TICC Capital: Taking A Second Look

We’ve been worried about the sustainability of TICC Capital’s  (TICC) 15 cents a quarter dividend for several months.  The company is a Business Development Company (BDC) which mostly focuses on middle market technology lending, and whose most notable feature is having no debt and no bank line, a result of drastic de-leveraging at the very beginning of the Great Recession. Of course, during the intervening time the Company has announced a new distribution of 15 cents, earned 1 cent more in Net Investment Income in the fourth quarter of 2009 than in the prior period, and seen it’s stock price jump up to nearly $7, just 16% off NAV.  So we thought the issuance of the 10-K would be a good time to revisit our analysis of the Company. Please read on, but in brief: we came away with a warmer feeling about TICC’s 2010 prospects, but continue to question the ability of TICC to maintain earnings per share above $0.60 a year should more credit problems develop.

Let’s start by pointing out that the Company does not have a stellar credit underwriting record. In each of the last 3 years the Company has recognized major Realized Losses (notwithstanding a few Realized Gains) which have totaled ($32mn). That’s 10% of initial capital. Plus, another ($61mn ) in assets still on the books have been written down, which means that TICC’s assets at FMV are being carried at 77% of cost, and that’s despite the Company recirculating a substantial portion of its assets in the past year. We used to be a major proponent of the Company back in the go-go days but we lost our religion when the Company announced several bad debts back in 2007-2008. Of course all companies have problem credits. The issue with TICC is that, from an investor’s point of view, many of its loans went from performing to valueless very quickly.  On paper the Company was principally a senior secured lender but when troubles occurred at portfolio companies the underlying assets often had no or little value. TICC was taking risks more akin to an equity investor  than a lender and was not being recompensed appropriately.  NAV dropped by more than 50%, its lenders bailed, the Company scrambled (very effectively) to de-leverage and the dividend was repeatedly cut from a high point of 36 cents a share in the first quarter of 2008 to 15 cents today.

With all that said, management has done a creditable job in the post-meltdown period. Rather than running after onerous bank borrowing, the Company has remained un-leveraged, and focused on deploying the cash generated from a healthy turnover of assets into better quality, high paying yield assets (97% of the portfolio). Last quarter was the first one in the past eight quarters where Total Investment Income and Net Investment Income were above the preceding period. NAV is up from a year ago although the value of the assets at cost actually dropped in 2009 versus 2008, thanks to Unrealized Appreciation boosting the Fair Market Value of the loans on TICC’s books. Moreover, TICC has a relatively modest cost structure. The independent manager does receive 2% of assets managed but the “Incentive Fee” is earned only after the investors receive a hurdle return. In 2009, the Incentive was quite modest and may be again in 2010. Overall, total operating expenses amount to 2.7% of assets at cost and 34% of Investment Income.

Where we were worried in the past is about where TICC goes from here. The Company does not have much room for asset expansion. Yes, there is $24mn of cash on the balance sheet, equal to 12% of investment assets at FMV. However, with no line of credit management has made it clear on conference calls that only a minority of those funds are available for long term investing. TICC will probably keep $10mn-$15mn in cash at all times to be ready to face any unforeseen adversities, pay dividends and management fees and such. We don’t hold out much hope for drastic reversals of fortunes from its non-accruing loans, which could otherwise be a source of increased revenue. By our count there are 3 major “problem loans” with a cost basis of around $60mn.  Looking at the FMV trends on those loans in the last 2 years, there’s no reason to optimistic. At the end of 2008 the aggregate FMV of those 3 loans was $16.7mn. By the end of 2009, the aggregate value had dropped to $9.9mn.  Not a good sign, especially as the portfolio in general was going up in value.

The best hope in the short run is for TICC to turn its loan book over and increase its loan spreads.  If you ignore the non-accruing loans, TICC’s loan portfolio yields an OK 11.7% and could go higher. The Company (much to the confusion of some analysts on the latest Conference Call) has chosen to devote some of its resources to investing in the higher risk portions of existing CLOs selling at a discount. These investments may earn TICC north of 20% but the Company is unlikely to invest more than $15mn in this sector, with $7mn already booked during the IVQ of 2009.  The Company is not impressed by the spreads available in the syndicated loan market, which is getting overheated (already !).  That leaves direct middle market lending, which may or may not be a good idea.  We’re assuming that TICC will be able to grow its average yield throughout the year even if LIBOR rates remain at their current anemic level.  Yanking the average yield on the $200mn of existing yield assets  by 1% would earn TICC a projected 7 cents a year net-net. (We were not very excited to hear management is considering spending some of its capital on equity investments rather than 100% on yield investments. We understand the attraction, especially after TICC harvested $6mn on an equity investment this year, but this kind of income is lumpy for those of us who prefer steady dividend income).

Longer term TICC stands to gain if LIBOR rates start to appreciably increase. With 90% of its yield assets in floating instruments, and with no corresponding borrowing to pay for, TICC should benefit substantially from the long awaited higher interest rate period which most pundits are predicting for 2011 and thereafter.  As the 10-K points out a 1% increase in rates means $1.8mn in higher investment income, virtually all of which goes to the Net Investment Income line. That’s 6 cents a share a year, after accounting for higher Incentive Fees. A few cents here and there can make a difference for a Company whose annualized Net Investment Income (using the fourth quarter data) is just 52 cents a year. Should all go well, we estimate Net Investment Income could run $0.59 in 2010. Two analysts have a consensus of $0.61.  That would be just enough to cover the $0.60 dividend. Down the road (i.e. when rates rise) TICC could see even higher Net Investment Income Per Share. The analysts say $0.62 for 2011.  Our calculations, assuming a 200 basis points  increase in LIBOR, has the number even higher.

So what’s the problem ? As always it comes back to credit quality. Maybe we’ve entered a magic period like the one that existed in 2003-2006 when a rising tide lifted all boats and bad debts were virtually nil. Nonetheless, with a portfolio still replete with loans made in the go-go days, and facing up to the fact that TICC lends into a high risk sector, it’s hard to imagine that some more loans will not go on non-accrual.  Company by company credit information is not available so we just have to guess from whatever slivers of fact are available in the public filings. Currently we’re concerned about TICC’s investment in Box Services. The loan is still current but TICC has written down the senior loan from $12mn at cost  to $4.1mn at FMV. (A year ago the FMV was $10.5mn). Should that loan stop paying that’s ($1.1mn) in lower income or 4 cents a share per year.

If instead of being too specific we just assume that 10% of the performing yield assets which TICC owns go bad that would imply $20mn of loans currently paying interest would cease to do so. Quantifying that, there could still be 7 or 8 cents reduction in Net Investment Income coming from these additional bad debts to take into consideration. That lower income would offset some or all of the higher yields from portfolio reinvestment. The bottom line is that TICC’s earnings per share-barring anything drastic happening-should trade in a relatively narrow range a few cents above or below the current dividend rate.  At today’s stock price and using the $0.52 a year in Net Investment Income Per Share the Company is currently earning, TICC  seems expensive at a multiple of over 13x.  The yield is only 8.6%. However, if you believe the 2010 estimate advanced by the analysts of $0.61, TICC is a little less expensive at 11.4x.  Go one step further and believe that yields can be increased and NEW bad debts completely side stepped, our calculation pegs a pro-forma TICC earnings per share of $0.73 and a multiple under 10x. We’ve been burned before so we may be more cautious than most investors where TICC is concerned. However, the good news is that the absence of a lender to contend with limits some of the downside risk here.

Ares Capital (ARCC): Fourth Quarter 2009 Results Spot On

Ares Capital Corporation Declares First Quarter Dividend of $0.35 Per Share and Announces December 31, 2009 Financial Results – Yahoo! Finance.

Ares Capital (ARCC) announced its earnings for the fourth quarter of 2009, and declared a first quarter 2010 dividend. At first blush, and after listening to the Conference Call (see the Transcript on Seeking Alpha) the Company hit all its marks.  Earnings per share were up, assets increased, as did loan yields, borrowing costs remained low, credit quality was stable and liquidity remained impressive. Net Investment Income Per Share was up over a year ago, which only a few BDCs can claim so soon after the fading of the Great Recession. The Company announced a $0.35 a share dividend for the first quarter of 2010, unchanged from the fourth quarter.

Of course, a good performance was more important than usual for Ares given that it needs to impress both its own shareholders and those of Allied Capital (ALD). Just round the corner is the Wednesday March 3, 2010 joint conference call with Allied Capital’s managers, whose principal purpose is to convince everyone involved that the proposed merger makes sense.

Let’s review the highlights in greater detail:

1. Earnings : Helped by higher assets and higher yields (as ARCC emphasizes subordinated investments at the expense of senior debt)  Net Investment Income was up by 17%. This boosted Net Investment Income Per Share to $0.35 from $0.32 just a quarter before. When ARCC adds back one time expenses associated with the ALD acquisition, the earnings per share were $0.37 versus a dividend of $0.35,  or 106% coverage. Not bad.

2. Asset Growth. As mentioned on the Conference call, ARCC has been on a spending spree. The Company invested $344mn in the quarter, the most since 2007. Much of that spending (which continued in 2010) was aimed at buying key assets from Allied Capital, including its two asset management subsidiaries, which is going to give ARCC a major presence in the middle market lending business. Moreover, ARCC had a healthy backlog of deals likely to close in the next few weeks which should keep investment income growing.

3. Liquidity strong. Ares Capital boasted, and with good reason, about the excellent financing arranged during the quarter. The Company managed to arrange inexpensive financing, acceptable covenants and plenty of availability. Moreover, asset coverage (after deducting cash at year end) was still an OK 250% at December 31, 2009. With the new equity raised in February 2010, liquidity only looks better.

4. Credit Quality OK: It’s hard to cheer too much when a company recognizes ($46mn) of losses in a quarter, yet we’re satisfied with Ares credit underwriting by comparison with its peers and given the risks associated with the higher risk lending that they’re involved in. The Company sold off two investments for those losses. Still the remaining portfolio only has 5 companies out of 95 on non-accrual, amounting to only 2.9% of yield assets at year end. Looking at the big picture ARCC’s net Realized Losses on bad investments have eroded paid-in capital very modestly: just under 3%. With every BDC seemingly “cleansing” its portfolio, ARCC seems to be nearly there.

All the above notwithstanding, there are a few items to worry about (there’s always something). First, there is the dilution from the February 2010 equity offering. Nearly 23 million new shares all clamoring for a $1.4 a year dividend means ARCC has to come up with $32mn of incremental Net Investment Income to keep everyone paid the current dividend rate. We’ve done the numbers and we can convince ourselves that the new capital,when properly leveraged, will be accretive. However that might take a few quarters to show up in the results as the monies are deployed. This means Net Investment Income Per Share (without regard for the impact of the Allied deal) might go down before going up.  Will ARCC cut the dividend to meet its temporarily lower Net Investment Income Per Share ? We don’t think so, but it bears watching.

Second, Ares continues to generate a sixth of its income in the form on non-cash PIK income. That means ARCC’s dividend is essentially being partly paid out with cash or borrowings that would otherwise go to new investments, as $41mn (2009) accrues in non-cash form. Effectively (and I know this is controversial with managers) Ares will be paying out some portion of  its dividend in the next few quarters with the cash raised from the new stock issuance. It’s par for the course in the BDC industry but Ares ranks towards the top of PIKing companies. If everything goes to plan the high amount of PIK income will be irrelevant.  If many of the investments end up not paying off their PIK income today’s shareholders and management will benefit at the expense of tomorrow’s shareholders who will hold a bunch of “funny money” with no value.

Finally, note that Ares has a large unpaid incentive fee accrued which is going to have to be paid. To their credit, Ares has not paid out for six quarters in a row incentive fees which have been expensed, presumably in order to strengthen its balance sheet during a critical time. Sooner rather than later this accrual will have to be paid to the BDC’s manager: $58mn. To put that into perspective that is equal to 61% of all cash Net Investment Income earned in 2009. Or put another way that is nearly 60 cents a share, using the average number of shares in 2009. Like many BDCs, Ares Capital has high operating costs. Excluding interest, operating costs are equal to 3.7% of investment assets at cost.  When interest expense is included, only 55 cents of every dollar earned in investment income drops through to Net Investment Income. (We recently made a similar calculation for Pennant Park Investment Corporation, another BDC, and their drop- through percentage was 53%). The hits that Ares took on Realized Losses do not affect these fee calculations.

Fees: It’s a subject that nobody much wants to talk about but needs to be noted. Just using ARCC’s 2009 earnings, if we add back to Net Investment Income the Management Fee and Incentive Fees earned by the Company’s external manager of $63mn, we can see that two-thirds of net income earned  went to shareholders and one-third to the external manager. Remember that the management and incentive fees are seperate from the other costs of running the business: interest, administrative fees, professional fees etc. For shareholders who want income it’s the cost of doing business, but it’s no bargain especially as the external manager reaps fees on the incurrence of PIK income which the shareholders may not collect for years, if at all.

Overall, though, Ares’ results were encouraging and its prospects for modest earnings growth per share even in the absence of the much-discussed Allied Capital acquisition seem good. Of course, if and when the Allied Capital acquisition is thrown into the mix all these metrics will be scrambled. We are waiting expectantly for the conference call on Wednesday to get an idea what a new expanded Ares Capital will look like.

HTGC: Down But Not Out

Hercules Technology (HTGC) surprised us last week by announcing results below the prior quarter, and below our expectations. Worse, the Company cut its dividend by one-third from $0.30 to $0.20. Of course the stock price swooned, dropping over 15% at one point but ended 9% down. We’ve been a big fan of Hercules in recent quarters, impressed by its deft de-leveraging when Citibank and Deutsche Bank cut and run in the middle of the credit crunch, and by its ability to minimize bad debts in a sector which seems primed for regular disasters.  Just a few weeks ago the Company paid an extra dividend of 4 cents for 2009, after the regular $0.30 quarterly dividend for the period. Last year HTGC paid out a not-so shabby $1.26 in distributions. Recently the Company has been preparing its shareholders for growth by releasing announcements of the hire of a new COO, a new position at HTGC. As late as the last quarter’s earnings report, HTGC was announcing its intention to significantly expand its staff in anticipation of an increase in deal origination thanks to ample liquidity from cash on the balance sheet, unused SBIC capability and an under-utilized Revolver with Wells Fargo, as well as from fast re-circulating loan repayments.

So what happened ? In the fourth quarter of 2009 assets at cost dropped to $380mn, or 13%. Total Investment Income dropped 6%, Net Investment Income  9% and Net Investment Income Per Share 10% to $0.27 from $0.30. Moreover, HTGC recognized material Realized Losses on two  companies, writing off ($11.3mn), and was still left with $25mn in 5 non-accruing loans, up from 4 in the prior quarter. Even the very wide net interest margin which HTGC has benefited from narrowed from 13.68% to 12.82%.  All of this is at variance with the high hopes we had for the Company.  Nonetheless, we remain bullish about the Company.

Truth be told HTGC did warn in the IIIQ 2009 earnings report that they were still being cautious about spending their growing firepower of cash and borrowing capacity. Moreover, CEO Henriquez warned that the Company was continuing ” to focus our attention on resolving a handful of outstanding credit issues”.  After dodging the bad debt bullet all through 2008, HTGC has racked up over ($30mn) in Realized Losses in 2009.  That’s about 7.5% of paid-in capital-a metric we like to look at across the BDC space. Compared to other BDCs that’s not so bad, and $25mn in non-accruing loans is a still OK 7.7% of  its debt assets.

HTGC is being cautious and we’d argue that’s a good thing in this environment. Even this quarter the CEO , on the Conference Call, sounded ambivalent about the current year, even while providing statistics about the the huge backlog of prospective deals being reviewed by HTGC’s growing staff.We’d rather postpone some earnings for a few quarters than walk into a double dip recession, and this seems to be HTGC’s position too.

This conservatism applies to the dividend as well. We don’t want to talk out of both sides of our mouth. We tend to look suspiciously at BDCs which pay out a dividend way in excess of its earnings. HTGC, to its credit, is being very strict on this score and only paying out in distributions what it earns in Taxable Income. Sadly, Taxable Income this quarter was 6 cents a share behind Net Investment Income Per Share. (According to the Conference Call, OID income which is recognized as earnings in GAAP accounting is treated as a Realized Gain for tax purposes. That tax income was lost in the big Realized Losses for the quarter. )  Another BDC might have maintained the dividend at the IIIQ 2009 level of $0.30 and assumed they’d make up the difference the next time round. Certainly HTGC has the cash to fund a dividend shortfall, but they chose to live within their current means. We believe that’s commendable from a shareholder’s perspective but will make the stock more volatile than others.

The key question now, though, is whether HTGC can bounce back, and if so when ? On the Conference Call the CEO indicated that the Company already has $50mn in signed Term Sheets for new deals (a few months ago HTGC was doing no new deals), and $160mn under “active negotiation”. Then there is always the funding of existing companies, offset by the heavy repayments which are common for this company.  Nonetheless, we were being guided by management on the Conference call to recognize that assets might not grow until the second quarter of 2010. The Company both sees good opportunities in the early stage and middle market segments, and speaks of hedge fund competitors dropping away or liquidating. At the same time, spreads on good loans are narrowing as some lenders stay price competitive on the best credits.  If the economy, and especially the life sciences segment, recovers as expected we can expect to see HTGC grows its assets back up. How much ? We’d guess that total assets could get to $500mn at cost , a 31% increase in a few quarters. That’s $120mn in net new assets.

That will probably be partly funded by  already committed SBIC long term debt and the cash on the balance sheet. Our back of the envelope calculation suggests that if HTGC uses $100mn of its $125mn in cash, and borrows the rest, $13mn or more could drop to the Net Investment Income line on an annual basis or $3.25mn a quarter. That’s over 9 cents a share and would get HTGC close to the recent $0.30 level in earnings and dividend without straining leverage (debt to equity as of 12/31/2009 would be only 0.4:1.0), and with plenty of room to grow further with $75mn in extra SBIC monies on their way, and $70mn in Revolver debt and $25mn in cash. Then there are the equity gains to be harvested from portfolio companies.

The wild card here is bad debt. We don’t really know if HTGC ‘s debt troubles have peaked or are on their way up. Does anyone ?  If non accruals continue to climb, the benefit from higher asset formation will be mitigated. Worse: if HTGC holds back on adding new loans because of a concern about the fundamental health of the economy, we’ll see more Net Investment Income Per Share erosion and we could see the distribution drop again. To quantify all that: if non-accruals double HTGC could forseably see its dividend drop another 2 cents, or 10%.   Obviously the Company could cut expenses if things go awry and offset some of the increased losses. The CEO has already suggested as much on the Conference Call, notwithstanding all the talk about growing the staff.

HTGC is at an inflection point. Success is not guaranteed, nor is failure and the environment is very uncertain. We are betting that bad debts have peaked, Realized Losses will be non-material and that assets and earnings will grow substantially over the next 4-6 quarters. If we’re right HTGC will meet or exceed the Investment Income of $0.30 a share achieved in the third quarter of 2009. An annual dividend of $1.20 will give a yield of 13.0% on today’s price of $9.22. That’s a reasonable return in our minds for a BDC.

We’re also reassured that should the economy sour HTGC has the protection of a slimmed down balance sheet, no net debt (borrowings less cash), access to SBIC monies (as much as $95mn in incremental monies) and an activist approach to working out whatever troubled loans comes its way. In a worst case we can foresee lower earnings, but no disaster.  All of us are grappling with what we learned from the Great Recession. One of the main lessons we felt we’ve learned is that avoiding disasters such as American Capital (ACAS) is more important than any other factor, and the key is having adequate liquidity under all possible market conditions. This is known as the “live to fight another day” approach. We feel HTGC, with its conservative, even skeptical approach to the market, is one of the safer bets in this industry despite this week’s dividend cut.

Fifth Street Finance (FSC): On Track

Fifth Street Finance Corp. Announces Quarter Ended December 31, 2009 Financial Results – Yahoo! Finance.

No great surprise in Fifth Street Finance’s (FSC) results for the quarter ended December 2009. As expected, Net Investment Income Per Share (NIIPS) dropped from $0.26 to $0.22, thanks to the dilution from the Company’s extra shares: up 24% on average shares outstanding. Yes, the earnings per share are 8 cents below the recently announced 30 cents a quarter dividend, but FSC has plenty of dry powder to spend to bring the two metrics back in sync before long.

FSC has been adding assets at a rapid clip: $138mn in just the last 3 months. The momentum should continue in the months ahead. We calculate that the Company only needs to add that many more assets in the next quarter to bring earnings in line with the dividend. (Of course that doesn’t take into account the new equity raised just a few weeks ago). FSC has $150mn in SBIC money to spend, $11mn in cash, undrawn amounts on its Revolver and another line of credit being negotiated. Plus the new equity monies: nearly $80mn.

Thankfully credit quality remains OK. The Company still has 2 non-accruing loans, but 9 loans in total in distress. That’s unchanged from the prior quarter. Unlike what we’ve seen with some other BDCs there’s been no Realized Loss cleansing of under-performing loans this quarter. We’ll get more color from the Conference Call.

Anyway, the perennial questions for us is whether the dividend is :

A. Paying a fair return ?

B. Is Safe ?

The answer to both questions seems to be in the affirmative. At Tuesday’s close FSC was trading at $10.6, and the annualized dividend was $1.20 for a yield of 11.3%. That’s higher than the 10.6% return when we last wrote about this stock in mid January 2010. The stock price is 12% below its 52 week high. Moreover, management is hinting that FSC will continue to increase thje dividend in 2010. Even at the current NIIPS, FSC is trading at a reasonable enough 12x multiple.

As for the dividend’s sustainability, we look to the guidance we’re getting from management. It’s worth noting, though, that in the past FSC has surprised its shareholders by suddenly cutting its dividend even when in a growth mode. That was just a year ago. We’re guessing the available capital and the more favorable economic environment will ensure we don’t get fooled again, to quote The Who.

Fifth Street Finance (FSC) Previews Results And Raises New Equity

Fifth Street Finance Corp. Issues Preliminary Estimate of Net Investment Income and Announces Term Sheet for an Additional Credit Line – Yahoo! Finance.

In a pattern we’ve noticed before Fifth Street Finance (FSC) provided a preview of fourth quarter earnings, NAV and bad debt (all pretty good), then announced a major stock offering.

FSC suggested Net Investment Income Per Share would come in at between $0.21-$0.24 per share, down from $0.26 last quarter but expected due to an earlier dilutive stock offering in September.  That’s still below the recently upped dividend of $0.30, suggesting that FSC is adopting the strategy of growing assets and earnings to catch up with its pay-out over time.

The NAV is projected to be essentially unchanged, which means the stock (which closed at $11.7)  is being sold at a premium to NAV. The market is clearly supportive, especially as FSC is proposing to sell 8 million shares to go with 50 million already outstanding.

FSC suggests bad debt is limited to non-accruing loans at 2 companies, unchanged from the last reporting period. Or in other words: we don’t have credit surprises likely to jump out when the official results are announced.

Finally, FSC announced (very preliminarily) that another lender has been lined up with a $100mn Revolver, which will (presumably) be added to its 3 year facility with Wachovia.

Our initial conclusions are as follows:

1. FSC’s balance sheet looks rock solid at the moment. With the new equity offering the Company has over half a billion in equity, and a maximum borrowing capacity of $250mn. All the debt is either SBIC or 3 year money, so there is reduced Liquidity risk from mismatching loan assets and debt borrowings.  This is no small matter. If we do face a double dip recession under-leveraged BDCs with available capital will be the best port in the storm.

2. Earnings per share will drop in the fiscal first quarter (calendar fourth quarter) and in the following quarter thanks to these dilutions. Presumably,though, management will hold to the $0.30 a quarter dividend until assets are deployed and earnings increase. The current yield is about 10.2%, which is OK.

3. We’re a little puzzled why FSC is accumulating so much cash and fire power at a time when good loan opportunities are still muted. Could an acquisition be in the cross hairs ? Or is it just a matter of grabbing the money when it’s available ?

4. A few days ago we calculated FSC could ramp up its assets to over $600mn. After this last round of capital raising and new Revolver, FSC could top out well over $750mn in assets, and aim at $1bn. That would take it into the higher echelons of the BDC industry just a couple of years after their initial IPO. Does management have the right set of skills and systems to maintain adequate credit quality with so much money to spend. With such a short history it’s impossible to tell.

Ares Capital (ARCC) : Preview of Bad Debt Outlook

As part of convincing the Street that the company can absorb the acquisition of Allied Capital, Ares Capital (ARCC) issued a brief preview of certain key results. We were most interested in what Ares Capital’s bad debt results might look like. Here’s why: After GSC Investments reported far worse than expected bad debts in the quarter to August, we’ve been on tenterhooks about just how widespread credit problems might look like. Many BDCs earnings per share ( as defined as Net Investment Income Per Share) are already under pressure because of the combined impact of the dilution from new equity offerings and slow new investment activity. In some cases BDCs are paying higher financing costs, which is also eroding earnings. A big jump in bad debt would be a kick in the teeth to any BDC, and might result in dividends being cut just after the level appears to have stabilized.

By the way, Fifth Street Finance (FSC) also gave us a preview on its bad debt situation. In their October 2009 newsletter, FSC reported that there were 2 companies on non-accrual, unchanged from the prior period. We heard anecdotal information from FSC which was intended to be encouraging: “Surprisingly, we are seeing some strength in our consumer-exposed companies, and since they were the hardest hit last year, we are excited about the potential for a strong rebound”. We were also told the following about a portfolio company on the Company’s Watch List: ” We continue to evaluate and restructure underperforming (rated 3, 4 or 5) securities within our portfolio. Lighting by Gregory, which is in this basket and of which we own 95%, had its best month since September of 2008. The company now has accumulated enough cash on its books that no further funding from us is anticipated”.

So FSC is looking OK (which is a very good thing in today’s environment of lower expectations). However, FSC’s portfolio is quite dissimilar from Ares and GSC Investments. FSC is focused on lower middle market buy-outs. The other two BDCs are more engaged in the upper middle market arena.

Anyway, Ares Capital’s bad debt insight was encouraging. We’ll just quote from the press release:

Ares Capital also estimates that its loans on non-accrual declined from 6.2% of the portfolio at cost and 2.1% at fair value as of June 30, 2009 to 5.3% at cost and 1.7% at fair value as of September 30, 2009. There were no new loans placed on non-accrual as of September 30, 2009.

That leaves us 17 companies to report, but the score so far seems to be 2 BDCs with bad debt under control, and 1 with serious problems. There’s a long way to go.