PSEC - Trinity Capital: Initiating Coverage Of This 14% Yielding BDC

2023-08-01 12:48:02 ET

Summary

• This article discusses TRIN which I have started active coverage assessing the sustainability of the dividend, portfolio credit quality, and quality of management, used to set target prices.
• TRIN is internally managed with the potential for growing its regular dividend and NAV per share while paying meaningful amounts of supplemental dividends.
• My primary concerns include a higher expense ratio relative to the other internally-managed BDCs (new hires etc.), the amount of watch list investments, upcoming realized loss, NAV dilution from stock.
• Please see the chart at the end of this article comparing the potential impact on NAV per share, assuming that 100% of watch list investments (including non-accruals) defaulted with 0% recovery.
• If you're not getting a decent level of detail for each of your BDC investments, please consider taking a more detailed approach to due diligence each quarter.

Quick Introduction To Business Development Companies

Business development companies ("BDCs") invest shareholder capital in privately-owned, small- and medium-sized U.S. companies generating income from secured loans and capital gains from equity positions, much like venture capital or private equity funds. Anyone can invest in BDCs as they're public companies traded on major stock exchanges.

This article discusses Trinity Capital ( TRIN ) which became publicly traded in 2021 and I have added to active coverage which includes assessing the sustainability of the current dividend/distribution, portfolio credit quality, management quality, and target prices (useful for setting limit orders).

TRIN has been added to my suggested "Total Return" portfolio due to investing in secured debt, equipment financing, and equity positions in high-growth venture capital ("VC") backed technology companies, historically providing realized gains to support supplemental dividends. As shown below, secured debt investments accounted for around 74% of the portfolio's fair value compared to equipment financing at almost 22%, and equity/warrant positions at 4%. Also shown is the sector breakdown with 4.3% of the portfolio invested in companies with exposure to cryptocurrencies/digital assets, as discussed later.

The BDCs in the chart below account for around 90% of the total assets and market capitalization for the sector.

Over the last six weeks, we discussed the portfolio credit quality and/or dividend coverage for many of them including Ares Capital ( ARCC ), FS KKR Capital ( FSK ), Prospect Capital ( PSEC ), Goldman Sachs BDC ( GSBD ), New Mountain Finance ( NMFC ), Oaktree Specialty Lending ( OCSL ), Hercules Capital ( HTGC ), PennantPark Floating Rate Capital ( PFLT ), PennantPark Investment ( PNNT ), BlackRock TCP Capital ( TCPC ), Gladstone Investment ( GAIN ), Gladstone Capital ( GLAD ), Monroe Capital ( MRCC ), and TriplePoint Venture Growth ( TPVG ) in the following articles:

• Solid 10% Yield From GAIN And GLAD .
• ARCC: Assessing Dividend Coverage For Its 10% Yield .
• OCSL or NMFC For Solid 11% Yield?
• Better High-Yield Buy: FSK or PSEC?
• PNNT: Big Win From Dominion/Fox Settlement .
• Venture Debt Opportunity Yielding 13% To 14%: HTGC or TPVG?
• TCPC or PFLT For Solid 12% Yield?
• Safer 12% Yield: GSBD or MRCC .

As shown below, many of these BDCs are among the highest yielding. The yield for TRIN takes into account a conservative $0.10 per share of supplemental dividends annually (compared to $0.60 per share paid in 2022).

Also, many BDCs have investment grade ("IG") bonds/notes for lower-risk investors building a balanced 60/40 portfolio (composed of 60% to 70% stocks/equities and 30% to 40% bonds or other fixed-income offerings). These notes were previously overpriced, but prices have declined and are now at attractive levels. TRIN has a Baby Bond that is currently yielding around 8% as mentioned last month in " Introduction To BDC Google Sheets ."

BDC prices have continued to head higher as investors are trying to front-run the upcoming Q2 2023 earnings season which will likely be strong, similar to the previous three quarters. It is important to note HTGC, BXSL, GLAD, GAIN, ARCC, CSWC, and MAIN, have recently increased their dividends, announced special/supplemental dividends, and/or reported strong results maintaining credit quality with increased NAV per share. As shown below, TRIN will be reporting after the close of the markets on Thursday, Aug. 3:

TRIN Dividend Coverage and Risk Profile

The three biggest mistakes that new BDC investors make are:

• Focusing on historical dividend coverage instead of projected dividend coverage which is heavily reliant on portfolio credit quality.
• Not taking the time to dig into portfolio credit quality and assess which investments could potentially have a negative impact on earnings and NAV.
• Not understanding why BDCs trade at different prices and thinking that price-to-NAV is the only measure to find a "good deal." Please see the end of this article for a quick discussion of how BDCs are valued.

Each quarter I update the financial projections for each BDC with base, best, and worst-case scenarios to test the sustainability and/or changes to the current dividends. Below I discuss many of the drivers used for projecting dividend coverage including the base, best, and worst-case projections similar to what we provided in the "ARCC: Assessing Dividend Coverage For Its 10% Yield" article linked earlier.

TRIN is considered a "Level 1" dividend coverage BDC, implying the potential for increased regular dividends and/or additional supplemental dividends mostly due to the ability to leverage its internally managed cost structure and history of realized capital gains. The company has increased its regular dividend for ten consecutive quarters, from $0.27 per share in 2020 to the previously announced $0.48 per share (not shown below) for Q2 2023. Also, the company paid $0.60 per share of supplemental dividends in 2022 and $0.05 per share so far in 2023.

I'm expecting additional supplemental dividends paid out of spillover which was around $1.64 per share:

"I would also like to remind our shareholders that we had spillover income of approximately $1.64 per share at year-end that we'll continue to reinvest. Management is diligently evaluating our liquidity position in this market and regularly discusses the various uses of our capital with our Board, including the possibility of special dividends in 2023."

Earnings per share should continue to improve over the coming quarters due to the following items taken into account with the financial projections:

• Leveraging its internally managed cost structure.
• Increased benefit/returns from the JV/RIA (see earning call notes) that will likely benefit from the closure of Silicon Valley Bank (also discussed).
• Continued record demand, delivering record fundings.
• Higher yields from new investments.

In December 2022, TRIN entered into a joint venture agreement to co-manage its i40, LLC ("JV") which invests in secured loans and equipment financings to growth-stage companies that have been originated by the company. TRIN has agreed to offer the JV the opportunity to purchase up to 40% in dollar amount, but not less than 25% in dollar amount, of the entire amount of each secured loan and equipment financing advance originated by the Company during the period commencing on September 1, 2022, and ending on June 5, 2026.

We announced the creation of two unique value-driving investment vehicles, a direct lending joint venture and our registered investment adviser. These initiatives solidify our ability to continue to grow and deploy capital via off-balance sheet investments. The benefits of this off-balance sheet growth, including fee interest, income will provide incremental returns that will flow to our shareholders at the BDC. Q1 was the first quarter that we started to recognize the benefits of the JV through both fee income and liquidity. Subsequent to quarter end, we closed the JV credit facility with KeyBank and intend to leverage that financing similar to the BDC. The total size of the equity capital is $171 million, and we did close subsequent to Q1, $75 million of a debt facility with KeyBank. So we do think that will be levered similar to what the BDC is at. And then with recycling, we'll see $400 million to $500 million likely over time that is available to invest in the marketplace from that JV."

The i40 JV is now starting to grow and contributed to around $0.5 million in fee income.

Q. "Did the JV contribute any fee income here in the quarter?"

A. "Yes. It was about $0.5 million. Again, this is early first quarter where we started to ramp. But as a part of the fees and then interest income, about $0.5 million this quarter."

There's also the RIA business and both of these are expected to contribute to income and provide flexibility to manage leverage, including off-balance sheet.

"We are confident in our capital structure and balance sheet, especially with the commencement of the JV and RIA. Both are expected to provide us with access to additional liquidity and are just two examples of how we are raising capital in ways that are accretive to our shareholders, while being opportunistic at the VC level. We also utilized our ATM offering program during the quarter, raising approximately $4.2 million, further supporting the long-term growth of Trinity. We look forward to sharing more updates on these initiatives in future earnings call."

The last line in the table below shows "Operating Cost as a Percentage of Available Income" which measures operating, management, and incentive fees compared to available income. As mentioned later, TRIN's expense ratio has not improved as the portfolio continues to grow, which is strange for an internally-managed BDC. Hopefully, this will improve over the coming quarters and is taken into account with the best-case projections.

Our operating expenses, excluding estimated excise taxes were approximately $10.5 million during Q1 as compared to approximately $9.2 million during Q4. The increase of approximately 14.6% was primarily driven by an increase in variable compensation, employee benefits and professional fees as a result of this operating activity."

TRIN issued 783,100 shares at a grant price of $12.85 resulting in NAV dilution of $0.25 per share for Q1 2023. Without this stock award, NAV would have increased during the quarter. It's important to point out that stock awards impact NAV immediately, but are expensed over time and will continue to impact earnings. Management discussed on the call and there will be additional grants during Q4 2023 and Q1 2024.

NAV per share decreased to $13.07 compared to $13.15, the decrease in NAV per share was primarily related to the impact of additional shares issued under Trinity's restricted stock award program ."

Q. "In terms of kind of restricted stock grants. Can you talk about the cadence of that and what maybe to expect on a quarterly basis, annual basis, whatever makes the most sense?"

A. "This is a plan that we've had in place for the last few years and we look at it twice a year relative to grants and the larger portion of that is this quarter and the hit is this quarter. And it was good to see now increase meaningfully with a little adjustment for that. We're well into that plan. There are more shares available under it, so I think you'll see it again to a smaller degree in the October timeframe and then another probably more next time this first quarter of next year."

Another item to keep in mind is the $50 million of convertible notes with a fixed coupon rate of 6.00% and the potential for the holders to seek liquidity through converting to common shares if the stock price trades above the conversion price. The conversion price is adjustable "following certain corporate events" and is currently $13.40 "as a result of a certain cash dividend of the Company." Please note that the conversion price has declined from $14.92 at the end of 2021.

As of March 31, 2023, TRIN had equipment finance facilities with three companies ( Core Scientific , Hut 8 Mining , and CleanSpark ) in the crypto space representing around $57 million or 5.0% of the portfolio on a cost basis and $47 million or 4.3% on a fair value basis. These investments accounted for around $1.31 or 10% of its NAV per share and are included in its watch list.

In October 2022, Core Scientific announced that it would be suspending equipment and other financing payments as a result of a liquidity crunch and overextension of debt and was placed on non-accrual "pending the outcome of future developments at the company." In December 2022, the company filed for Chapter 11 and TRIN's management discussed on the recent call:

In Q1, the number of loans on nonaccrual remained unchanged with the same four debt investments that have a cumulative investment cost and fair value of approximately $49 million and $24 million, respectively. For reference, this represents 4.5% and 2.3% as a percentage of the company's total debt portfolio at cost and fair value, respectively. The $6 million increase in fair value on the nonaccrual assets is related to our fair value market adjustment to our investment in Core Scientific. The company is benefiting from improved underlying market conditions."

Q. "In relation to the Core Scientific, a pretty healthy markup of $5.7 million, was your markup just generally driven by what you saw in the macro? Or do you have indications in your negotiations from Core that leads you to believe that there's a better outcome for the loan and - or for the equipment finance facility and do you know - also, do you have some sort of a sense of timing when they're likely to reemerge?"

A. "So the backdrop to that mark, is the trading price of Bitcoin, the $16.5K on December 31 that was about $28,400 as of March 31. So a 72% increase in the digital asset price kind of as a backdrop to the whole thing. We don't have any particular insights into the process, but there are publicly reported events with respect to the bankruptcy, replacement, DIP financing was finally approved by the bankruptcy court in early March. That is better overall terms for all lenders and the bankruptcy court also appointed an equityholders' committee. That committee is arguing there is equity value. We hope they're right, but we have no knowledge. With respect to our valuation, we did a scenario analysis considering the likelihood, everything from a worst-case outcome to a best-case outcome with the most probable scenario in our minds, being a negotiated settlement. And so that's how we set our mark ."

Q. "Just two follow-ons to that. First of all, I mean, you said you don't have any insight to the process. You guys are involved in the process. So I'm not sure I understand that statement. But - and they have to negotiate part of the settlement with you. So I don't really quite understand your statement there."

A. "Yes. Well, I think we're certainly - we are - we're able to access all of the same information that others are publicly. We're not in control of the process, I think, is probably a more correct statement."

On June 20, 2023, the company/debtors filed a proposed "Joint Chapter 11 Plan of Reorganization" to restructure its debts and operations. The plan requires approval from the bankruptcy court and creditors. Please note that Bitcoin miners in Texas recently halted operations after a heat wave and subsequent surge in electricity prices put the state's power grid under pressure.

On June 26, 2023, Hut 8 Mining , a Bitcoin mining company, announced that it has secured a $50 million credit facility through Coinbase Credit. The loan arrangement, which will mature 364 days after the initial borrowing, will provide Hut 8 Mining with additional capital to be utilized for general corporate purposes, as well as its ongoing operations. The obligations under the credit facility are secured by the Bitcoin holdings held by the Canadian crypto-miner in the custody of Coinbase Custody, and the loan is guaranteed by the company. The SEC has accused Coinbase of operating an unregistered securities exchange in one of two recently-filed lawsuits.

One of its loans to FemTec Health (previously Birchbox) was recently marked up reflecting the exit subsequent to quarter-end and was discussed on the call:

"We recognized unrealized appreciation of $8.2 million in our debt portfolio and unrealized depreciation of $4.7 million in our equity and warrant portfolio primarily related to market volatility. Approximately $6.6 million of our unrealized appreciation in the debt portfolio is related to two portfolio companies, Core Scientific and FemTec Health, both of which we have previously identified. FemTec was realized after quarter end and the impact is reflected in our first quarter NAV ."

TRIN had a total cost basis of $28.6 million in FemTec, including the equity position, and will drive around $0.73 per share of realized losses during Q2 2023:

Over the last four quarters, there has been a slight decline in TRIN's internal risk ratings that stabilized in the recent quarter and will likely improve after the exit of FemTec.

"Our portfolio has stabilized and strengthened. During the quarter, our overall internal risk rating remained constant at 2.8. When you look at historical loss rates, Trinity has been consistent over its 16-year history at approximately 24 basis points annually. When you factor in realized gains, loss rates are a net positive."

As shown below, the amount of investments on my watch list for TRIN is around 16% of the portfolio at cost (13% of the portfolio fair value), which is higher than most BDCs . However, excluding FemTec, the amount of watch list investments would be around 14% of the portfolio at cost and 13% at fair value (still higher than most BDCs).

Please see the end of this article for the chart comparing the potential impact on net asset value ("NAV") per share assuming that 100% of watch list investments (including non-accruals) defaulted with 0% recovery.

In 2022, similar to our BDC peers, we experienced a decline in NAV due to the unrealized losses attributed to multiple interest rate changes, market volatility, and some specific valuation adjustments. Additionally, we had an unusual event in Q1, in which we converted a prior year unrealized appreciation on two public company investments into a historic $50 million net realized gain that resulted in a decline in NAV of approximately $0.67 per share because of that flip. I also would like to remind our investors that $0.60 of the NAV decline in 2022 was related to the special dividends we paid to our shareholders. We have begun, and we believe we will continue to grow our NAV in the long term. Our loan portfolio should recover markdowns due to interest rate movements as we hold our loans to maturity. We also seek to recover losses from market volatility and valuation adjustments over time as we continue to work with our portfolio companies during market uncertainty to garner full recoveries."

Comparing BDC Expense Ratios

On June 26, 2023, TRIN announced the continued expansion of its life sciences team with the appointment of Igor DaCruz as Managing Director, Life Sciences, and the opening of a new office in the San Diego area. On June 29, 2023, TRIN announced the strategic expansion of its origination team with the appointment of Andrew Ghannam as Managing Director of Tech Lending, based in New York.

This expansion is part of Trinity's strategic vision to become a comprehensive solutions provider offering a wide range of financial products and services to growth-stage companies, and we believe that the life sciences industry holds immense potential for growth," said Kyle Brown, President and Chief Investment Officer of Trinity. "We're excited to have Igor join our growing team in San Diego as we aim to be the trusted financial partner for these companies seeking to make a lasting impact."

As a part of assessing BDCs, it's important to take into account expense ratios. BDCs with lower operating expenses can pay higher amounts to shareholders without investing in riskier assets.

"Operating Cost as a Percentage of Available Income" is one of the many measures that I use which takes into account operating, management, and incentive fees compared to available income. "Available Income" is total income less interest expense from borrowings and is the amount of income that is available to pay operating expenses and shareholder distributions .

Some BDCs have been temporarily waiving fees or have fee agreements that include a total return hurdle (taking into account capital losses), resulting in lower cost ratios. The following table shows the average operating cost% for each BDC over the last four quarters, with an example for TRIN as well as the adjusted ratios for GSBD , FSK , and TPVG

Also shown are the current price-to-NAV showing that investors pay higher multiples for BDCs with lower expense ratios because these BDCs can pay higher returns relative to NAV per share and the amount of income from the portfolio. TRIN's expense ratio has not improved as the portfolio continues to grow, which is strange for an internally-managed BDC similar to MAIN , CSWC , and HTGC all of which have much lower expense ratios, as shown below:

BDC Valuations

There are very specific reasons for the prices that BDCs trade driving higher and lower dividend yields mostly related to portfolio credit quality and dividend coverage potential (not necessarily historical coverage). BDCs with higher-quality credit platforms and management typically have higher-quality portfolios and investors pay higher prices. This drives higher multiples to NAV and lower yields.

The following chart shows the potential impact on NAV per share for each BDC, assuming that 100% of watch list investments (including non-accruals) defaulted with 0% recovery. This is the worst-case scenario for this group of investments. The largest NAV declines over the last four quarters were mostly BDCs with larger amounts of watch list investments. Subscribers who believe the economy is headed for a "hard landing" with a deep, broad, and/or extended recession should focus on the BDCs closer to the top left corner.

TRIN Important Considerations

TRIN has a relatively volatile stock price declining from $20.00 in March 2022 to almost $10.00 in December 2022 and then rebounding to $15.00 last month. It has started to go back down and I will likely be getting a starter position if the price continues lower.

The following are many of the positive considerations for TRIN, many of which are discussed in this article:

• More than 25 of its portfolio companies have recently (early 2023) received over $1 billion of new equity.
• Consecutively increased its regular quarterly dividend over the last 10 quarters, from $0.27 (in 2020) to $0.48 per share (for Q2 2023).
• $0.60 per share of supplemental dividends in 2022 and $0.05 per share so far in 2023.
• Continued new investments at higher yields with $339 million of unfunded commitments.
• Increased benefit/returns from the JV/RIA with fee income that started in Q1 2023.
• Excellent historical dividend coverage.
• Undistributed taxable income ("UTI") of $1.64 per share to support additional dividends.
• Ability to leverage its internally managed cost structure (at some point).
• Recent instability in the banking sector and venture equity slowdown will drive continued improvement in yields on new investments and a wider range of investment opportunities.
• Ability to issue shares through its ATM equity program.
• Strong balance sheet supported by mostly unsecured fixed-rate borrowings with the nearest maturity in January 2025 (its Baby Bond).
• Lower non-cash/PIK interest income at around 0.7% of total income for Q1 2023.
• Portfolio is 96% secured debt and equipment financing.
• NAV per share has increased by 5% over the last three years.
• Net realized gains of $36 million or around $1.00 per share over the last three years.
• Likely lower amount of non-accruals/watch list investment due to restructuring Core Scientific and exiting FemTec Health.
• The potential for a better-than-expected outcome for the restructuring of Core Scientific.
• Management focused on ROE with the ability to earn higher returns through investing in VC-backed tech companies providing NAV per share growth and realized gains.

The following are many of the negative considerations for TRIN, many of which are discussed in this article:

• Upcoming realized losses of $26 million ($0.73 per share) due to exiting FemTec Health.
• Hut 8 Mining announced that it has secured a $50 million credit facility that could be senior to TRIN's position (not sure).
• NAV per share has declined by almost 14% over the last four quarters.
• Negative impact on NAV per share from recent and upcoming stock grants/awards.
• Potential conversion of its convertible notes (current conversion price of $13.40).
• Higher-than-average non-accruals at 2.3% of debt investments at fair value.
• Higher-than-average amount of watch list investments at 16% of the portfolio at cost.
• Higher expense ratio partially due to increased operating expenses (continued new hires).
• Relatively higher leverage including an upper targeted debt-to-equity ratio of 1.35.
• Currently only one investment grade rating (Egan-Jones).
• Crypto exposure could result in higher NAV volatility (higher/lower) and/or credit issues.

For further details see: