Advisory. Although the OHAI portfolio comprised predominantly second lien assets (which are not a focus for PTMN), the transactions nevertheless further expanded the asset base:

OHAI shareholders received 108% of net asset value ($1.84 per share at March 31, 2019) via:

• $8.0mn payment from Portman Ridge ($0.40 per share) in cash

• Remaining OHAI NAV ($1.44 per share = $1.84 NAV - $0.40 cash payment) paid via new shares of Portman Ridge, issued at NAV

• Additional $3.0mn payment from Sierra Crest ($0.15 per share)

We would highlight that Oak Hill accepted the bulk of their compensation in the form of PTMN shares. Oak Hill management and advisors likely thoroughly vetted the Portman Ridge portfolio (presumably receiving private information on the underlying assets) as part of their diligence. The structure of the OHAI deal therefore represents an unambiguous third-party endorsement of Portman Ridge’s asset value.

With closing the OHAI deal, Portman Ridge grew its net assets by 6.4% to $152mn in less than 9 months.

Pending Acquisition: Garrison Capital

Portman Ridge is successfully executing a strategy that many market participants thought impossible—a roll-up in the BDC universe. The planned deal for Garrison Capital suggests PTMN’s efforts are gaining traction.

In August 2020, Portman Ridge announced a deal to acquire Garrison Capital (ticker: GARS) for cash and stock (expected close in 4Q20). As we highlight in the chart below, the GAR deal will dramatically increase PTMN’s assets: 

The chart also highlights one of the central drivers for the transaction from the GARS perspective: Garrison had become unsustainably levered, prompting them to seek relief by partnering with Portman Ridge.

GARS’ shareholders will receive 105% of net asset value ($6.59 per share at March 31, 2020) via:

• $19.1mn payment from Portman Ridge ($1.19 per share) in cash

• Remaining GARS NAV ($5.40 per share = $6.59 NAV - $1.19 cash payment) paid via new shares of Portman Ridge, issued at NAV

• Additional $5.0mn payment from Sierra Crest ($0.31 per share)

Like the OHAI acquisition, Garrison will receive the majority of deal payment in PTMN stock, providing yet another outside confirmation of Portman Ridge’s asset value. The Garrison deal represents the third validation of PTMN’s asset value by an outside institutional credit manager in the last 18 months.

On a related note, BDC management contracts are highly coveted by asset managers and private equity firms because they generate high fee income from a permanent capital base. However, because they are so valuable to managers, the sale of these contracts has historically been rare. Because of this dynamic, a potential sale or review of “strategic alternatives” by a BDC manager has attracted significant interest. We have heard anecdotally that the Alcentra BDC (ABDC) auction late last year (ultimately won by Crescent Capital) attracted 26 first round bids. It is likely to assume that KCAP, OHAI and GARS garnered similar interest.

In short, when they conducted their respective strategic review processes, KCAP had many options; OHAI had many options; GARS had many options. In the end, each of these managers selected Portman Ridge as a partner; each specifically choosing PTMN shares as takeover tender. Given that the stock is trading at a 45% discount to net asset values, investors can buy into these same assets at a significant discount.

Again, building assets is among the main drivers of shareholder value for BDCs. Starting from effectively $0 in April 2019, Portman Ridge has posted a remarkable track record of growing assets. Increasing AUM helps boost NII by spreading fixed costs over a larger base and helps increase the float/liquidity of the stock. For the period ending June 30, 2020, the planned GARS deal will further increase PTMN’s net assets by 70% to $205mn.

Growth of PTMN Assets:

Improving Underling Book Value

In addition to Portman Ridge’s rapidly increasing asset base, improving fundamentals provides another catalyst for PTMN shareholders.

PTMN’s 2Q20 results (period ended 6/30/2020) beat market expectations as NII of $0.06 per share (vs. expected $0.04 per share) and fully covered their $0.06 quarterly distribution. Portman also booked solid NAV gains helped by higher marks on several of its debt investments; PTMN reported NAV of $2.71 per share compared to $2.69 at March 30, 2020, an improvement of 0.8%.

At quarter end, PTMN leverage stood at 1.43x, though this metric is expected to increase with the closing of the Garrison deal (more detail below). As an offset, Portman ended the quarter with $2.5mn of cash and short-term investments, which could facilitate debt paydown, as needed. Similarly, PTMN ended the quarter with $11.4mn of borrowing capacity under its revolving credit facility, providing further liquidity and capital structure flexibility.

As of 6/30/2020, Portman Ridge reported nine total investments on non-accrual, which represents about 6.6% of the total portfolio (at fair value).  PTMN assumed two of these non-cash paying loans (OCI and ATP) as part of the OHAI deal; both had been on non-accrual prior to the transaction. The remaining non-accruals had been on the KCAP balance sheet at 4/1/2019, prior to BC Partners assuming control:

Source: Company presentation (August 10, 2020)

Perhaps most importantly, As as illustrated by the FV Fair Value graphs below, PTMN’s 2Q 2020 results reflected the continued improvement of the portfolio:

Source: Company presentation (August 10, 2020)

We note that PTMN’s has reduced CLO equity to 6% of the portfolio and management has articulated the goal of continuing to shrink this asset class

As part of second quarter earnings, management reaffirmed their commitment to the $10mn share purchase from the KCAP deal. On the earnings call, management emphasized that these dollars would buy new shares at NAV (not for open market purchases), which will reduce leverage by expanding PTMN’s equity base.

Furthermore, issuing new shares aligns management with shareholders and highlights management’s confidence in their portfolio marks. If management were less confident in NAV, they might have been inclined to buy existing shares to prop-up the stock price. Issuing new shares—particularly when the stock trading at 55% discount—represents a strong statement of confidence by PTMN management.

To facilitate repurchase activity, in late August, Portman Ridge announced a 10B5-1 plan, which will automatically buy up to $10mn of shares at predetermined levels from August 31, 2020 through March 5, 2021.  

Compelling Valuation

Punitive Implied Default Rate:

Despite its notable asset growth and improving fundamentals, PTMN trades at a significantly discounted valuation. By our calculation—based on recovery rates from the Great Financial Crisis—PTMN’s current stock price implies a default rate of nearly 60%.  

Our analysis begins by deconstructing PTMN’s portfolio by underlying investments (e.g. 1st Lien, Senior Secured Debt, 2nd Lien, etc.). Next, we discount PTMN assets based on realized recovery rates by investment class (e.g. 1st Lien, Senior Secured Debt, 2nd Lien, etc.) from the 2008 and 2009 timeframe; we provide the recovery rates of corporate loans and corporate bonds during 2008-2009 in the table below:

As a final step, we compare PTMN’s current stock price of $1.24 to our discounted portfolio valuation to calculate their market-implied default rate. We demonstrate our methodology in the chart below:

For emphasis, based on historical recovery rates, PTMN’s current stock price implies a portfolio default rate of 59.1%—which we view as a punitive valuation.

Taking an even more conservative (if not draconian) approach, even if we assume ALL of PTMN’s investments other than its secured loans and JV investments are worthless, the market’s implied default rate remains punitivitely inflated at 37.7%:

For context, as evident in the following chart, BDCs have historically experienced default rates well below 10%: 

Again, the market is expecting PTMN to realize defaults nearly 6x higher than the industry’s long-term average. We believe this remarkably low valuation provides a compelling opportunity for shareholders.

Book value likely conservative

PTMN current trades at 0.45x to book value while most peer BDCs trade closer to 0.75x – 0.85x NAV. In short, a BDC trading at that magnitude of discount implies that the market doubts the value of the underlying assets. We would again highlight that three different credit platforms (KCAP, Oak Hill Advisory and Garrison) have vetted the Portman Ridge book (each presumably receiving private information on the underlying) within the last 18 months.

We would also note that PTMN already trades at a notable discount, with 6/30 NAV per share of $4.64 at Cost vs $2.71 at Fair Value. Hence, PTMN’s current book value already implies a notable 23.5% discount to Cost. This is admittedly a somewhat labored argument because BDCs trade based on Fair Value, not Cost, but it is worth highlighting nevertheless. 

Additionally, we would argue that PTMN’s Book Value will likely prove conservative because it does not reflect upside from recycling legacy assets. Newly originated BC Partners deals have become the majority of PTMN’s assets; legacy KCAP and OHAI investments have declined to just 30% of NAV as of 6/30/2020.  The portfolio overhaul will get a turbo boost from the Garrison Capital deal. As highlighted in the following graphs, with roughly 98% of 1st Lien assets, the GAR portfolio will dilute the riskier assets in the Portman Ridge portfolio.

BC Partners platform not reflected in valuation

Direct lending is a scale business—the larger the balance sheet, the greater the offerings and the greater the deal control, which ultimately result in higher quality assets.

Portman Ridge is just one of the vehicles that comprise the BC Partners credit platform, which has ~$4.1bn in AUM: 

Source: Company presentation (August 10, 2020)

BC Partners’ also enjoys more than $21 billion of private equity investments.

As Portman Ridge’s CEO, Ted Goldthorpe, noted during PTMN’s 2Q20 earnings call, Portman’s portfolio companies are supported by the entire BC Partners platform. This is meaningful for shareholders in helping maximize value from each investment.  Assets acquired through PTMN’s M&A process should presumably be valued more highly than under legacy management, given BC Partners’ significantly greater capabilities and scale. 

In addition to BC Partners, Portman Ridge also enjoys the balance sheet support of two joint ventures—BCP Great Lakes Holdings and KCAP Freedom 3 LLC. Joint Ventures by BDCs are not bound by the same regulatory leverage limitations as BDCs themselves. Like many of their BDC peers, Portman Ridge can utilize the JV’s borrowing capacity to fund new deals, often at higher ROEs than balance sheet lending. Origination by the JV can also support NII by generating new fee income.

Lastly, the BDC universe generally enjoys limited sellside coverage. In comparison to its peers, Portman’s analyst coverage is particularly thin. The additional size brought by the pending Garrison acquisition, which, again, will more than double the size of Portman’s investment portfolio, should attract additional attention from the Street. As PTMN continues to grow, the stock will begin to attract institutional shareholders. This dynamic will meaningfully accelerate as we begin to see regulatory changes in the space.

Regulatory Landscape Provides Potential Tailwinds

The BDC industry, largely represented by the Coalition for Business Development (CBD), has pushed for significant regulatory changes over the last few years. These efforts were rewarded in March 2018 in the form of additional leverage capacity (limit increased from Debt-to-Equity of 1.0x to Debt-to-Equity of 2.0x). The group is currently focused on changing how BDC management fees are disclosed in mutual fund expense ratios--more specifically, the impact of Acquired Fund Fees & Expenses (“AFFE”).

As background, recall that In 2007, the Securities & Exchange Commission (SEC) passed the Acquired Fund Fees & Expenses (AFFE) rule, requiring Mutual Funds that invest in BDCs to include portions of the BDCs’ operating expenses in the fund’s expense ratio. The rule intended to limit investors’ exposure to “fees-on-fees,” but the unintended consequence has been to drive institutional investors from the BDC market.

Highlighting this dynamic, due to AFFE disclosure, the VanEck Vectors BDC Income ETF (ticker: BIZD) reports an expense ratio of 9.62%. These onerous fees—orders of magnitude higher than funds targeting other market segments—discourage most Mutual Funds and ETFs from owning BDCs. As a result, only approximately 1/3rd of BDC shares (36% median) are held by institutional investors.

Notably, the SEC is expected to overturn this regulation as early as this year (as part of its Fund-of-Funds rule making process). On August 5, 2020, the SEC approved a proposal to amend expense disclosures, subject to a 60 day comment period. This proposal would remove the requirement for investors to include AFFE in their expense ratio as long as “other funds” (includes BDCs) represent no more than 10% of the investor’s assets. While this does not unlock the full demand for BDCs outlined above, it will nevertheless invite institutional interest in a market starved for yield.

The revision of AFFE could unleash a wave of new capital into the BDC market. Whenever the market panic subsides, with Treasuries pushing to the zero bound, investors will have limited options for yield. Freed from fee disclosure, actively managed Mutual Funds will seek out BDCs’ high dividends, we strongly believe

Catalyst

Continued improved earnings will underscore the strenght of the new manager/platform. 

Rotation of PTMN's book value out of legacy asset and into newly underwritten deals will increase investors confidence in NAV. 

Steady decline of non-accruals will highlight the qualty of PTMN net asset value.

The 10 Year Treasury at 70bps will, in time, force investors to look for alternative fixed income investments, like publically traded BDCs. A nearly 20% yield cannot exist long in a yield-starved world. 

Potential changes to AFFE disclosure could unleash of wave of new investors into the BDC universe from income-based mutual funds.