Description

Upside Target: $13.50 (35%); Downside Risk: $8.00

TCAP is the cheapest BDC of scale, and it is even cheaper than it appears because NAV attributes no value to its internal manager.  While the low valuation is matched by a low-quality portfolio, management is solid and aligned with shareholders. The Board has initiated a strategic review, which we believe will result in a monetization of its internal manager at a valuation that is 20%+ of the current stock price. We believe this transaction—which we expect to be announced in the next few months—will serve as a catalyst to rerate shares.

Triangle Capital is one of the oldest business development companies (BDCs). Keys to its success have included: (1) low-cost internal management, (2) a focus on the lower middle market, (3) a focus on higher-yielding subordinated debt, (4) NAV accretion from gains in equity co-investments, and (5) NAV growth through accretive share issuances. This model generated a mid-teens return for nearly a decade. It enjoyed a good reputation, and it traded at one of the highest valuations of its peers.

 This model began to crack in late 2014 as credit losses began to overwhelm equity gains, though the overall loss level remained muted for several years—from 2014-16, net losses (realized + unrealized) averaged 250-300bps, while the consolidated, organic ROE over this period was a still-respectable 7.5%. In 2017, TCAP’s credit issues worsened substantially: Q2 2017 losses were on-par with the average annual losses of the 2014-16 period, and Q3 2017 losses were greater than the sum of the losses from the 2014-16 period.  In the quarter, management also announced a steep dividend cut, bringing the dividend to just half of what it was three years prior.

 Management attributes most of the credit issues to subordinated debt issued in the frothy 2014/15 market. They further attribute these bad credits to a mandate from prior management (former CEO Garland Tucker and former CIO Brent Burgess) to continue investing in LMM sub debt during this period, despite feedback from the investment team that subordinated debt no longer offered attractive risk-rewards. This explanation is consistent with where the problem credits are arising, and it also confirms suspicions of some infighting around the time of Tucker’s 2015 retirement and Burgess’s 2016 resignation.

 Orphaned & Forsaken

1.      Recent Dividend Cut & NAV Cut Led to Indiscriminate Selling—TCAP has long had a heavy retail shareholder base. We believe that the sharp November 2017 dividend cut has led to price-insensitive selling from these dividend-focused investors, and tax-loss selling near the end of the calendar year may also have contributed.

2.      Capitulation from Institutional Community—The sell-side has been supportive of TCAP, its low cost structure, its differentiated platform, and its strong track record. The Q3 report was followed by a number of downgrades. Frustration with management’s unwillingness to draw a line under NAV or initiate a stock buyback was clear on the conference call.

Low Valuation

3.      Low Absolute Valuation—the current price of $10.00 per share represents a 25% discount to NAV. The NAV discount has only been wider in early 2009. The new dividend yield is 12%, and it is covered.

4.      Low Relative Valuation—of the scale BDCs (BDCs with at least $1.0bn in assets), TCAP is the  cheapest by NAV, earnings yield, and dividend yield.

5.      Internal Manager is a Source of Hidden Value—unlike most BDCs, TCAP’s internal management allows it to have a lower cost structure, adding a couple of points to ROE. Moreover, that ~200bps ROE bonus can be capitalized to value the internal manager: a 10x multiple implies 20% of NAV—more than $2.50 per TCAP share. This 20% is corroborated by the recent sale of the management contracts of two other distressed BDCs: ARES paid 19% of PF NAV for ACAS in an uncompetitive 2016 auction, while OAK paid 27% of PF NAV for FSC/FSFR earlier this year. Therefore, in order to properly compare the NAV of TCAP to its externally managed peers, one must include the value of the internal manager, making the comparable NAV discount close to 40%.

Other Notes

6.      Alignment—because TCAP is internally managed, it does not have the same alignment issues that most BDCs have. Additionally, D&Os own over 4% of shares outstanding, meaning that they stand to gain $10m and monetize $25mn if they are able to realize a $15ps price. Furthermore, they modified their change-of-control terms in November, such that the 5 NEOs will receive an aggregate $10mn under a change-of-control (this was announced alongside their hiring of Houlihan Lokey to conduct a strategic review). Management is actively seeking a value-crystalizing transaction.

7.      Bidding for the BDC and Management Contract should be Robust—Five years ago, there were only two scale BDCs with major institutional sponsors; last year there were five; now there are eight. Major institutions are recognizing the value of BDCs, but also recognize the difficulty of growing them organically.  Bidding for the FSC/FSFR management contract earlier in 2017 was robust: 28 parties entered into confidentiality agreements and 16 submitted bids, of which 10 were for more than 20% of PF NAV under management (OAK ultimately paid ~27%). We believe there was a similar level of interest when HTGC made efforts to externalize its manager in May 2017.

8.      Transaction Costs—under the new change-of-control provisions, management would get ~$10mn cash. A 3% of fee on TCAP’s $500mn market cap would imply another $15mn. These two items sum to $25mn, or $0.50 per share.  This is less than two quarters’ dividends.

9.      Subordinated Debt Exposure—the biggest risk in TCAP is its heavy sub debt exposure: sub debt and equity account for 55% of the portfolio at fair value (compared to 90% three years ago). Management is working to address this issue by portfolio rotation, but they are also looking to accelerate the rotation through the strategic review.

10.   Lower Middle Market Exposure—the LMM focus of TCAP’s book could reduce the pool of bidders because: (a) the book will be harder for acquirers to underwrite; (b) the LMM pool is shallower; and (c) a lower middle market strategy does not scale as well as an upper middle market strategy. These issues are mitigated by: (a) the demand to manage a BDC is very high; (b) it should take under three years to rotate the portfolio, should the acquirer choose; and (c) the bidder with the lowest cost of capital—for whom acquiring TCAP would be massively accretive—also focuses in the LMM (MAIN).

11.   Marks—one point of debate in the market about TCAP is the reliability of their portfolio marks. The recent & rapid NAV deterioration has led some market participants to believe that the book in inflated. The evidence suggests otherwise:

a.      management’s reputation has historically been strong on portfolio marks;

b.     they use real third parties to provide valuation services (Lincoln International, Houlihan Lokey, E&Y, and Duff & Phelps);

c.      their marks on club deals are almost always more conservative than their partners’;

d.     PIK income was under 9% of TII in Q3 2017, down from 13%+ in 2016 and 15% historically; this is consistent with management’s narrative of writing down the problematic vintages and rotating the portfolio into higher-quality loans.

e.      Management and the Board knew they were putting the company up for sale when they signed off on the Q3 marks. It is hard to imagine that they would open their books for this process with glaring errors.

Scenario Analysis – How this Plays Out

A.    TCAP purchased by a “strong” BDC (e.g., TSLX)—we assume the bidder haircuts NAV by 15% and pays using the stock of its own BDC valued at a NAV premium, while the manager kicks in an additional 15% of PF NAV in cash. In this scenario, TCAP holders receive $11.20 in shares and $1.70 cash for ~$13ps total consideration. This transaction would be highly accretive for both the acquiring BDC and its manager; depending upon the acquirer’s NAV marks, a bid as high as $17 could still be accretive for all parties.

B.     TCAP purchased by a “solid” BDC (e.g., ARCC)—if the bidder has a strong sponsor, but not a strong BDC cost of capital, the bidder can afford less with its BDC “currency” (in practice, this can take the form of haircutting TCAP NAV more aggressively or by valuing its own currency at NAV rather than at market). Given the acquirer’s high cost of BDC capital, the manager should be willing to chip in more (it is unable to grow otherwise, and a successful deal could also set the stage for future growth). Therefore, we haircut TCAP NAV by 25% and have the manager chip in 20% of NAV in cash: $10 in shares and $2 in cash for ~$12ps total consideration. Such a bidder could make an economic bid as high as $14ps.

C.    TCAP manager externalized by a sponsor with no BDC (e.g., TCW)—we assume the bidder haircuts NAV by 15% and pays 20% of NAV to the BDC for the manager. Shareholders are then holding BDC shares with $13.50 in “kitchen-sinked” NAV, a brand-name external sponsor, low leverage (0.5x), and sub debt exposure under 25% (after the excess capital is deployed). We don’t expect this to trade at NAV, but the discount should collapse under 20%; a 15% NAV discount implies a $11.50 price.  It is plausible that the deep pool of bidders could lead to a PF NAV as high as $15, which would imply a $12.50 price at a 15% discount.

Catalyst

The company is sold or externalized within the next few months.