While risk seekers will appreciate Capitala Finance (NASDAQ:CPTA), the company shows large financial risk that we learned only by studying its portfolio of investments. I will provide due diligence on this matter in this new piece.
Incorporated in Maryland, Capitala Finance Corp. commenced operations on May 24, 2013 and completed an IPO on September 30, 2013. The company elected to be a business development company and is managed by Capitala Investment Advisors, LLC, which was created in 1998. It has assets of $2.7 billion.
What’s the business objective? Capitala Finance casts itself with the following words in its last 10-k:
“Our investment objective is to generate both current income and capital appreciation through debt and equity investments. We invest in first lien loans, second lien loans and subordinated loans, and, to a lesser extent, equity securities issued by lower middle-market companies and traditional middle-market companies.” Source: 10-k
Being more specific, the company acquires high yield debt and equity from companies that generate $4.5 – $30 million in trailing twelve month EBITDA. The following lines are quite a good first read about the portfolio of loans and equity of Capitala Finance:
Capitala Finance was formed for acquiring an investment portfolio from different entities, raising capital in the IPO and continuing and expanding the business. The following are the entities acquired right before the IPO:
CapitalSouth Partners Fund I Limited Partnership
CapitalSouth Partners Fund II Limited Partnership
CapitalSouth Partners Fund III, L.P.
CapitalSouth Partners Florida Sidecar Fund I, L.P.
Collectively with Fund I, Fund II, Fund III and Fund III Parent, and the “Legacy Funds.
The company raised $74.25 million, after deducting underwriting fees, through the sale of 4,000,000 shares of the company’s common stock.
Dividend Yield (TTM) is 12.03% – What are the risks?
Yield investors will be attracted by the large amount of money distributed by CPTA. It is quite attractive, but what are the risks involved? Let’s commence checking the balance sheet and the net assets audited in the last 10-K by Ernst & Young LLP.
On the asset side, as of December 31, 2017, the company shows $288 million in non-affiliate investments, $31.2 million in cash, and a total of $534 million in total assets.
Please note how the investments made in non-affiliate investments decreased by 26% from 2016. Additionally, the amount of money invested in affiliate and controlled entities increased approximately by 69% and 25% respectively. I dislike this fact because CPTA invests in non-public companies and the fund is in charge of assessing the value of the debt and equity positions. Read the following lines and note that the ultimate determination of the fair value is made by the board of directors:
With this in mind, who can tell us that controlled companies are not modifying the EBITDA to benefit CPTA? This is a serious risk that shareholders need to consider.
The company exhibited approximately $297 million in financial debt including SBA debentures, notes, convertible notes, and credit facilities. The total amount of liabilities was equal to $312 million. The net asset per share is $13.91, which is way above the stock price of $8.31. In my view, the market does not appreciate the portfolio of loans owned by CPTA.
Check the liabilities before we provide more information on the loan and equity owned by CPTA:
With the company having large amount of financial debt, the investors are not appreciating that CPTA is investing in first lien debt of entities with an average leverage ratio of 3.5x, and adjusted EBITDA of $21.4 million.
In my view, the risk of those entities is large, not only because they are small, but because their leverage is very high. With that in mind, the financial risk of CPTA shareholders is even higher as the company is investing on those entities using leverage as well.
Additionally, the company says in the prospectus that it invests, to a lesser extent, in equity securities. However, taking a look at the portfolio, the amount of equity and warrants in the portfolio is quite high, $122.6 million.
I could read in the most recent quarterly earnings call that the company is trying to reduce the amount in equity. Read the following comment:
“We’re still focused on rotating some of those equity at around 25% equity and the portfolio has too high of a concentration of equity for the BDC, we need to get that down much closer to 10 and we’re working hard to try to do that. And lastly we’re spending a lot of time you know, folks on the non-accruals and approving those underperforming loans.” Source: Q1, 04-06-18 Earnings Summary
Why is it very difficult to reduce the amount of stock and warrants? It is simple; the stock and warrants acquired cannot easily be sold because the company invests in private companies. This fact makes the portfolio even more risky.
How did the company get to have approximately 25% invested in equity? In my view, the company received large amount of stock and warrants as a result of restructuring processes. Cedar Electronics Holdings Corp. was a clear example of this type of deal:
“Subsequent to the quarter end, our investment in Cedar Electronics Holdings Corp. was restructured into a preferred equity position, thus removing it from non-accrual status.” Source: Q1, 04-06-18 Earnings Summary
Cedar Electronics was not able to pay its debt, so it negotiated a deal with CPTA, under which Cedar Electronics provided equity and warrants to CPTA.
What’s the problem with this equity and warrants? I see two major problems. First of all, equity and warrant holders may not receive payments like debt holders do. As a result, CPTA is not able to receive cash and may have to reduce the amount of dividends. Furthermore, it may be very difficult to determine the fair value of the equity and warrants since the companies are private.
How much is CPTA paying for its debt?
The company pays 3.71% for its SBA Debentures:
It also pays 7.13% for its 2021 Notes:
Additionally, 2022 Notes and 2022 Convertible Notes bear an interest equal to 6% and 5.75% respectively:
When will CPTA have to pay these obligations? The following table obtained from the 10-k shows that CPTA will need $257 million to repay its debt in 3-5 years:
With that in mind, now please have a look at the non-affiliated companies, in which CPTA invested. Remark that they will have to pay back in 2020-2023, exactly when CPTA needs to repay its debt. Additionally, note that the interest rate to be paid to CPTA is 10%-16.25%:
What’s my take on this information? In my opinion, CPTA may have difficulties in repaying to its note and convertible note holders from 2020. Given the size of CPTA’s debt and its cash in hand, if a few companies fail to pay back, bankruptcy could occur.
The management is brilliant – They know how to react
The management is led by talented and brilliant individuals. The CEO and Chairman, Joe Alala, III, went to Princeton University. The following is his Linkedin profile:
They know very well that the most important are note and convertible noteholders. If they don’t pay those lenders, the company will go to bankruptcy, and they will lose their jobs. With that in mind, if earnings commence to fail, the first thing to do is to decrease the amount of dividends:
Source: Seeking Alpha
Source: Seeking Alpha
Source: Seeking Alpha
In addition, they are now changing their lending strategy. Since Q2 2016, the company is moving away from risky loans and is investing in senior secured structures:
Source: Q1, 04-06-18 Earnings Summary
What’s my take on the dividend decrease? In my opinion, it should have been widely expected by the investment community. If you are lending at rates equal to 10%-16.25% and paying rates of 4%-10% to note holders, you should have problems in providing large dividends for a long time.
Will the company decrease dividends in the future? In my opinion, if the management wants to save money to repay its debt in 2020, it will have to keep money in 2018 and 2019. With $43 million in cash for operating activities in 2017, I don’t believe that giving $20-$30 million in dividends is sustainable:
With a dividend yield (TTM) of 12.03% rate, I believe that yield seekers will appreciate this name. Furthermore, the recent words of the CEO noting that they are now investing on more secure loans are also encouraging.
With that, I invite investors to study the company’s portfolio closely on their own. Be sure to understand that reducing the portfolio risk may not be that easy with a portfolio turnover of 16%-20%. Finally, try to follow the increase in average debt outstanding per common share. Every time the company increases its debt, the financial risk of shareholders picks up:
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.