We're right in the middle of earnings season for the business development company industry, and there is a lot to talk about.
From Oaktree Capital Group's (OAK) plan to take over the Fifth Street Asset Management (NASDAQ: FSAM) BDCs, to Solar Capital Ltd's (SLRC 0.47%) new leasing arm, and Hercules Capital's (HTGC 0.50%) plan to shuffle shareholder's money into management's pockets, here are a few things investors should be watching carefully.
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Oaktree's plan for Fifth Street
Oaktree Capital Group is in the process of acquiring management contracts from Fifth Street Asset Management that will make it the new manager of Fifth Street Finance and Fifth Street Senior Floating Rate. On Oaktree Capital's recent conference call, Oaktree CEO Jay Wintrob explained that he thinks these two BDCs can be platforms for future acquisition activity in the BDC industry.
I think it will be mildly accretive initially, but I think most importantly, if we do a good job stabilizing and repositioning that portfolio, improving those stock prices to be at or above NAV, that will open the door for us to a lot of additional opportunities be it for growing those BDCs, for other BDC M&A activity, or frankly just for driving more loan origination into Oaktree generally and allocating those to the appropriate pools of capital.
This is amusing long-term commentary from an alternative asset manager that is just now getting into the BDC game. So much has to happen for the Fifth Street BDCs to become platforms for mergers and acquisitions, but most importantly, these BDCs would have to trade up to net asset value, or book value, before they have any hope of being an acquirer.
Image source: Author.
I don't know about Oaktree's ambition. It is a good alternatives manager. But the fees Oaktree will levy on Fifth Street Finance and Fifth Street Floating Rate are so high that Oaktree would have to be really special for the BDCs to get a valuation above book value.
Clayton Kershaw may be the best pitcher in Major League Baseball, but if you're playing Moneyball-style, you might recognize that his salary correctly prices him as the best in the league. That's how I see Oaktree as a BDC manager: good, but at a price that reflects its abilities.
Oaktree will need approval from the SEC to allow its new BDCs to invest alongside its other managed funds. That will give us some insight into what assets it plans to put in the publicly traded BDCs.
Solar Capital as a community banker
In tandem with its earnings release for the second quarter, Solar Capital announced it acquired a commercial leasing and lending company by the name of Nations Equipment Finance (NEF).
The acquisition checks off a few "good" boxes -- GE Capital alum, increased earnings for Solar, compelling yields from small loans that are secured by hard assets. (Pro-tip: Always mention GE Capital alum in a press release about a financial acquisition in BDC land.)
Solar Capital CEO Michael Gross summed up NEF's business succinctly on its earnings call:
It's trucks and trailers. It is yellow metal. It's a transportation equipment. If some aircraft, it's highly diversified given the $2.3 million average investment, but yes, it's heavy equipment.
You can see some of its recent transactions on its website.
Of course, there are some negatives, most importantly how this acquisition fits within the Solar Capital fee structure of 2% of assets plus 20% of returns. I'm not aware of any commercial bankers who earn 2-and-20 compensation on equity capital put to work in otherwise pretty plain-vanilla asset-backed leases and loans, but that's exactly what's happening here. Solar Capital put yet another big spotlight on its above-average management and incentive fee burden with this acquisition.
Image source: Author.
Nations Equipment Finance uses securitizations to leverage its portfolio by as much as eight times its equity on day one. That works well when leases perform, but it magnifies the losses when they don't. As a reminder, Solar Capital's fee agreement doesn't exclude capital losses in its calculation for incentive fees.
As it stands, a levered financial company is a "heads management wins, tails shareholders lose" kind of asset. As with any small-dollar lender or lessor, the financial losses aren't constrained to charge-offs alone. Collection can be costly as a percentage of the loan or lease value, thus underperforming assets tend to come with a lot of additional legal and administrative expenses that further drag down returns. (Financial investors often make a mistake by looking at loan or lease losses in isolation, and don't spend enough time thinking about how losses affect other expenses. The smaller the loan or lease, the greater the impact loan losses have on operating expenses.)
Hercules Capital isn't giving up on externalization plans
The management team at Hercules Capital isn't giving up on its plans to externalize its management team for the primary benefit of insiders at the cost of shareholders. Its CEO, Manuel Henriquez, has championed the benefits of internally managed BDCs ever since Hercules went public as Hercules Technology Growth Capital, but now he wants you to forget about all that.
It's my view that Hercules is going to find a way to externalize the management team, which is why the stock dropped after an otherwise good earnings report. Here's a snippet from the prepared remarks on the company's recent conference call about the externalization process:
We expect this process will continue until late Q3 or mid Q4, which time the respective advisors will present their findings to the Company and the Board of Directors. It would be inappropriate and premature for me to comment any further on that process until the Board of Directors has concluded its own process that evaluation.
Of course, Henriquez, never one to pass on the opportunity for a discussion on Hercules' long-run plans, did say more about externalization plans when prompted by an analyst:
I think I've spoken about this many times in the past. The ability to complement an asset based lending transaction that may price somewhere neighborhood of 7%-6.5%, 7.5% yield. I don't think we should be doing that out of the existing fund today, if you will, because it lowers our overall yield and consumes that much more capital.
Don't be fooled. Main Street Capital is a model for how a BDC can tack on an asset management arm. Many BDCs also use senior loan funds that employ off-balance-sheet leverage for the express purpose of making 6% to 8% yielding securities more attractive from a yield standpoint. (See the aforementioned Solar Capital, which loves to use off-balance-sheet leverage, as just one example.)
This is about getting paid, nothing else. Hence why the stock drops every time the subject comes up. It's good for the managers, bad for the owners. Can you identify the two times externalization plans were talked about on the chart below?
I guess I can't blame Henriquez for wanting to carve out an asset manager for himself. I mean, if Fifth Street could sell the management contracts to its poorly performing BDCs for $320 million, one can only imagine what the fee agreement to a top-performing BDC with real deal-sourcing abilities might be worth.
That said, given the conflicts of interest that externally managed BDCs face, it's difficult to spin this externalization plan as a positive for Hercules Capital shareholders.
