Oxford Lane Capital Has ‘Got Some Splainin’ To Do’
OXLC’s decision to stretch its normal 12 month dividend over 13 months this time around has shareholders scratching their heads. Rule No. 1 of corporate communications: Always get out in front with the explanation instead of leaving the public to guess. Breaking that rule merely invites people to make up their own explanations — usually far worse than the reality. The bigger question begging for an answer: Does the drop in NAV reflect taxable income better than GAAP accrued income because of GOOD things, like better credit experience… … Or does it reflect BAD stuff, like failing to sell or dissolve CLO investments before they start returning principal? As I Love Lucy ‘s Ricky Ricardo often said to his wife Lucy, “Honey, you got some splainin’ to do,” so might Oxford Lane Capital (NASDAQ: OXLC ) shareholders expect some explanation from the fund’s management after it quietly announced its quarterly dividend “stretch” earlier this month. With a history of paying dividends at the end of March, June, September and December, the company announced August 10th that its next dividend would be paid October 30, four months after its last dividend on June 30 (to holders of record September 30.) “Not a big deal,” some investors might say, essentially stretching a typical year’s dividend to cover 13 months instead of 12. But a dividend cut is a dividend cut, however it is served up and described, and certainly worthy of some explanation. That’s especially true inasmuch as “Good Corporate Communications Rule No. 1” is Always get out front and explain what you’re doing instead of leaving shareholders to guess . Especially because, in most cases, they will guess something even worse than the real reason. Let’s hope that is the case here, and that there is some reasonable explanation. Beyond that, there are other things OXLC’s management needs to do a better job explaining. (The upcoming stockholders’ meeting on September 9 would be one good venue, although I hope they put something out before then.) They essentially revolve around educating their shareholders and the market to what their “income” really consists of, and what the difference between GAAP income and taxable/distributable income actually is and how it affects the fund’s NAV over time. This latter point is a really big deal and will determine whether or not OXLC and other funds, BDCs, etc. that hold CLO equity are to be regarded by the market as “wasting assets” like royalty trusts, whose payouts slowly but permanently eat up their capital to the point where they finally make the last distribution and there is then nothing left. I am not suggesting CLOs are wasting assets , but there is enough confusion about the subject that I can understand other people coming to that conclusion. Here is how I understand the situation (and readers should take this, and everything I write, with a grain of salt because I am far from an expert): I have recently come to understand that many CLO equity owners are taxed on the entire cash flow they receive from their CLOs (including principal repayments) as though it is all income. Meanwhile, on a GAAP basis, they only include some of that cash flow as income, excluding from income principal plus other accrued and/or projected expenses, like credit losses, losses due to interest rate adjustments, etc. This means that taxable income (which is used to determine distributable income for paying dividends to shareholders) will often be higher than the GAAP income, for two primary reasons (one reason good, the other bad). The good reason : If the fund has been prudently accruing for credit losses at say, 1.5% per annum, and in fact credit experience is so good that the actual losses are only 0.5% per annum, then 1% more cash flow will be received than was actually expected. GAAP income will assume 1.5% was lost in credit losses, but in fact that extra 1% that wasn’t lost will show up as additional cash flow available to pay dividends. If the CLOs’ equity (which is what OXLC owns) is typically leveraged 9 or 10 to 1 then that extra 1% on the CLOs’ portfolios will show up as 9 or 10% in extra margin for their equity. So there will be a considerable difference between reported GAAP income and the actual taxable/distributable income from this factor alone. In the short term, the fund’s accountants will assume that the 1.5% credit loss will hit eventually and will maintain the accrual at 1.5%, even though the loss suffered was only 0.5%. If the difference is paid out as a distribution, from a GAAP perspective that difference will represent an “unfunded” portion of the dividend, and will therefore be deducted from the NAV as a return of capital. Later on, if that CLO terminates or is sold without having ever suffered the credit loss that was accrued for, that unnecessary accrual should return as some sort of an adjustment or capital gain, with a corresponding adjustment upwards of the NAV. That, I believe would be the impact on OXLC’s NAV of accruing expenses (for credit or anything else) that are eventually not taken and therefore reversed. The bad reason: If the fund actually receives principal repayments that it is taxed on and treats as distributable income, that is money out the door never to return (i.e. a true return of capital), and would be just like a real “bricks-and-mortar” bank (a CLO is a virtual bank) using principal repayments from its loan portfolio to fund its dividends. But funds like OXLC aren’t stupid, and I don’t think they want to receive principal back, get taxed on it and have to use it for distributions. After all, it runs down their asset base and would, ultimately, put them out of business. So I believe they make an effort to dispose of their CLO assets – sell them or dissolve the CLO itself if they have a controlling position or can join with other investors for the purpose – before the CLO reaches its wind-down period where the CLO manager can no longer re-invest principal payments in new loans and has to return it as a taxable distribution to equity owners. If my understanding of this is at all correct, then OXLC’s management, if it is doing a good job, should be managing the portfolio in such a way as to ensure that there are very few principal repayments making their way into the distribution stream. That would mean that most of the difference between the GAAP income and the taxable/distribution income is represented by actual differences in the flows of a positive nature, like credit expenses that are less than what was projected for, and which will be reversed back into NAV once those CLOs end, one way or another, with their better-than-projected-for credit records intact. The above is my theory of what might be/could be and, I hope, actually is going on. If that is true, then the NAV drops we are seeing are not necessarily one-way only drops, but represent the GAAP-taxable income factors described above as well as the overall market drop in high yield assets generally. If that’s what it is, then it does not represent an economic deterioration in the ability to earn cash flow and pay dividends indefinitely. If I am wrong, and it were to actually mean that a major portion of the OXLC distribution is made up of principal repayment, then we would have to re-think the asset class and our expectations about it. As I said, I have no reason to think my upbeat interpretation is not the correct one. But it would sure be helpful if the fund’s management were to weigh in with some explanations that would put the matter to rest. It would help us all as shareholders to understand better what we are invested in. It would be in the fund’s interest as well to have investors understand management’s strategy and what the factors are that influence whether they are successful or not in executing it. Disclosure: I am/we are long OXLC. (More…) 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.