Medley Capital BDC and the high fees and dilution.

Medley Capital BDC has filed its latest N-2/A detailing plans to sell 13.3 million shares at $15.00/share. The initial portfolio will be contributed by some of the managers private funds, who will exchange loan assets for shares in the new BDC. This is similar to what THL capital did for its IPO. However unlike THL Credit (TCRD) Medley's fee structure is much more favorable to the manager, being (2% gross assets + 20% xs of quarterly 8% hurdle with a catchup). Unlike THL there is no total return requirement, nor any exception on paying an incentive fee for non-cash PIK interest.

The most worrysome aspect of Medley Capital's offering statement is that the company intends to pay 50% of the management incentive fee in shares of stock issued at the then current market price. This could lead to incredible dilution if the company manages to have decent earnings while trading below NAV. Constant issuance of new shares may also become a drag on total returns because of insidious dilution.

Subject to receipt of exemptive relief, we have agreed pursuant to the investment management agreement with our adviser to pay 50% of the net after-tax incentive fee in the form of shares of our stock at the then current market price, which may be below our NAV; this may affect the market price of our stock and may result in dilution to existing stockholders.

As we describe under “The Adviser”, pursuant to the investment management agreement with our adviser, subject to receipt of exemptive relief from the SEC, we have agreed to pay 50% of the net after-tax incentive fee in the form of shares of our stock at their then current market price. This may result in the issuance of shares to our adviser at a price that is below our then current NAV (if our market price is below our NAV on the issuance date of the shares). Any issuances below NAV may have a negative effect on our stock price. In addition, the interests of existing stockholders may be diluted. The extent of the dilution that may be incurred is not calculable.

The 1940 Act prohibits us from selling shares of our common stock at a price below the current NAV of such stock, with certain exceptions. One such exception would permit us to sell or otherwise issue shares of our common stock during the next year at a price below our then current NAV if our stockholders approve such a sale and our directors make certain determinations. At our next annual shareholders’ meeting, we will seek approval to continue this arrangement.

THL Credit and Horizon Technology Finance putting out new N-2's

THL Credit

THL Credit has uploaded its second revised form N-2/A with a bunch of changes that make it non-comparable to previous filings. Most notably the management fee structure has changed from being (1.5% Base + 15% xs of 8% with a catch up) calculated quarterly with no cap, to being 1.5% + 20% xs of 8% with a catch up, but also being subject to cumulative total return hurdle. Most importantly under the new scheme, PIK (paid in kind) interest is excluded from the calculation of the incentive fee.

In addition, THL Credit Advisors will not be paid the pro-rata portion of such incentive fee that is attributable to deferred interest (sometimes referred to as payment-in-kind interest, or PIK, or original issue discount, or OID) until we actually receive such interest in cash

Very notable and hopefully this is the start of new trend in externally managed BDC's, which shows an attempt to reduce the incentive for management to be focus on maximising quarterly results, rather than long term results. It never made sense to me that management would be paid an incentive fee for "earning" PIK interest. The rest of the changes to the N-2/A relate to pre-IPO schedule for the roll up of the existing THL Credit fund into the new public BDC.

Horizon Technology Finance Corporation

Horizon Technology Finance Corporation has filed a prospectus describing a new BDC that intends to "invest in development-stage companies in the technology, life science, healthcare information and services, and cleantech industries." My initial impression is that this will be an high cost externally managed version of Hercules Technology Growth Capital. The management fee is 2/20 with a catch-up on a 7% hurdle rate measured quarterly.

Weekend/Weekly Update on new REITs and IPOs

This and last week saw several IPO's/secondary offerings.

Terreno Realty

Terreno Realty IPO'd with a reduced offering of 8.75 Million shares at $20/sh. I'm not sure how much of the reduction from the original plan was due to general hostility to IPO's vs the specific business that Terreno wanted to persue. On paper, iwning property at a 9% cap rate with 40% leverage won'tgenerate the mid teens IRR's that folks are looking for these days. At the same time, the industrial REITs (especially the big ones like AMB) tend to trade a premium market multiple. So a fully invested TRNO could generate an impressive IRR from multiple expansion vs high cash dividend payouts.

Solar Capital

Solar Capital, a BDC entered the public markets with an offering of 5 million shares at 18.50/sh. This BDC is run by ex-Apollo/AINV folks, which makes it similar to PennantPark Investment Corporation (PNNT). This was a classic take under type IPO in which a company goes public at less than book value. The main purpose of the IPO was to create lqiuidty and stabilize the companies credit facility. The big question with Solar Capital is does the market need another BDC with a 2/20 management fee structure.

Piedmont Office Realty Trust

Piedmont Office Realty Trust, is finally public after years of pre-IPO drama, when it was known as Wells Real Estate Investment Trust. Like most non-traded REITs, Wells REIT became a cancerous monster, endlessly raising capital and buying new assets. After the company internalized management in 2007 it entered a multi-year dead zone while seeking a final liquidity event. During this time, the Lex-Win partnership of LXP + FUR launched a hostile tender offer, to shake things up and accelerate the "liquidity event". That event finally happened on Feb. 9, 2010 with the offering of 12 million shares at 14.50/sh, which was far below NAV. After the IPO, shares have floated upwards towards NAV (>16.50/sh) and if PDM's earnings power was given the same multiple as comparable REITs (BXP, DEI, SLD, CLI) the stock price would be much higher.

Hudson Pacific Properties

Hudson Pacific Properties, has filed an S-11, describing a new REIT intended to be "a full-service, vertically integrated real estate company focused on owning, operating and acquiring high-quality office properties in select growth markets primarily in Northern and Southern California." Senior managenment are ex-Arden Realty folks. Arden was the first of the really big public-to-private transactions when it sold for 4.8 Billion to GE Real Estate. The new REIT is born in the context of formation transactions which involve various funds and people assocated with Farallon Capital Management and Morgan Stanley.

Why no BDCs?

One thing that is odd in the rush to file S-11's for new REITs, is the lack of filings of N-2's for new business development companies. So far just three have filed during this landrush to the SEC. The public markets have lost two BDC's (ALD and PCAP) to mergers, along with relatively little capital raising from secondary offerings. This doesn't make sense since the credit conditions in the middle market C&I lending are constrained and profitable.

1. Trian Capital Corp
2. THL Credit
3. Golub Capital BDC

The Trian and THL offerings are boring 2/20-catch up jobs. The Golub offering is interesting, because Golub Capital had previously filed to create Golub Capital Partners LLC. This would have a been an LLC type vehicle similar to Compass Diversified Trust (CODI) in that it was structured as an LLC instead of as an investment company. Golub capital gets credit in my book for having funny advertising. Not often do we get to see the world through the gold colored glasses of a mezzanine lender.

The N-2 for Golub Capital BDC gets an award for the most byzantine management fee arrangement I've ever seen. I'm honestly not sure I even understand it, but it appears to be a traditional 20%+catch incentive fee over an 8% hurdle combined with a moving cumulative total return high water mark based on the relative differences of two different calculations of net investment income and total return. It's honestly not worth figuring out. Hopefully they simplify this fee structure in an N-2/A. Make it a straight 1.25% assets + 20% excess of an 8% hurdle on a four quarter rolling average, and they should be all set.

Financial LLC's (like the original Golub Capital Partners) have been an unpopular form of investment because they are flow through entities which issue K-1 forms instead of 1099-DIVs. An investor in such a entity gets to report his/her allocable share of taxable income which may not be matched by actual cash distributions.

The investor base is limited because tax exempt investors (including mutual funds) cannot jeopardize their status with the Unrealted Business Taxable Income (UBTI) that publicly traded LLC's/LP give off. Unlike traditional natural resource/hard asset MLP's, financial MLPs tend to generate almost no deductions which have the effect of shielding cash dividends from taxation.

This attained ultimate silliness in the S-11's for Michael Vranos's Ellington financial, which was planning to invest in subprime mortgages and related assets. The offering memorandum disclosed that Ellington intended to distribute only 50% of its taxable income each year; resulting in an absurdly high effective tax rate since the IRS would asking shareholders to pay 35% on 100% of the companies taxable income. The effective tax rate on cash distributions would be 70%. So you had a proposed IPO in which institutional investors were both unable to, and too smart to invest in.