Pgiam/iStock via Getty Images

Pgiam/iStock via Getty Images

I started following Portman Ridge Finance Corp. (NASDAQ:PTMN) in June 2020 when they announced their intention to purchase Garrison Capital, Inc. (GARS). At the time, I owned a bit of GARS since I thought it was significantly undervalued, and then GARS management announced that they were looking for a strategic partner or purchaser. Also, I owned a bit of Harvest Capital Credit Corp. (NASDAQ:HCAP) prior to PTMN's announcement that they intended to purchase them. On both trades, I made a nice bit of money. Until recently, I did not own much of PTMN even though I believed in their plan of building a BDC platform via acquisitions of marginal and underperforming smaller BDCs. I felt that PTMN's turnaround strategy of selling off the weak credits in the acquired BDCs and replacing them with senior secured loans from their robust middle market platform (Roll-up Strategy) would take a year or two for the market to appreciate their strategy.

After PTMN announced their strong Q2 2021 results, I started to build a position in PTMN and Logan Ridge Finance Corp. (NASDAQ:LRFC) (I plan to discuss more about LRFC in a separate article). I felt that PTMN's Roll-up Strategy was about to bear fruit. For most of 2021, PTMN traded in a relatively tight band between $24 and $25, which represents roughly a 20% discount to their Q3 NAV of $29.71. PTMN paid a $0.60 quarterly dividend with a yield of roughly 10%.

I felt that its strong financial performance, especially the Q2 Net Interest Income (NII) of $1.51, would allow PTMN to increase its dividend and hopefully trade much closer to its NAV. I was under the mistaken belief that PTMN could increase their dividend in the third quarter to be much closer to their NII. Unfortunately, my hypothesis was proven wrong when PTMN announced Q3 NII of $1.50 but only increased their dividend by $0.02.

BDCs generally set their dividends at their core repeatable income, which is similar to their NII and Distributable Taxable Income (DTI). I was surprised and disappointed that PTMN only increased its dividend by $0.02. So, I decided to roll up my sleeves and investigate what is really driving PTMN's dividend and why it's lower than their NII. This paper is the result of my research.

PTMN is a closed-end, externally managed BDC, which is managed by Sierra Crest Investment Management LLC (Sierra) and is an affiliate of BC Partners (BCP) . BCP is a well-established and respected private equity and investment manager with a $7 billion middle-market direct lending platform. BCP's credit business is led by Ted Goldthorpe, the longtime President and Chief Investment Officer of Apollo Investment Management, which managed Apollo Finance. Mr. Goldthorpe resigned from Apollo in the summer of 2016 and joined BCP in 2017. BCP has built an impressive middle market loan and BDC platform and has hired seasoned middle marketing lending, accounting, and back-office professionals. Given BCP's strong investment reputation, I am confident that over time they will prove themselves to a top-tier BDC manager.

BCP developed the business objective to add a BDC component to its middle-market loan platform by acquiring smaller underperforming BDCs. Initially, BCP took over the management of KCAP Financial, Inc. (KCAP) an internally managed BDC, by purchasing the investment contract from its management team on April 1, 2019. I believe that BCP paid $25 million for the contract. KCAP was renamed PTMN and had $282 million of assets.

Once BCP took control of KCAP, it did not take long for them to continue their Roll-up Strategy by acquiring other BDCs. PTMN acquired a total of $434.8 million of investments over their three acquisitions, OAHS, GARS, and HCAP (Acquired BDCs). In addition, BCP acquired $263 million of investments via the acquisition of Capitalia (CPTA). BCP completed the transaction by creating a new BDC, LRFC. As of Sept. 30, 2021, PTMN sold roughly 52% of the legacy investments from the Acquired BDCs. Management stated in the Q3 2021 conference call that they were basically done selling the OAHS and GARS legacy investments, but were still working through the HCAP investments.

Chart1 (PTMN and LRFC financial statements)

Chart1 (PTMN and LRFC financial statements)

The success of PTMN's Roll-up Strategy is at least partially dependent upon its ability to sell legacy investments without destroying NAV. According to management, PTMN has been very successful in selling legacy investments without incurring losses. Overall PTNM has made a small profit on the sales. PTMN must do a significant amount of due diligence on the acquisition's portfolio and the development of a divestment plan. While I give BCP credit for executing their plan, they were also very fortunate to make these acquisitions during a period of strong credit performance and liquid markets.

PTMN's acquisition of GARS immediately had a positive impact on its performance. The GARS acquisition closed in Q4 2020 and is PTMN's largest acquisition to date. As you can see in Chart 2 below, the GARS investment increased NII from $2.7 million or $0.61/share in Q3 2020 to $8.9 million or $1.35/share in Q4, an increase of over 100%. NII continued to be elevated throughout 2021, with an average quarterly NII 2021 of $1.36.

Chart 2 (PTMN's Q4 2021 Investor Presentation)

Chart 2 (PTMN's Q4 2021 Investor Presentation)

Since Q4 2020, PTMN has reported interest income on investments of roughly $20 million a quarter. The calculated yield on all investments during the period was between 19% and 15%. At Q3 2021, PTMN had investments of $562 million, 71.0% in debt securities, 4.0% in equities, 3.1% in CLOs, and 12.0% in JVs. The investment portfolio breakdown has been relatively constant since Q4 2020.

PTMN's strong Q4 2020 NII was driven by a corresponding increase in interest earned on debt securities, which increased from $4.5 million in Q3 to $14.3 million in Q4, an increase of roughly 3x. The yield on debt securities increased from 8.8% to almost 17%. These heightened yields continued throughout 2021, the yield on debt securities was 15.6% (see chart 3 below).

While the return on debt securities is fantastic, it doesn't represent the stated coupon on these investments. In PTMN's Q3 2021 investor representation, they noted that the weighted average yield on debt investments was 8.1% at par value. Given the stated coupon on the debt securities, the amortization of Merger Gains has increased interest income. I will discuss merger accounting later in this paper.

PTMN earns attractive yields on their CLO equity and JV investments as well. The yield on these investments has been relatively consistent since Q3 2020. I will discuss these investments later in the paper.

Chart 3 (PTMN Various financial statements)

Chart 3 (PTMN Various financial statements)

The amortization of the Merger Gains through interest income makes PTMN's NII confusing and doesn't reflex their core repeatable income. As the legacy investments mature or are sold, the increase in interest income due to the Merger Gains will significantly dissipate; therefore, PTMN's NII will be lower over the coming quarters and will revert to my calculated Adjusted NII. Merger Accounting rules have caused the divergence between NII and DTI. Until the market has a better insight into PTMN's core repeatable income and its ability to increase its dividends, I believe the stock will continue to trade at a discount to its NAV.

When PTMN purchased each Acquired BDC, they structured the transaction by purchasing the BDC with a combination of cash and stock. In structuring each acquisition, PTMN valued the acquired BDC's net assets and the shares that they issued at their NAVs and not at their fair values. Merger Accounting rules required PTMN to value the acquired investments and the stock issued at their fair values. For the GARS transaction, the $48 million difference between the fair value, $1.26. and NAV, $2.85, of the 30.7 million shares issued was the leading factor in the $40.4 million Merger Gains (see chart 4 below).

PTMN has generated $50.6 million in Merger Gains over the three acquisitions (see chart 5 below). In this article, I will only discuss the GARS Merger Gains since it is by far the largest of the three transactions. The merger accounting rules apply to the Merger Gains earned on the other two acquisitions. I also would note that the vast majority of the $6.4 million of OHAI Mergers Gains has been fully amortized/realized by Q3 2021.

As outlined in Chart 4 below, PTMN acquired $317.8 million of GARS' investments at fair value. However, due to the Merger Gains, PTMN recorded these investments at cost of $277.4 million, $40.4 million less than their fair value. PTMN applied the Merger Gains per investment on a pro-rata basis.

Chart 4 (PTMN's Q4 2020 10-K) Chart 5 (PTMN Various financial statements)

Chart 5 (PTMN Various financial statements)

Merger Accounting rules require that the amortization or realization of the Merger Gains be recorded to interest income or realized gains depending on the status of the investment. While the investment is held (or if it matures), the amortization of the Merger Gains over the life of the investment is recorded as interest income; however, if the investment is sold, the outstanding Merger Gain (fair value less amortized cost) balance is recorded as a realized gain. Because amortization of the Merger Gains goes through interest income, NII is impacted as long as PTMN holds the investment. The amortization of Merger Gains doesn't impact NI since unrealized gains are reduced in a corresponding amount. Also, realization of Merger Gains doesn't impact NII since realized Merger Gains go through the realized and unrealized gains section of the income statement.

With a little research, I was able to calculate the impact that the purchase of GARS had on PTMN's Q4 2020 financial statements. At December 31, 2020, the difference between GARS legacy investments at fair value and amortized cost was roughly $24.6 million, a $15.8 million reduction from the initial booked amount of $40.4 million. The reduction was due (X) the sale of approximately 31% of the GARS legacy investments and (Y) the amortization on the investments held (including the amortization on investments prior to their sale).

The Merger Gains realized on the investments sold in Q4 was approximately $12.5 million (31% * $40.4 million). Also, PTMN published in their Q4 2020 investor presentation that GARS Mergers Accounting impacted their interest income by $3.7 million. Based on these figures, GARS Merger Gains were reduced by $16.2 million, which is extremely close to the $15.8 million mentioned above.

As of Sept. 30, 2021, PTMN held $142.1 million, fair value, of GARS legacy investments and with an amortized cost of $129.3 million, a difference of roughly $12.8 million. Outstanding Merger Gains was reduced by roughly $11.6 million during 2021. For 2021, it is much harder to calculate the amount of the amortization/realization of Merger Gains had on interest income and how much went through realized gains. The obvious reason is that PTMN did not report the impact on interest income for 2021 like they did for Q4 2020. For the GARS legacy investments that PTMN no longer holds, it is impossible to determine whether PTMN sold them or if they mature/prepaid.

As an analyst and author, it is hard to admit but I just can't get 100% comfortable with merger accounting rules and the impact they had on PTMN's NII over the last 4 quarters. I believe the impact on interest income was larger than (X) the reported $3.7 million for Q4 2020 (see chart 6 below) and (Y) the $11.6 million reduction in GARS Merger Gains for 2021. With additional research, I was able to calculate an Adjusted NII that I believe more closely represents PTMN's repeatable core NII and that doesn't include the impact of the amortization/realization of Merger Gains. If correct, the Adjusted NII should be a good proxy for future dividends.

PTMN's calculated yield on the debt securities was 16.9% for Q4 2020 and 15.6% for 2021. Obviously, interest income has been significantly impacted by the merger accounting rules and the amortization of the Merger Gains. PTMN's stated coupon of the debt securities was 8.1% at Q3 2021. I calculated the required adjustment to interest income necessary to reduce the yield to 9.0% to get a better feel for the impact that Merger Gains had on PTMN's interest income. The adjustments equaled $6.7 million in Q4 2020 and $20.6 million in 2021 (see chart 5 below). These adjustments should help me gauge whether my Adjusted NII represents PTMN's returns without the impact of amortization of Merger Gains.

Chart 6 (PTMN Various financial statements)

Chart 6 (PTMN Various financial statements)

The only number I could find that PTMN published that would shed some light on the impact of the amortization of the Merger Gains was in the Q4 2020 investor presentation. As you can see in Chart 6 below, PTMN stated that Interest Income was impacted/overstated by $3.7 million of the quarter. While I have no reason to doubt the veracity of the number, it does seem to be too low. The reduction of interest income by $3.7 million would only reduce the yield to 12.5%, which I believe is still too high.

Chart 7 (PTMN Q4 2020 Investor Presentation)

Chart 7 (PTMN Q4 2020 Investor Presentation)

The next number that I found appears to be more in line with my expectations. In the DTI schedule for Q4 2020 and YTD Q3 2021, PTMN outlined the "Book/tax difference related to mergers" of $5.8 million and $17.5 million, respectively. When I adjust interest income by these amounts, I calculate a roughly 10% yield for both periods, which is a bit higher than the stated coupon of 8.1% at par value. Part of the difference between the two yields is that the 10% is calculated off the fair value of the investments and the 8.1% yield is on the par value of the investments. Since the fair value is lower than the par value, it would make sense that the 10% calculated amount would be higher than the par value coupon.

As you can see in chart 7 below, to calculate an Adjusted NII that doesn't take into consideration Merger Gains, I removed the "Book/tax difference related to mergers" from the reported NII. For Q3 2021, PTMN's Adjusted NII was $8.2 million or $1.00. This amount is almost double the Q2 2021 Adjusted NII of $4.6 million or $0.54. The three factors driving the $3.6 million increase in Adjusted NII are (X) a $2.4 million increase in interest income on debt securities of which $0.7 million was in PIK income, (Y) a $0.60 million increase in Capital structuring service fees, and (Z) a $0.6 million reduction in expenses. I think that the $2.4 million increase in interest income is the result of PTMN's overall Roll-up Strategy of selling weaker credits for loans originated off the BCP platform.

Chart 8 (PTMN Various financial statements and my calculations)

Chart 8 (PTMN Various financial statements and my calculations)

However, since PTMN's dividend is driven by DTI and not NII, I looked at PTMN's outstanding DTI at Q3 2021. As you can see in the chart below, PTMN had DTI of $1.09 for Q3 2021 but only declared and paid a dividend of $0.62, a difference of $0.47. Also, the year-to-date 2021 undistributed TDI is $0.67.

As stated above, I believe the $1.00 Adjusted NII is very close to PTMN's ongoing core income and thus will allow PTMN to increase their dividend to almost $0.75 a quarter, an increase of roughly 20%. Also, given the $0.67 of undistributed DTI, PTMN should be able to declare a special dividend sooner than later.

I hope that PTMN provides additional insight (X) into the impact that the amortization of Merger Gains had on NII over the last 4 quarters, and (Y) regarding future dividends.

Chart 9 (PTMN Q3 2021 10Q with my calculations)

Chart 9 (PTMN Q3 2021 10Q with my calculations)

PTMN is earning impressive yields on its CLO equity and JV investments. As of Sept. 30, 2021, the fair value of these investments was $17.2 million or 3% (of total investment (fair value)) and $67.6 million or 12%, respectively. I believe that BCP intends for PTMN's investment portfolio to be roughly 70%-80% senior secured loans and the remaining 30%-20% in other high-yielding investments.

Chart 10 (Various PTMN financial statements)

Chart 10 (Various PTMN financial statements)

The CLO equity investments are the legacy KCAP Catamaran platform that BCP has been trying to divest. They were able to reduce their exposure during 2021 by $2.4 million with the divestment of Catamaran 2016-1. These positions will roll off over time as the CLOs are terminated. All the CLOs were originated prior to 2018 and are out of their reinvestment periods. Based upon management's statements, I believe their intent is to reinvest these funds in their proprietary first-lien loans, which yield around 8%-10% or in the JVs. However, as management outlined in their Q3 investor conference call, PTMN and LRFC made an opportunistic investment in HCAP related JMP's CLOs. To be clear these CLOs were not part of the HCAP acquisition.

The JV Investment portfolio is made up of two investments, the KCAP Freedom Fund 3 (KCAP JV), with a 17.20% yield, and in BCP Great Partnership (BCP JV), with a 12.94% yield. Like the KCAP CLO equity investments, the KCAP JV investment is a legacy KCAP investment. While PTMN's disclosure is not as detailed as I would like, it appears that both JV funds invest in leverage loans on a levered basis. These JV structures are a common device that BDCs use to increase (X) yields on their portfolios, (Y) obtain leverage in a manner that is not included in the regulatory leverage limitation calculations, and (Z) the BDC's middle-market platform ability to originate larger loans.

During Q2 2021, PTMN increased their investment in the KCAP JV by $2.5 million, they now own 62.83% of the JV. Also, PTMN has increased its investment in BCP JV from $29.6 million at Q4 2020 to $43.7 million at Q3 2021.

BCP JV's investment objective is to investments in senior secured unitranche loans originated by BCP middle market loan platform. PTMN has a $50 million commitment to the JV, with roughly $43.7 million drawn on September 30, 2021. In addition to PTMN's capital, the JV has $69.1 million drawn on its $115 million L + 2.85% revolving loan facility. PTMN doesn't give a lot of details regarding the JV but the other LP is an affiliate of BCP. Also, PTMN has a 50% voting right. I assume the other JV partner has invested capital as well, but PTMN doesn't provide enough information to determine their investment. I believe PTMN will invest the capital returned by the KCAP legacy CLOs into the JVs.

PTMN management has consistently stated that they plan to reduce their exposure to CLO equity but in Q4 2021, they were presented with an opportunity that they could not turn down. PTMN and LRFC purchased 100% of the equity in JMP Credit Advisors CLO V and VI from JMP Securities, an affiliate of HCAP. In their Q3 2021 10-Q, JMP reported the fair value of these investments to be $30,590,000 with an original par value of roughly $62 million, which represents all the equity in these 2 CLOs.

PTMN paid for the investment in cash of $1.4 million and with 556,852 shares valued at their NAV. LRFC paid a similar amount but all in cash. Since PTMN paid for the CLO equity with shares valued at their NAV, they will realize a gain on the transaction equal to the difference in the stock's NAV and fair value on November 2, 2021, the date of the transaction. PTMN should book a realized gain on the transaction in excess of $2 million.

Since BCP, through PTMN and LRFC, controls all the equity in these two CLOs, they have the right to terminate CLOs when they believe it will maximize their investment. I am not sure what the effective yield on these investments will be, but I do know that each CLO distributes roughly $650k a quarter. Based upon JMP's calculated effective yield and the CLOs cash flows, I believe that these investments will yield between 10% and 15% but it could be much higher depending on the amortized cost of the investments. Based upon my calculations, the investment in these CLOs should increase PTMN's DTI by $0.07 a quarter.

BCP has done an outstanding job quickly implementing its Roll-up Strategy. BCP has sold the vast majority of the problematic legacy investments. They still have some work to do on the $57.8 million HCAP legacy investments. BCP has fully underwritten PTMN's investments and is now comfortable with all the credits. With the Roll-up Strategy basically completed, BCP will be able to concentrate on the day-to-day middle market loan origination process and running the BDC.

BCP's success is starting to bear fruit in the financial performance of PTMN, they reported Adjusted NII of $1.00 and $1.09 of DTI for Q3 2021. I believe PTMN can sustain these amounts over the coming quarters. And this doesn't take into account rising interest rates. If my calculations are correct, PTMN should be able to increase its dividend in Q4 and even declare a special dividend. As the Merger Gains run off, PTMN's reported NII will decrease but its dividend should not.

PTMN's stock has been hurt by the limited amount of its operating history and the fact that merger accounting has made its NII confusing. I hope that starting in their Q4 2021 reporting, BCP will provide its investors with more insight into the impact that the merger accounting had on the last four quarters, as well as provide some metric that provides the investor more insight into PTMN's core repeatable income and availability of future dividends. We should know more on Friday morning when the company reports earnings.

This article was written by

Disclosure: I/we have a beneficial long position in the shares of PTMN, LRFC either through stock ownership, options, or other derivatives. 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.