Winter may bring cold reception to TICC Capital (NASDAQ: TICC) and Apollo Investment Corp.'s (NASDAQ: AINV) calendar fourth-quarter earnings. Both have big stakes in collateralized loan obligations, or CLO equity. CLO equity translates into a 10-14 times leveraged bet on bank loans, making impairments to their investment portfolios appear likely.
You can think of a CLO as something that mimics the workings of a bank. The CLO invests in loans to businesses. Instead of deposits, a CLO raises money from investors in the form of senior and subordinated debt. Below that is the equity slice, which gets all the "scraps" after the senior and subordinated debt investors receive their returns.
Because the equity is last to be repaid, it's said to be the "first-loss" slice of the pie. Any defaults or slumps in loan prices hit the equity first, and the hardest. Another CLO equity investor describes the structure with the following chart in its filings.
Two major trends are working against CLO equity investors. The market is expecting more losses in CLO assets. Payments to CLO debt investors are going up. The net result is that CLO equity prices must come down.
Back to the bank example: If bank investors thought a bank would experience higher loan losses, and would have to pay higher rates to its depositors, the bank's equity would be worth less than before. Of course, a CLO, unlike a bank, doesn't have supplemental income sources like fee income from ATMs, service charges, or asset management arms to soften the blow of loan losses and smaller spreads.
Warnings have been plentiful. Bloomberg reports that JPMorgan saw CLO equity trading for as little as 58% of par value in December. Data service CreditFlux noted that Citi saw CLO equity trading for as little as 55% of par value in a Dec. 3 report.
TICC Capital has a lot at stake. Roughly 24% of its portfolio was invested in CLO equity in the third quarter of 2015 vs. about 6% for Apollo Investment. (Only a portion of Apollo's "structured products" are CLO equity; some are debt investments in CLOs, among other esoteric investments.)
If the two companies mark their CLO equity at an average of 55% of par value in the fourth calendar quarter, both would stand to see sizable impairments to their net asset values, or book values, on a per-share basis.
|
BDC |
Per-Share NAV at Sept. 30 |
Per-Share NAV If CLOs Were Marked at 55% of Par |
|---|---|---|
|
Apollo Investment |
$7.83 |
$7.46 (-5% change) |
|
TICC Capital |
$7.81 |
$7.34 (-6% change) |
Data source: NAVs from SEC filings. Adjusted NAVs calculated from data in SEC filings, with analysis by author.
TICC Capital is most exposed to further declines in CLO equity due to its leverage. It spent a good portion of its latest conference call -- from which analysts were barred from asking questions -- explaining that it intended to pay down debt. Its balance sheet was levered at a higher ratio than the 1:1 debt-to-equity ratio allowed for BDCs as of the end of the third calendar quarter.
In a real stress test scenario where CLO equity was marked down to 20% of par value, Apollo Investment's NAV per share would crumble by about 9% vs. about 34% for TICC Capital. Further declines in the asset class have real consequences for investors. As unlikely as this scenario may be, it shows how TICC's higher leverage works against it when the value of its investments fall.
All this is to say that the high-risk, high-reward vehicles that fueled double-digit dividend yields for much of the last few years are starting to show their ugly side. Capital losses could result in shrinking book values in the next quarterly report.
