Solar Capital Ltd. (NASDAQ:SLRC) is an externally-managed BDC. The company invests in leveraged middle-market companies in the form of senior secured loans, mezzanine loans, and equity securities. Last time I looked at this vehicle is back in 2014 and I advocated caution due to five structural concerns. To be fair since that time SLRC beat the S&P 500 by a wide margin. On request I looked at this company again and, notwithstanding performance, I’m not dying to get in.

Data by YCharts

1) High management fees – The first time I looked at this the company charged more but the company is currently charging 1.75%/20% in management fees with hurdle rates and a high watermark. This has come down from my previous article. I think this will continue to weigh on the odds of an outside investor getting a good return. Obviously, the last years have been very rewarding. However, over a full cycle, this will be more difficult to achieve. Of course, a levered entity investing in risky loans will outperform as long as there is no recession. It’s the depth of the drawdowns (if not blow-ups) that ultimately determine the track record.

2) Leverage – The company decreased leverage somewhat since my previous article. But it has about a 33% debt to asset ratio. It also seeks out leveraged targets to invest in. At the same time, it does have a cash hoard of about $200 million which provides liquidity. However, there also are companies that can drawdown on loans.

3) Risk profile – SLRC primarily invests in leveraged loans, high yield or junk securities. It’s also concentrating in certain sectors like financial services, healthcare providers and pharmaceuticals.

In it’s latest Q2 press release it warns on markets and says it’s taking a defensive stance within its strategy:

“Given the frothy credit markets, Solar Capital continues to take a conservative investment approach with a focus on first lien senior secured transactions which now represent over 88% of our portfolio,” said Bruce Spohler, Co-CEO. “With our available capital to grow our portfolio, we believe Solar Capital is positioned for net investment income growth over the balance of 2019.”

4) Valuing the book – The company also has some leeway on what valuation it carries investments as exhibited by this exchange on the recent earnings call:

Chris York

And switching gears, I know I have talked about this investment with you before but American Telecom was written down this quarter and it’s still little bit above other BDC values that own it. So could you maybe explain to us what inputs drove the write-down in the quarter and then what other factors may explain your mark relative to other peers?

Bruce Spohler

Yes, I can’t address other people’s marks but I can say that we are — this is effectively a private investment while it is a large tranche, 600 million or so, it is — was clubbed together by a small group of investors holding the vast majority of it. So we don’t look to quotes for this one, because it trades by appointment if it trades at all.

And what I would say is that we are in close dialogue with our co-lenders as well as the management team and the sponsor to look at how to best capitalize the company going forward and we feel that these conversations have been very constructive and so the valuation reflects private information that we have.

The table below, from the 10-Q, shows the methods by which the company values its loans. Quite a number are valued not at the market but through an income approach. When odds of default rise – often reflected in market prices – this doesn’t necessarily show up in income. The end result is not necessarily different, but if you aren’t paying very close attention you can get blindsided by sudden steep losses during a recession/crisis. In reality, these losses had been building for a while but it only starts showing up when income is actually impaired:

Conclusion

Even with the company trading below book value, at 0.94x book, I don’t think this is a great investment. It’s not a given that the discount to book value will disappear. Investors are enjoying a large dividend but it has been going down and now around ~7%-8%.

I view this type of vehicle as a pretty risky proposition, especially in the current economic environment. I think odds of a recession within 12 months are somewhere in the 40%-60% ballpark (follow me as I plan to write more about that). That would be a real test for this structure.

Note that I’m not dogmatically opposed to taking credit risk now, although I’m tilting hard toward idiosyncratic risk taking, but if I want to add that risk I want to take it through a basket that I really love, at a discount with a stellar management team. Preferably even offset with a short opportunity in credit.

But I’ve been overly cautious since 2014 and perhaps I’m missing out on another five years of great returns.

Check out the Special Situation Investing report if you are interested in uncorrelated returns. We look at special situations like spin-offs, share repurchases, rights offerings and M&A. Ideas like this are especially interesting in the current late stages of the economic cycle.

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.

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2019-09-11