Capitala Finance Corp’s (CPTA) is a business development company [BDC] that invests in illiquid debt of small companies. The Company’s dismal performance, as is also the case of many such BDCs, is caused by its intrinsically flawed structure and conflicts of interest (which I detail in a subsequent section). On August 24, 2020 CPTA executed a 1-for-6 reverse stock split meaning that current per-share numbers are six-times higher than if the stock had not reverse-split.
Capitala Finance Corp’s (CPTA) recent post-split-adjusted NAV is $38.76 (which equates to a $6.46 per share NAV pre-split) and its recent post-split market price is only $9.46. This is equivalent to a $1.58 price per original share.
CPTA is not just a victim of COVID-19, it is a victim of a flawed financial and governance structure. This picture tells the story: CPTA has been a train wreck since Day #1. Here is its market price from its inception adjusted for the 1-for-6 reverse stock split. Note the abysmal performance for the six years prior to the pandemic.
Some may argue that CPTA’s generous payouts are worth the capital losses. That has not been true. Here is the Company’s description of CPTA returns (the blue line showing a loss over the last five years) from Page 72 of its 2019 annual report:
The benchmarks are, admittedly, unrealistic. But the clear and important point is that the Fund admits that from 12/31/2014 to 12/31/2019 (i.e., pre-pandemic) the cumulative wealth index of CPTA has declined during a five -year period in which equity prices rose 50%. CPTA has lost money even with distributions included!
Here is my calculation of the total market return of CPTA (i.e., including both distributions and changes in its market price) including the pandemic:
(author’s presentation of “Adjusted Price” from Yahoo! Finance 10/17/2020)
The cumulative wealth graph also shows that CPTA broke about even in terms of since-inception total return up to March 2020. After the pandemic occurred CPTA fell to an 80% cumulative loss by October of 2020. This 80% loss takes into account the distributions but assumes that the dividends were reinvested in CPTA (which is inherent in most cumulative wealth indices). If the dividends were not reinvested the cumulative loss would be roughly 37% by my calculations.
Based on CPTA’s financial statements, the aggregated accounting numbers for the years 2013-2019 are as follows (according to my computations and shown in thousands of dollars):
|less management and incentive fees|
|less other expenses (gen and admin)|
|less realized and unrealized net capital gains and losses|
|Equals: Total 2013-2019 accounting performance of equity||Near Zero*|
*There was a $2,000 loss on extinguishment of debt not included.
The above table shows that the $360 million collected in interest revenues since-inception and prior to the pandemic were completely eaten up by expenses, fees and capital losses. Despite generating no profits, CPTA paid out large distributions to its shareholders. Why? there were seven years of no aggregate profit despite $360 million of interest revenue. Of course the losses this year (2020) will put the shareholders deeply into the red on an accounting basis over the eight years.
The key for long-term shareholders is this: your distributions were not profits – they were return of capital (economically speaking). Shareholders weren’t making money because CPTA was not making money. The total netted change in net assets resulting from operations from 2013-2017 was negative! The only way that CPTA could be said to be profitable (even before COVID) was to count interest income but ignore capital losses. But that makes no economic sense: the capital losses are real. CPTA was simply breaking even but making distributions of capital to shareholders. The long-term effect was to erode the equity value as shown in this graph of tangible book value per share:
The potential profits were going towards interest, fees and expenses. Distributions to shareholders depleted net assets:
The distributions came from one component of profits (net investment income) and ignored the offsetting realized and unrealized net capital losses. Shareholders received a total market return of roughly zero from 2013 to early 2020 – a period of incredible returns in stocks and bonds. The opportunity costs have been staggering. Obviously, in 2020 CPTA went into the deep red by all metrics.
What went wrong with CPTA?
Fees and conflicts of interest are a problem throughout the BDC sector. I have previously provided a primer on Seeking Alpha entitled: Business Development Companies: A Primer with Two Warnings. I urge you to read that document to understand the issues – especially management fees on gross assets (rather than netted assets) and bifurcated incentive fees – before reading more about the specifics of this case.
According to my computations, over the period 2013-2019, management collected over $61 million in management fees and over $16 million in incentive fees (available on pp. F-4, F-3 and F-4, respectively in the annual financial statements of 2013, 2016 and 2019).
Over $61 million in incentive fees? Yes, in a period in which a previous graph indicates that the fund’s tangible book value per share steadily dropped from over $120 to less than $60, management received incentive fees in every year! The explanation (bifurcated incentive fees) is detailed later in this article. CPTA, like many BDCs, can increase their managements fees by increasing leverage because the advisory fees are assessed based on gross assets (i.e., debt plus equity) rather than on net assets (equity).
In simple terms here’s the story. In the “good times” (leading up to the pandemic) the investment profits from CPTA’s assets were eaten up by expenses including financing expenses, management fees, incentive fees and the general and administrative fees. Shareholders may have thought that they were receiving distributions of profits, but (altogether) they were merely receiving back their capital.
When “bad times” came (i.e., the pandemic), debtholders and management continued to receive cash, while the “chickens came home to roost” for the shareholders. If misery loves company, CPTA shareholders can take solace in this: many BDCs are run the same way.
Total return can be viewed as emanating from two components:
Total Return = Distribution Yield + (Net Capital Gains or Losses)
Investors seeking high distributions were led into BDCs that were, in effect, paying the distributions from the shareholder’s equity, not just from profits. In fact, there really weren’t many profits. My computations indicate that from 2013 to 2019 the fund racked up $140 million in realized and unrealized capital losses against $138 million net investment income leaving a total loss of $2 million (including loss on debt extinguishment) going into 2020 (i.e., before COVID-19)!
The Source of BDCs Poor Performance
BDCs like CPTA often buy loans and other debt securities that have high coupons and high risk. The high coupons are passed through to the BDCs shareholders (minus, of course, massive interest expenses, fees and other expenses) who likely think they are receiving profits. They are not. The high risk investments have high default rates. The high default rates cause the NAV of the firm to drop. Leverage ramps up the effect.
Let’s examine the 10Q for 6/30/2020. As shown previously, huge expenses ate up the revenues for the years 2013-2019. Let’s look at the performance for the first six months of 2020 compared to the first six months of 2019:
Note that investment income plummeted from $24.3 million to $14.1 million while expenses have dropped only from $16.1 million to 14.7 $million and only because management fees and incentive fees declined (due to poor performance). CPTA’s loss from operations for the first half of 2019 ($29.3 million) widened to $39.3 million in 2020. The loss in the first half of 2020 is attributable to a $38.7 million net capital loss. Note that the $8.157 million “Net Investment Income (loss)” figure above is much less than the “operational loss”. That is because “Net investment income” ignores capital gains and losses – which can leave investors with an incomplete picture of the total net investment performance.
Why do BDCs Invest in Such Risky Loans?
Therein lies the rub. As detailed in my Seeking Alpha article on fees and conflicts of interest in the BDC sector (Business Development Companies: A Primer with Two Warnings) some BDCs use bifurcated incentive fee structures, and CPTA is one of them. Bifurcated fee structures give managers an incentive to use high leverage and to invest in very high coupon securities (with very high default rates). Here’s how the bifurcated fee structures work:
First, let’s review some simple economics of investing in debt: High grade bond funds receive modest interest income and little or no capital losses through defaults. However, bond funds taking large credit risks (i.e., buying high yield – aka junk – debt) receive enormous interest income and bear enormous capital losses (from the portion of the portfolio that defaults). There is nothing intrinsically wrong with this. There are no free lunches. It is a tradeoff: High coupons come with high default rates.
Bifurcated incentive fee structures give managers two ways to collect incentive fees on shareholder “profits”: high interest income and high capital gains. In other words, they receive one “call option” on interest income (more precisely “net investment income”) and one “call option” on capital gains (more precisely, net capital gains and losses in a particular time period).
A manager that buys safe bonds will likely receive no incentive fees because interest income will be low. But a manager with bifurcated incentive fees has an incentive to find the securities with enormous coupons (to generate incentive fees on net investment income) while likely knowing that there will be little chance of receiving incentive fees on net capital gains due to the inevitable default rates. In the case of CPT even prior to 2020 the since-inception capital losses were wiping out all income.
In a nutshell CPTA has a flawed governance structure with perverse incentives: use leverage, buy high coupon bonds despite their default potential, and make large distributions of net investment income to shareholders even if net capital losses are lowering net asset value.
The expenses are devastating to performance. Here is the company’s summary as it appears in the 2019 annual report for CPTA:
The 2% management fee is levered up to 4.79% based on equity. Think about the extent to which that monstrous fee provides a powerful incentive for management to entrench themselves, take on leverage and keep high distributions to entice shareholders to stay the course.
Total annual expenses, expressed as a percentage of net assets was a devastating 17.46% for 2019. How could any fund provide a reasonable risk-adjusted return to its equity holders with that annual drag?
The Three Strikes of Bad BDCs
Strike One: CPTA is incorporated in Maryland. As detailed in my article on BDC warnings (Business Development Companies: A Primer with Two Warnings), Maryland law protects its funds and, implicitly, allows fund shareholders to be fleeced. CPTA reveals their Maryland location of incorporation in their annual report.
Strike Two: CPTA has a staggered Board of Directors as indicated in their annual report which is honest enough to admit this:
“These provisions, as well as other provisions of our charter and bylaws, may delay, defer or prevent a transaction or a change in control that might otherwise be in the best interests of our stockholders.”
Strike Three: CPTA uses a bifurcated incentive fee structure. Their annual report does not use the word bifurcated, but it states this:
The incentive fee consists of the following two parts: …first part…net investment income… second part…realized capital gains, if any”.
The Only Hope for Shareholders
Many BDCs are set up from Day One to benefit management at the expense of shareholders. The only hope for shareholders who are captive to flawed structures is shareholder activism. I am a shareholder activist. To quote a great movie: “For the last ten years this company bled your money… Who cares? I’ll tell ya: Me. I’m not your best friend. I’m your only friend…”.
Some shareholder activists are correctly vilified. But, in my experience in the closed end fund and BDC space, most shareholder activists benefit existing shareholders and enhance the integrity and efficiency of our capital markets.
My analysis of CPTA indicates that shareholders should support shareholder activism when it is designed to impose a long-term solution to an inherently flawed structure. According to Closed-End Fund Advisors (“CEFA”) CPTA has an annual expense ratio of 24% and a discount from its NAV of 75%:
Financial reports estimate a reverse-split-adjusted net asset value of $38.76 – indicating that all has not been lost at CPTA despite its share price being under $10.
Shareholders originally invested in CPTA hoping that managers would exhibit talent in their investment decisions and reward their shareholders for providing capital and bearing risk. But CPTA has structure so flawed that there should have been labeled with a warning sign “Abandon all hope, ye who enter here”. Shareholder activism offers the possibility of extracting shareholder wealth from the grips of a flawed governance structure and allowing long-suffering shareholders to recover some of their investment.
But What if CPTA’s NAV is Overstated?
CPTA reports the following summary of information regarding its assets:
Note that all of the assets are described as “Level 3 assets” which the Company notes are “..based on inputs that are unobservable and significant to the overall fair value measurement” and
“Those estimated values do not necessarily represent the amounts that may be ultimately realized due to the occurrence of future circumstances that cannot be reasonably determined. Because of the inherent uncertainty of valuation, those estimated values may be materially higher or lower than the values that would have been used had a market for the securities existed. Accordingly, the degree of judgment exercised by the Company in determining fair value is greatest for securities categorized in Level 3. In certain cases, the inputs used to measure fair value may fall into different levels of the fair value hierarchy.”
CPTA’s Level 3 assets can be prudently liquidated near their reported values unless management is grossly overstating their worth. In either case (i.e., whether the assets are fairly valued or overstated) the solution is the same: Shareholders must take bold action and carefully analyze the arguments raised by activists and managers. In the case of CPTA there is no case for the status quo. Something must be done. The goal of activism should be to ensure that whatever value remains in CPTA is used to benefit all shareholders.
Activism can fail. Activism can be an uphill battle in which everyone loses. I do not know how successful activism at CPTA could be. But really, how much is left to lose? Some might argue that there is $9.46 to lose (i.e., CPTA’s recent share price). But if management is left unchecked I believe shareholders will never receive competitive long-term returns. There is much to be concerned about. Consider this from CPTA’s most recent annual report:
“Under Maryland General Corporation Law and our charter, our Board is authorized to classify and reclassify any authorized but unissued shares of stock into one or more classes of stock…Thus, our Board could….have the effect of delaying, deferring or preventing a transaction or a change in control that might involve a premium price for holders of our common stock or otherwise be in their best interest. The cost of any such reclassification would be borne by our common stockholders…The issuance of preferred shares convertible into shares of common stock may also reduce the net income and net asset value per share of our common stock upon conversion…These effects, among others, could have an adverse effect on your investment in our common stock.”
For disclosure purposes: I have had no contact with CPTA management and I am not part of any shareholder group. I have had a very small long position in CPTA for a short period.
Please contact me if you are a shareholder of CPTA ready to support change or if you are a concerned shareholder of another BDC or other firm in a similar situation.
CPTA was merely breaking even prior to COVID-19. Shareholder distributions were coming from the fund’s net asset value, not from net profits.
CPTA has a flawed governance structure with massive fees and perverse incentives.
CPTA shareholders best and, perhaps, only hope is shareholder activism.
Disclosure: I am/we are long CPTA. 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.