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How to Draw an Activist Investor

By Jordan Wathen - Jan 25, 2016 at 2:21PM

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Cheap business-development companies are becoming activist targets, but "cheap" alone isn't good enough.

What do American Capital (NASDAQ: ACAS), TICC Capital (NASDAQ: TICC), Fifth Street Finance (NASDAQ: FSC), and KCAP Financial (NASDAQ: KCAP) have in common?

They all make money financing buyouts, sure. But the main commonality is the involvement of an activist investor. Each and every company above has a thorn in its side -- an activist trying their best to help their beaten-down shares trade closer to book value.

The presence of an activist indicates these companies aren't just cheap (on average, they trade at just about 60% of book value vs. about 75% for their peers), but that they're cheap for a reason.

Discounts and activist interest have varied causes: bloated expenses (American Capital and the Fifth Street entities), complicated portfolios (KCAP Financial), or disinterested management teams (in the case of TICC).

Yet activists are finding something to love about each of these companies. When it comes to what's drawing activists to these stocks, valuation is part of it, but what they don't have may be just as important as what they do have. 

No activist repellent
For almost as long as there have been activist investors and corporate raiders, there have been poison pills designed to slow even the most benign outsiders.

A poison pill can be anything from a big payday for insiders in the event of a takeover, to shareholder rights plans and staggered board elections. It's a broad term that encompasses anything that is designed to make change from the outside more difficult.

Business-development companies are a little weird, and not all traditional poison pills are available to all BDCs. However, there is a big one -- a massive one, available to all BDCs -- that many investors overlook. That's whether a company has asked for, and received, approval to sell stock at virtually any price -- even prices that destroy the company's value.

By law, if a BDC reports having a book value of $10, it cannot easily issue new stock at any price under $10 without shareholder approval, which it must seek each and every year.

It's a good law, built on good intentions. (Imagine if a mutual fund you owned sold shares to new investors for $10, while claiming it was really worth $15 per share!)

When BDCs have the right to issue stock on any terms, they can dilute the voting power and economic value of each share -- and do it in such a way so that many shareholders will never notice. It's an issue that seemingly stops activists in their tracks.

Most are powerless...
Of 44 publicly traded BDCs, I found that a majority (25) did not ask for this right, or were denied the right, to issue stock below NAV at their most recent shareholder meeting. The minority (19) asked for, and received it. (Any management team that implies this vote is basic housekeeping isn't telling the whole truth.) 

Not surprisingly, the "activist" BDCs are all in the same camp -- they are all unable to issue new stock at low prices because they haven't asked for it, or couldn't round up a sufficient number of votes to approve it.

In one of the most amazing examples, KCAP Financial attracted an activist in October 2015, less than two months after shareholders broke a 3-year streak of authorizing share issuance at any price. Similarly, TICC Capital was put "in play" in the same year they stopped asking shareholders for more freedom on stock issuance.

The table below summarizes whether each BDC had the right to issue stock below its most recently reported book value in the last five years. 

 

2015

2014

2013

2012

2011

American Capital

No

No

No

No

No

Fifth Street Finance

No

No

No

No

No

TICC Capital

No

Yes

Yes

No

No

KCAP Financial

No (DENIED!)

Yes

Yes

Yes

No

Source: SEC filings. 

Taking a stand
I get it. I'm writing about a very obscure, and seemingly unimportant, governance matter. But the ability of a BDC to issue shares before NAV should be thesis-altering for most investors.

I've heard from a number of investors who view votes against below-NAV stock issuance as being a little too paranoid. "It's just a request to issue shares below NAV; it doesn't mean they'll actually do it," is a common refrain.

And while that may be true, it's my view that shareholders should instantly reject any such proposal. Giving a BDC the right to issue stock at low prices gives activists (and institutional investors, generally) the hint to look elsewhere for undervalued stocks. It also exposes investors to terrible agency problems, but that's another topic for another day.

The bottom line is this: If you need an ally in the trenches, it's helpful not to scare them away before they can help.

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