Description

Summary

CCT is a closed end permanent capital vehicle that provides mostly senior secured loans to KKR’s portfolio companies. Like KKR in 2009, CCT did a back door IPO on November 15, 2017 completely unnoticed by Wall Street – very surprising given its $2bil+ market cap and $4bil+ of assets making it one of the largest public BDC companies in the world.  CCT is managed by a strategic partnership between KKR and FS Investments, which together manage the largest BDC platform at $18bil+ on AUM.

CCT is a classic special situations investment that at first glance sounds complex (the insomnia-curing name doesn’t help), but is a relatively simple story with an attractive, equity-like upside with the low risk characteristics and volatility of a bond-like investment. At the current share price of $15.62, CCT offers the prospect of earning ~30%+ absolute return
over the next 12 months through a combination of: (1) an attractive dividend yield of 10% and (2) a narrowing of the ~20% discount to NAV. It is worthwhile noting that CCT (through a recent tender) and KKR through a 105b plan both have been buyers of the stock. As one of the best capital allocators in the world and having insider knowledge of the portfolio, it should give investors comfort that KKR is a buyer of CCT stock.

There are three things we typically look for in any investment and CCT ranks extremely high in each of these categories:

1. Is it mispriced and what is the technical or fundamental reason for the mispricing?
2. Is it a high quality business or an asset being managed by a top tier mgmt team?
3. What factors provide downside protection and what are the catalysts/path to making money?

A brief answer to each will elucidate the opportunity in the stock:

1. Mispricing

CCT last reported its book value of $19.72/share at 3/31/2018. At current prices, the P/NAV is 0.79x, which is well below where its peers of comparable size and reputation are trading. The average of comparable companies trades at 1.0x-1.1x NAV - see valuation table below.

There is nothing fundamental that would lead to this discount to peers. A further understanding of the “situation” makes it clear that the mispricing is a result of a technical overhang due to the conversion of the stock to a public listing 100% owned by retail investors.

Prior to its listing, CCT was owned 100% by retail investors and KKR basically issued public shares to this retail ownership base that either had no clue what they were receiving or had no interest in owning a public security. This uneconomic selling is understandable and the reason why the arbitrage exists. In fact, CCT announced a tender offer for $185mm or 9.2mm shares in December. Of the 127mm CCT shares outstanding, 66mm were tendered by shareholders - 7x
oversubscribed. Only 14% of shares tendered were purchased by the company. This supply demand imbalance partially explains the discounted valuation in the stock.

The stock since its IPO on Nov 15, 2017 has significantly underperformed even the HYG index, which has much riskier credit profile than CCT. The selling of CCT has likely been compounded by a general sell of in REITs due to higher interest rates. However, CCT owns mostly senior secured floating rate loans which will benefit as rates rise. Additionally, CCT is only levered at 0.64x and has a portfolio of diversified loans that are senior in the capital structure.

2. High Quality Business

1. While there is risk inherent in a rising rate environment to a lending business, CCT is unique given its proprietary relationship with KKR, mostly senior secured loans and 80%+ floating rate debt which will benefit as rates rise.

2. CCT also has a proprietary origination advantage through its relationship with KKR. We are owners of KKR because of the confidence we have in management and the business. CCT is first derivative play on KKR, but fundamentally safer since they are providing the senior secured loans for KKR deals. Further, KKR has identified credit and capital markets as significant growth drivers which should drive volume of loan growth at CCT.

3. Finally the management team at KKR, led by Todd Builione, and the team at FS Investments, led by Michael Forman, is very strong. Todd has successfully spearheaded a number of initiatives at KKR. He was appointed initally CEO, then President, of CCT and we think very highly of him and the rest of management through our successful investment in KKR and are happy with the addition of the team from FS Investments. We are confident that he will look to be shareholder friendly. Among the actions we expect is the continued share buyback program given the discount to NAV in addition to the $50 million share repurchase program initiated in March 2018, $16.6 million of which was already executed as of May 11, 2018.

3. Catalysts to Realize Value

There are a number of catalysts we are expecting in 2018 that will address the mispricing in the stock. Below are some of the catalysts we are tracking and expect to occur over the next 12 months.

1. A catalyst which we expect to play out throughout 2018 is continuted share repurchases at a deep discount to NAV.  The company announced a $50 million share repurchase plan in March 2018. We expect additional repurchases that are highly accretive to NAV. With over $600mm in 2018 repayments, the company will have significant cash to purchase shares at a significant discount to NAV.

2. Increasing sell side research coverage -- currently only 4 sell side analysts (Compass, Wells Fargo, BMO, Suntrust) cover the name, which is low for the size of the company. We expect more as the trading liquidity and NAV grows over time.

3. Potentially increase leverage opportunistically.

Company Overview

CCT is a publicly traded business development company (“BDC”) focused on investing in primarily senior secured debt of privately owned companies. The business is effectively a spread business where the company borrows money through the debt markets typically at longer term fixed rates and invests in mostly debt of private companies.

CCT launched in July 2011, and has since grown to become one of the largest BDCs in the market. CCT’s portfolio is well diversified by company and industry and their relationship with KKR is a significant competitive advantage allowing them to participate in proprietary opportunities. As of 3/31/18, CCT had approximately $[4] billion of investments in 128 portfolio companies across 22 industries.

CCT’s investment portfolio of $4 bil has an average yield of 9.6%. This compares to a weighted borrowing rate of 4.6%. This spread levered at 0.64x net of expenses results in an ROE of approximately 8%+ on NAV.

CCT is externally managed by KKR Credit and FS Investments for which CCT pays KKR a 1.5% management fee and an incentive 20% above a 7% hurdle with a 3 year incentive look back. The look back is significant as it aligns CCT with long term shareholders and is a strong risk management tool. KKR Credit and FS Investments are large, well-respected credit managers.

Portfolio

Approximately 75% of the portfolio is floating rate (with a floor) and almost 73% of the portfolio is senior secured debt. In order to enhance the return profile, CCT has selectively invested the balance in the junior securities of companies it knows very well. The portfolio has exposure to 128 companies across 22 different sectors, with an average investment size of $50MM. The weighted average debt leverage (through CCT’s position in the capital stack) is only 0.64x. The portfolio composition is outlined below:

Investment Highlights

Superior scale

CCT is the third-largest listed BDC as measured by total gross assets. Its proprietary relationship with KKR will ensure a strong origination pipeline to continue to growth the business. Larger scale allows a BDC 1) to participate in larger deals (where competition is relatively limited), 2) more deal control, given that largescaled BDCs more often act as the sole or lead lender, and 3) more attractive funding options. You can see that scale also correlates to valuation well over 1x book.

Strong asset quality

CCT’s nonaccrual rate (2.4% of loans on a fair market value basis) is one of the lowest in the industry demonstrating KKR’s conservative underwriting approach, as well as CCT’s diversified sector exposure and relatively senior position in the capital stack. The company’s annualized loss rate on cost has been 1.2%. The 20% discount to NAV implies a mid teens loss ratio (portfolio at cost is $4bn) which is much higher than this 1.2% historical number.

Low funding costs and increasing leverage

CCT has 4.6% weighted average interest rate on borrowings due in part to its higher exposure to floating rate debt. Additionally, we expect leverage to move from 0.64x to mgmt’s stated goal of 0.75x over time. This will further support the company’s dividend.

Stable NAV

Since CCT’s recognized material energy-related losses (at the end of 2015), its NAV has remained more stable than that of its BDC peers. Given the composition and diversification of its portfolio we estimate NAV to be fairly steady going forward.

Levered to rising rates

Since approximately 75% of the portfolio is floating rate (with a floor), the company’s net income rises with increasing LIBOR rates.

Generally stable backdrop for BDCs in 2018

Key Risks

Origination risk

The ability to maintain the dividend and portfolio size has become increasingly difficult as direct
lending capital coming into the market has outstripped supply, allowing for sponsors to exact more favorable terms. Bank and capital markets are also robust, which gives the issuer more options and serves to the detriment of direct lenders, which offer a more expensive product.

Repayment risk

The current market environment has resulted in a significant amount of prepayments as borrowers have taken advantage of lower rates. CCT has a high level of repayments in 2018 which would need to be redeployed at an attractive spread. To the extent repayments continue and subsequently push down market spreads and terms, CCT’s earnings profile could deteriorate and pressure the dividend payout.

Interest rate risk

Substantially higher interest rates could also lead to financial stress on portfolio companies that are borrowing in floating rates, as many middle market issuers do not hedge thoroughly.

Regulatory risk

CCT employs off balance sheet leverage strategies including the Strategic Credits Opportunities Partners fund to enhance returns. If regulators were to decide that the embedded leverage or dollar amount of debt ahead of their positions needs to be included as senior securities in the asset coverage test, this would negatively affect CCT’s ability to leverage to the detriment of returns. There are also unknown regulatory risks, including ‘40 Act/BDC-specific increased legislation and/or broader financial legislation that would apply to BDCs.

Economic/credit risk

Direct lenders including CCT invest mostly in the debt of private, highly leveraged middle market companies, which may be adversely affected by an economic downturn more than other, more established companies. Performance in management’s ability to underwrite credit will also likely be critical in mitigating potential credit losses. In the current credit cycle, it is also broadly acknowledged that terms are ‘loosening’ meaningfully, which translates to watered down covenant packages, hindering creditor protections in the event of an idiosyncratic event or broader economic downturn. To the extent CCT is not receiving attractive terms, recovery rates could be severely affected.

Liquidity risk

CCT invests in illiquid assets and, if forced to liquidate, these assets may need to be sold well below fair value. Middle market/direct lending assets are especially known for the trade-off of (1) enhanced spreads/returns but (2) illiquidity, given these assets are largely outside of the banking system. While CCT runs a sound leverage structure, specialty finance/wholesale funded companies often sell-off considerably during periods of financial volatility.

Catalyst

• Continued steady performance of the investment portfolio

• Continued share repurchases

• Additional sell-side analyst coverage

• Increasing portfolio leverage

• Lack of major disruption in the credit markets and less fear of a major sell-off in the asset class