BDC Update: Logan Ridge Finance
March 31, 2023
For a long time, Logan Ridge Finance (LRFC) - one of the smallest public BDCs - has been an outlier in our coverage. The BDC - which used to be Capitala managed and branded - did not pay a distribution. Given that the greater part of BDC returns over time come from distributions received - which is arguably the very point of the industry - this was a problem. Even today, we value LRFC - as we'll discuss - more on a balance sheet than an earnings basis.
Of late, though, the situation has been getting better. Although in the full year s2021 and 2022, LRFC lost money on a recurring income basis ( i.e. Net Investment Income Per Share). However, in the IVQ 2022 management proudly "Reported positive Net Investment Income (“NII”) of $0.6 million or $0.23 per share, which marks the Company’s second consecutive quarter of positive NII". Even more to the point, LRFC began 2023 with a first-quarter dividend of $0.18 - presumably the first of many.
Promises To Keep
Better Than Losses
The only analyst who follows the BDC - going by Yahoo Finance - projects 2023 and 2024 NIIPS will both come to $0.75. That's a modest profit which represents a return on equity of just over 2% but a great improvement from quarter after quarter of operating losses and no payouts.
Frankly, as you'll have seen in the Expected Return Table if you happened to look any time since we launched, we didn't expect any sort of regular distribution out of LRFC till recently. This was due to its small base of assets, a high-cost structure, and - most of all - a very high proportion of investments either on non-accrual or in non-income generating equity investments. Just a year ago, more than a third of the portfolio at cost (and an even greater percentage at fair market value) was not generating any income. Not surprisingly, LRFC had a ($1.3mn) operating loss and ($8.5mn) in realized losses to boot.
A Little Help From The Fed
The new management gets credit for turning over the old Capitala portfolio; shrinking the number and value of non-performing assets; refinancing the balance sheet, etc. However, LRFC also got lucky, benefiting from higher interest rates: up 230 basis points in 2022, according to its earnings press release.
The bottom line, though, is that both profitability and dividends appear to be here to stay. In fact, with interest rates headed even higher in the short term and the IVQ 2022 results annualizing at $0.92 per share, LRFC could earn a great deal more than the rather tame projection by the analyst. Chances are, though, management will retain as much of the earnings as possible given its tiny net asset base (under $100mn) and the myriad opportunities available to lenders right now.
Longer term, though - and even if earnings do climb thanks to the Fed and continued shifting of equity investments into income-producing loans - we wonder what is management's game plan. Just to achieve an ROE of 10% (at a time when most BDCs are generating a much higher return) LRFC would need to book annual NIIPS of $3.5 a share - nearly 4 times the IVQ 2022 earnings pace just mentioned. That's very unlikely to happen in almost any scenario we could conceive of.
Investors don't seem to care. Even before any dividend was announced, the stock price reached a $27.60 high. Today - with animal spirits for all BDCs muted by the recent bank crisis - LRFC trades for $20.70. That's 27.6x the projected NIIPS of 2023 and 2024, and 59% net book value per share. (At its earlier height, LRFC reached a price to book of 78%). The current yield is 3.5%, even lower than what investors receive for market favorite Main Street Capital (MAIN).
If earnings and dividends don't have that much farther to go, then why does LRFC trade at such a high price and low yield? We imagine investors are hoping that the BDC will still be merged into that other BDC also managed by CEO Goldthorpe - Portman Ridge Finance (PTMN), which is three times larger. Or a "cleaned up" LRFC (down to only 2 non-accruals and 14% of its assets in equity investments) could be sold to a third party. In either case, the BDC would be valued - in this hypothesis - at par, or $35 a share.
That Was Then
We used to have those sorts of illusions/delusions, but management has not hinted at any sort of transformative move of that kind. Maybe they're happy with the compensation coming from the BDC. After all, for a long time the only"stakeholders" getting paid were the lenders to the BDC and its managers. The management fee of 1.75% of assets and 20% of earnings is one of the highest in the BDC sector. In 2022, the external manager earned just under $4mn and going forward should receive well over that bogey.
Out Of The Ordinary
For the purposes of the Expected Return Table, we're going to value LRFC in this unusual way. In terms of distributions, we're undertaking our normal projections of what the annual payout should be. In this case, we're expecting a slight bump from the $0.72 dividend pace to $0.80 per annum - to be maintained through 2027. (As is the case for many BDCs, we expect LRFC will have a record-breaking earnings year in 2023 but hold back some of its profits to smooth out distributions when rates do start to fall. The BDC should also continue to grow the value of its interest-bearing investments as equity stakes are sold and take advantage of wider loan spreads for some time to come).
At The End
However, as a Target Price, we are basing ourselves on net book value. We're assuming that the BDC could ultimately reach a price equal to 90% of its current book value per share - or $31.04. That would be a record price, but not so terribly higher than the prior peak, and still 5 years away in our model.
As always, the market has been looking ahead and given a small, fully leveraged, and barely profitable BDC a very rich valuation. Anyone considering an investment based on our projections will need to be a believer that LRFC will be sold somewhere near book value at some point. Otherwise, why accept such a tepid yield in such a small, illiquid stock?