Description
This security is illiquid.
I wrote up SAR on 4/14/07 when it traded under the symbol GNV. It has declined by about 50% since that time. Lindsay790 wrote it up on 3/18/11, and it is off about 15% from that write-up. I am hopeful that it is time for SAR to produce a profit for its investors. It should not be difficult, but anything is possible.
Saratoga Investment Corp is a BDC which has had a rough ride. Its former managers (GSC Capital) were ex-Goldman Sachs executives with great resumes and lots of smarts. Those attributes were unable to overcome the effects of leverage in the terrible markets of 2008 and 2009. Their investment structure imploded and control of their public entity (SAR) was acquired by Saratoga Partners in 2010. Saratoga Partners invested $15,000,000 in the shares of the company for a 37% ownership interest. Defaulted bank debt was paid off with their equity infusion and a new line. Since that transaction, the market for leveraged loans has improved and the portflio has been reworked. As of November 30, 2011, the company had $84.4 million of investments, $11 million of cash and equivelents and other assets of $4.4 million. There was no debt outstanding, total liabilities amounted to $5.5 million, and stockholders equity was $99.8 million. With 3,876,661 shares outstanding, NAV was $24.32. With the stock at $15.50 a share, it trades at a 36% discount to NAV.
There are several reasons for the discount and several reasons for the discount to shrink.
1) With a total market cap of $60 million, it is too small to be of interest to most investors. If the discount to NAV narrow, new shares will be sold and the market for the shares will broaden.
2) BDS's are required to distribute 90% of their taxable income annually. However, during the 2008/2009 crunch, the US Treasury allowed BDC's (and REIT's) to make their distributions 90% in stock and 10% in cash. Because of SAR's small size, it chose to retain its cash earnings and distribute new shares. In 2010 SAR paid out 90% of its distribution in stock and 10% in cash. In 2011 the company paid out 80% in shares and 20% in stock. While the retention of earnings strengthened the balance sheet, it did not please investors. The stock's price fell and the discount to NAV increased. I believe that SAR will become a regular dividend payor in 2012 which should attract investors. At the present price, the stock will yield in excess of 11%.
3) The portfolio is highly concentrated. The former management sold SAR the equity strip and the management of a CLO. As a result, $25.4 million, or 30% of the $84.4 million portfolio is in one position. However, the position is priced at a 19.2% interest rate and brings in fees for the management of the CLO. In all, the CLO generates $6.6 million a year. As the portfolio is expanded through the use of leverage or the issuance of new shares, the degree of concentration will diminish.
4) The BDC business is a fabulous fee machine. The base management fee is 1.75% per annum on gross assets, so there is a desire on the part of managers to grow assets and to leverage them. Then, there is an incentive fee which pays the manager 20% of the income generated in excess of 7.5% with a catch-up. Last, management is entitled to 20% of realized capital gains less realized and unrealized capital losses. The only thing mitigating these fees is managements ownership of over a third of the company's outstanding shares.
5) The cost of running a small company is high. Expenses such a insurance, administration, G & A, directors fees and professional fees are a real burden on a company with a portfolio of less than $100 million. They are relatively fixed expenses. As the portfolio grows, the burden of these expenses will lessen as a percentage of revenues and assets.
6) All BDC's, like mortgage REIT's, want more assets under management and more fees coming into the manager. With a large discount to NAV the sale of new shares is not an attractive option for raising funds. In order to increase earning assets, SAR has applied for SBIC funding and their application has been accepted. If they get an SBIC license, they will put $25 million of equity into the SBIC and borrow $50 million. SBIC interest rates are about 4%. It is a very attactive opportunity. SAR will have $15 million of cash from cash-on-hand and earnings, all earning nothing. It has availability on its line at 7.5% interest for the rest of the $25 million of equity. SAR should be able to loan the money out at 10% or better. Here is the economics.
Investment Earnings/Costs
$75,000,000 of loans @ 10% $7,500,000
Costs
$50,000,000 SCIC loan @ 4% $2,000,000
$10,000,000 Line loan @ 7.5% $750,000
Management fee @ 1.75% $1,312,500
Equity 0.00
Gross earnings $3,437,500
Income incentive fee $687,500
Net income to shareholders $2,750,000
Net per share $0.70
With earnings of $2.35 and a dividend $2.12, which is 90% of net income, SAR shares should trade near a 10% yield which equates to a price of $21.12 - an increase of 40%. Even at that price, SAR will still be trading at a 18% discount to NAV which at the end of this year should be, with the retention of this year's earnings, around $25.75.
Catalyst
There are several catalysts.
1) The resumpion of cash dividends
2) The granting of an SBIC license
Cons
1) The CLO blows up
2) The SBIC does not grant a license
3) The junk bond/loan market blows up