2Q15 BDC Earnings Preview and 2017 Estimates Rollout

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1 Diversified Financials BDC/PTP North America Equity Research July 22, 2015 Industry Update Overall, we are expecting a mixed quarter for the group. We expect credit to remain relatively stable; however, non-accruing loans are near historical lows and there could be some new non-accruals in the quarter, particularly in energy-related sectors. Origination activity should be slow as most BDCs are capital constrained, which will likely cause more selectivity in the origination process that could lead to better yields and slightly improving portfolio yields. Recent outflows in leveraged loan and high yield funds are also positive indicators for portfolio yields. We anticipate book values to be flat to down slightly (1% - 2%) as liquid leveraged loans traded down slightly in the quarter. Finally, we are rolling out our 2017 estimates for the BDC group, which we consider conservative and include the impact from rising rates and increasing non-accrual rates to historical norms. Out of the BDCs in our coverage universe reporting 2Q15 results, we expect 6 to beat, 7 to miss, and 12 to fall in line with consensus estimates. See Figure 1. Credit quality was generally stable in 1Q15 and remains benign. In 1Q15, non-accruals increased slightly to 2.0% from 1.9% and our KBW Credit Watchlist was unchanged at 2.8% of the debt portfolio. Non-accruals remain at historically low levels and about half of the historical average since 2008 of 4.2%. This tells us the path of least resistance is non-accruals increasing; however, we anticipate this to be a slow process. Given the positive economic/credit data we have seen, we do not expect a significant negative hit to credit in the quarter for the group. The most susceptible industry to a credit event would be energy; however, energy prices were strong in 2Q15, which lessens our concerns a little bit. Oil has weakened post-quarter, so it still remains a concern longer term. See Figures 2-7. We expect originations and net deployment to be weak in the quarter. Pressure on BDC stock prices limited capital raising activity in the 2H14 and YTD 2015, which leaves the space capital constrained. Lower investment activity will likely lead to lower fee income, particularly for BDCs that take origination fees up front. However, BDCs that are capital constrained are likely to be more selective on new loans, which could lead to better yields on new investments and slightly improving portfolio yields. Both leveraged loans and high bond fund flows are showing incrementally positive trends that are favorable for the BDCs; however, these trends only have an indirect impact on the illiquid, middle-market markets where the BDCs invest. See Figures 8 and 9. Liquid credit market spreads remain elevated in 2Q15. We would note that these are liquid market spreads so these trends do not fully translate to middle-market illiquid credit trends. However, as mentioned above, one additional positive for BDCs beings semi-capital constrained is that we think BDCs will be more selective in investment opportunities, which can lead to increased yields on new investments relative to the current portfolio yields. As such, we expect there could be some modest portfolio yield expansion in the quarter. See Figures 10 and 11. Liquid leveraged loans traded down 1% in the quarter. Based on marked-to-market impact we expect BDC portfolio values and book values to be flat to down slightly (1% - 2%) in the quarter. See Figure 12. We are rolling out our 2017 estimates on the BDC group. Generally, our FY2017 estimates are lower (-1.2%) than our FY2016 estimates due to how we are modeling the effects of slowly rising rates, as well as the assumption of slightly higher non-accruals in the BDCs portfolios. We consider our modeling assumptions as fairly conservative and the negative impact could be offset by better loan yields. One positive takeaway from our 2017 estimates is that, broadly speaking, dividends look to be safe. Even with our conservative assumptions on rising rates impacts and credit, the BDC group still has an average of 104% dividend coverage. See Figures 13 and 14. Troy Ward wardt@kbw.com Ryan Lynch, CPA lynchr@kbw.com Greg Mason, CFA masong@kbw.com Keefe, Bruyette & Woods, Inc. does and seeks to do business with companies covered in its research reports. As a result, investors should be aware that the firm may have a conflict of interest that could affect the objectivity of this report. Investors should consider this report as only a single factor in making their investment decision. Please refer to important disclosures and analyst certification information on pages

2 See the Appendix for the BDC earnings schedule, BDC valuation and industry charts, and the detailed KBW credit watchlist. Figure 1 KBW s BDC Earnings Expectations Matrix Calendar Calendar Cons. Est. Net 2Q KBW 2Q Cons. Beat/ Est. Portfolio Mar '15 Ticker Company Rating Est. Est. Miss Originations Grow th BV BKCC BlackRock Capital Outperform Beat FSIC FS Investment Market Perform Beat HCAP Harvest Capital Outperform Beat HTGC Hercules Tech Market Perform Beat MCC Medley Capital Market Perform Beat SLRC Solar Capital Market Perform Beat SCM Stellus Capital Market Perform In-line (1) 25 (5) ABDC Alcentra Capital Outperform In-line ACSF American Capital Outperform In-line 15 (3) AINV Apollo Investment Outperform In-line FSC Fifth Street Finance Market Perform In-line KCAP KCAP Financial Market Perform In-line NMFC New Mountain Market Perform In-line PNNT PennantPark Invest. Market Perform In-line PSEC Prospect Capital Market Perform In-line TCAP Triangle Capital Outperform In-line TCPC TCP Capital Outperform In-line WHF WhiteHorse Fin. Market Perform In-line ARCC Ares Capital Outperform Miss GBDC Golub Capital BDC Market Perform Miss TCRD THL Credit Market Perform Miss ACAS American Capital Market Perform Miss HRZN Horizon Tech Fin. Market Perform Miss TAXI Medallion Financial Market Perform Miss NA NA TICC TICC Capital Market Perform Miss 50 (10) 8.72 (1) We do not consider this a beat. Our estimate is higher than consensus due to our modeled management fee w aiver to make up for under-earning dividend in previous quarters. This is a voluntary fee w aiver from management and may not occur this quarter. We expect SCM w ill w aive management fees to the extent necessary to cover the dividend on longerterm basis but may over/under-earn on a quarter by quarter basis. Source: Company Reports, Factset, KBW Estimates Company-Specific Earnings Expectations Positive: Blackrock Capital (BKCC Outperform): We are expecting BKCC to beat our estimate by $0.01. However, a more significant positive catalyst could come from BKCC exiting some of the nearly $200 million equity investments in the quarter or management s commentary surrounding potential near-term exits. BKCC exiting non-yielding equity investments is a one of the potential catalysts for the stock and we estimate redeploying these proceeds would positively impact earnings by $0.13/share annually, all else equal. While we do not have any insight as to when the investment will be exited, we do know the new management team at BKCC has made it a top priority to reduce its equity position. Please refer to important disclosures and analyst certification information on pages

3 Negative: Horizon Technology Finance (HRZN Market Perform): In mid-july HRZN provided a portfolio update for 2Q15. On the positive side, net portfolio growth was strong, which is good because HRZN has plenty of available capital to deploy from its March 2015 equity raise. On the negative side, part of the growth was fueled by weak prepayments which are expected to continue throughout the remainder of This is negative because prepayments come with prepayment fees and accelerated amortization, which is a component of earnings. Additionally, most of HRZN s fundings net portfolio growth came late in the quarter which means the positive interest income impact will be minimal. As such, we lowered our estimate $0.03 to $0.26. Our estimate is also below consensus of $0.29. TICC Capital (TICC Market Perform): Consensus estimates for TICC are $0.22 versus our estimate of $0.18. Last quarter TICC reported earnings of $0.21 but that was driven by $0.04 from a reversal of previously accrued incentive fees that should not have been previously recorded. By excluding this incentive fee reversal, 1Q15 earnings would have been $0.17. We believe 2Q15 consensus of $0.22 is too high and TICC will report lower than the consensus estimate. Additionally, TICC currently pays a quarterly dividend of $0.29/share which is not supported by GAAP NOI earnings. TICC is basing its dividend on distributable net investment income which is not a metric most investors focus on. The combination of the earnings miss and GAAP NOI earnings well below the dividend has us negative going into the quarter. Maintain Market Perform rating and $6.75 target price. Industry Commentary 2Q15 Credit Expectations Credit has been a non-issue, in aggregate, for the BDC space over the last 18 months. Over this same 18 month time period, non-accruals averaged 2.1% which is approximately where it finished in 1Q15; however, since 2008 non-accruals for the BDC group have averaged 4.2%. As such, we believe the path of least resistance is for non-accruals to trend higher versus lower. However, a reversion to the mean would result in non-accruals doubling from the current levels. So if we believe credit is more likely going to get worse versus better and historical averages would further support this trend, the key point is trying to predict when credit will turn and how fast. Credit trends in the middle-market suggest that credit should continue to remain relatively strong in 2Q15. Leverage loan default rates finished 2Q15 at 1.2%, which is well below the historical average of 3.2% and remained stable throughout the quarter. While this data is tracking leveraged loans in the more liquid credit market, this data point should be highly correlated to the trends in the middle-market/bdcs portfolios. As such, this data point is telling us credit in the BDC space should be stable in 2Q15. Please refer to important disclosures and analyst certification information on pages

4 Figure 2 Lagging 12-Month Leveraged Loan Default Rate by Amount Source: S&P Capital IQ LCD Another good data point for credit is a recently created index: the Golub Capital Altman Index. This index measures the median revenue and earnings performance from the data of approximately 150 private U.S. companies in the loan portfolios of Golub Capital. These are companies which are represented throughout of the entire Golub Capital platform and not necessarily only the companies in GBDC. The index is reporting data for the first two months (April and May) of 2Q15 as this is the only available data yet for the quarter. The index showed revenue growth in these middle-market companies of 9.3% and earnings growth of 6.9%. See Figures 3 and 4. While this is only a partial quarter of data, it does show favorable trends for both revenue and earnings Y/Y growth higher than what was experienced in 1Q15. This is definitely a positive data point for GBDC, in our view. Additionally, because Golub is using a large diversified base of private U.S. companies, we would also use this as a positive data point for credit in the BDC industry. If, on average, U.S. private businesses are exhibiting stronger revenue and earnings growth in 2Q15, it bodes well for credit quality across the BDC space. Please refer to important disclosures and analyst certification information on pages

5 Figure 3 Golub Capital Altman Index Revenue Growth Note: 2Q15 represents a partial quarter w ith dataonly from April and May. Source: Golub Capital Middle Market Report Please refer to important disclosures and analyst certification information on pages

6 Figure 4 Golub Capital Altman Index Earnings Growth Note: 2Q15 represents a partial quarter w ith data only from April and May. Source: Golub Capital Middle Market Report Overall, we do not expect any new significant credit issues in the quarter outside of energy. Credit quality basically remained flat Q/Q with non-accruals ticking up 10bps to 2.0%, up from 1.9% and watchlist investment remaining flat at 2.8%. While watchlist investments were flat Q/Q, there was some churn in the list as new investments were added and some old investments were removed. It is interesting to note that of the new investments added in the quarter, approximately 20% were related to energy. With the continual weakness in energy prices, there is heightened risk around these energy investments. Although oil prices were strong in 2Q15, rallying 22% in the quarter to finish at $59.47/barrel, it was not until July where we saw the substantial drop in oil price. So while the energy industry concerns us longer term because of the strong move in oil in 2Q15, we are less fearful of a writedown in energy investments in 2Q15. In summary, given the economic/credit data we have seen, we do not expect a significant negative hit to credit in the quarter for the group. The most susceptible industry to a credit event would be energy; however, energy prices were strong in 2Q15 which lessens our 2Q concerns a little bit. See Figures 5-7 for portfolio credit statistics. Our full KBW Credit Watchlist is in the Appendix of this report. Please refer to important disclosures and analyst certification information on pages