March 7, 2017 / 7:52 PM / 5 months ago

Fitch Affirms Apollo Investment Corp at 'BBB-'; Outlook Remains Negative

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(The following statement was released by the rating agency) NEW YORK, March 07 (Fitch) Fitch Ratings has affirmed the Long-Term Issuer Default Rating (IDR), secured debt rating and unsecured debt rating of Apollo Investment Corporation (Apollo) at 'BBB-'. The Rating Outlook remains Negative. Today's rating actions have been taken as part of Fitch's periodic peer review of Business Development Companies (BDCs), which comprises eight publicly rated firms. BDC INDUSTRY OUTLOOK Fitch's outlook for the BDC sector remains negative; reflecting competitive underwriting conditions given unattractive supply/demand dynamics in the middle-market, earnings pressure, weakening asset quality metrics, and limited access to growth capital. While some firms are better positioned, given their more conservative financial profiles, platform strength, capital market access and portfolio characteristics, others are likely to see rating pressure over the outlook horizon. Underwriting conditions have been competitive for several years, as the continuation of low interest rates around the globe has increased the demand for higher-yielding middle-market paper for a variety of investor classes. While demand has been on the rise for several years, supply dropped meaningfully in 2016 bringing added pressure to middle-market deal structures and pricing. Fitch believes challenging underwriting conditions are likely to persist in 2017, further highlighting the importance of a BDC's scale, platform, the consistency of its risk tolerance, and its access to meaningful deal flow, to avoid adverse selection. Non-accrual levels for the industry have been on the rise, but portfolio issues to date have generally been isolated to energy-related investments and idiosyncratic portfolio issues. Core industrywide defaults remain below historical norms and Fitch does not currently see a catalyst for meaningful portfolio deterioration over the near term. However, BDC portfolios are heavily concentrated in 2014-2016 vintages, which generally exhibit higher underlying leverage levels and weaker terms and conditions. As a result, any cracks in the economy are likely to translate into asset quality issues more quickly, given the smaller embedded financial cushion in most portfolio credits. Capital market access was limited for the rated peer group in 2016, with $78 million of public equity issuance for the year. However, BDC share prices rallied as the year progressed, and the average share premium was 1.8% at March 3, 2017, although the gap between the strongest and weakest stocks remains relatively wide. Fitch expects equity issuance to increase in 2017, with those having access to the market benefiting from a competitive advantage. On the debt front, a $600 million issuance in September 2016 was the first public-note issuance in nearly 17 months. Fitch expects public market access to remain challenging for some in 2017, but debt maturities this year are considerably more manageable. Fitch observed a modest improvement in BDC leverage in 2016, as share repurchase activity declined with the run-up in share prices and because portfolio repayments surpassed origination volume. Average leverage for the rated group was 0.66x at Sept. 30, 2016, compared with 0.71x at year-end 2015. Fitch expects BDCs with elevated non-accruals and outsized exposure to non-debt investments to operate with a more meaningful asset coverage cushion given the potential for valuation volatility and/or incremental portfolio losses. KEY RATING DRIVERS IDRs AND SENIOR DEBT The affirmation of the 'BBB-' ratings reflect Apollo's affiliation with the Apollo Global Management, LLC (AGM) platform, which provides access to investment resources and deal flow, declines in leverage that better align with the portfolio risk profile, the continuation of management fee waivers and the dividend cut which better align with current earnings capacity, solid funding flexibility, and the benefits of the BDC regulatory construct which limit leverage. The maintenance of the Negative Outlook reflects Apollo's continued higher-risk portfolio profile given outsized exposure to challenged oil & gas investments, structured products and other equity positions, in addition to a meaningful concentration in aircraft financing, and higher-than-average non-accrual levels. While the firm is working to reduce its exposure to more volatile investment categories as part of its new operating strategy, portfolio rebalancing and investment restructurings may come at the cost of additional realized losses over the near term. In mid-2016, Apollo announced several management changes and a new strategic direction, meant to capitalize on the exemptive order relief it received from the SEC in March 2016, allowing the firm to co-invest with other pockets of capital across the AGM platform, most notably with affiliate MidCap Financial (MidCap). The exemptive order allows the firm to lead bigger deals in the middle market as it can commit to a larger proportion of the financing and internally syndicate the commitment across different pockets of capital on the AGM platform, which is something other firms in the BDC space have found beneficial. The firm's new target portfolio is expected to consist of traditional corporate loans (50%-60%), co-investments with MidCap in life sciences, asset-based lending, and lender finance (20%-25%), aircraft leasing (15%), and legacy verticals. Apollo expects to opportunistically rotate out of oil & gas, structured products, solar power, shipping, and other equity investments, while rotating into yielding debt securities over time, to improve the consistency of its earnings and net asset value (NAV) and to reduce portfolio risk. Resolution of the Negative Outlook will be dependent upon the firm's ability to execute on this strategy, which may take some time to realize. Still, the firm has made initial progress on this plan over the past six months. Structured product investments, consisting largely of middle-market CLOs and credit-linked notes, accounted for 8.6% of the portfolio at Dec. 31, 2016, down from 10.7% a year ago. Apollo exited its investment in MCF CLO III, LLC subsequent to quarter-end, which would take its structured product exposure down to about 6.9%. The firm has also begun to make good on its efforts to pursue co-investment opportunities, having completed eight transactions through early February, including three transactions in fiscal 3Q17 for about $55 million of capital. Other parts of the new strategic plan may take longer to achieve. Oil & gas investments still accounted for 9.4% of the portfolio at Dec. 31, 2016, which is down from 12.9% a year ago, but remains amongst the highest for the rated peer group. In February 2017, Canacol Energy Ltd. repaid its loan, which brings the firm's oil & gas exposure to 6.5% on a pro forma basis. In the first nine months of fiscal 2017, Apollo recorded realized and unrealized losses on oil & gas investments, including Osage Exploration & Development, Inc. ($19.4 million realized loss), and Venoco, Inc. ($42.2 million unrealized loss), while investments in Pelican Energy, LLC (Pelican) and SHD Oil & Gas, LLC (SHD) were on non-accrual at quarter-end. Further market movements or company-specific challenges could result in incremental valuation hits in coming quarters and eventual realized losses. Further, exposure to preferred and other equity securities (excluding investments in aviation) represented 9.5% of the portfolio at Dec. 31, 2016, consisting of investments in renewables, shipping, and restructured oil & gas investments, amongst other equity investments. While Fitch believes the broader AGM platform has experience investing in these industries, these investments are less suitable for the BDC platform given their contribution to valuation volatility. In the nine months ended Dec. 31, 2016, Apollo recorded a $42.1 million unrealized loss on its investment in Solarplicity Group Limited (Solarplicity), due largely to the impact of the forward power curve and inflation expectations on its valuation, although a significant portion of the loss is offset by gains on foreign exchange. Fitch expects Apollo to opportunistically exit its preferred securities and other equity investments over time. Exposure to aviation amounted to 19.1% of the portfolio at Dec. 31, 2016, compared with 15.3% a year ago, consisting solely of the firm's investment in Merx Aviation Finance, LLC (Merx), which owns and leases a diverse portfolio of current-generation commercial aircraft. Apollo holds a first-lien investment in Merx, with a 12% coupon, in addition to 100% of Merx's common equity. Fitch views the entire investment as a levered equity position, as Apollo is the majority owner. Apollo's exposure to Merx, on a fair value basis, declined in recent years, given the return of capital to Apollo, but it has grown as a percentage of Apollo's portfolio given overall portfolio contraction. Fitch believes this investment is outsized, which in combination with the cyclical nature of the aviation industry, introduces more valuation volatility than a portfolio of first-lien positions that are diversified by obligor and industry. Investments on non-accrual status accounted for 7.9% of the debt portfolio at cost and 3.3% of the debt portfolio at fair value, at Dec. 31, 2016, which is above the peer average. The fair value exposure is across three portfolio companies; SHD and Pelican, both of which are legacy oil & gas exposures, and SquareTwo Financial Corp., an asset recovery business. While Apollo has restructured and/or exited the majority of its oil & gas exposures, Fitch believes further losses are possible, given unrealized write-downs on several restructured energy names. Additionally, non-accruals could increase over the near term, given that non-energy credit performance is likely at unsustainable lows. Apollo's long-term track record in credit is weaker than that of its BDC peers, having generated cumulative net realized losses of about $1.2 billion from inception through Dec. 31, 2016. Fitch will assess the investment acumen of the new management team over time based on the performance of new-vintage originations. Apollo's core operating performance remains challenged thus far in fiscal 2017 given the impact of a shrinking portfolio and continued asset quality challenges. Net investment income (NII) was down 24.7% in the first nine months of fiscal 2017, year over year, as interest income declined 24.5% and the portfolio, at cost, contracted 11.7%. Fitch believes earnings growth will be challenged in coming quarters as the firm continues to deal with elevated non-accruals. However, over time, the rotation of the portfolio from non-yielding equity investments into yielding debt securities should provide increased stability and growth potential. Apollo's leverage was 0.7x at par, at Dec. 31, 2016, down from 0.8x a year ago. Leverage benefited from a decline in debt outstanding, as maturities were repaid with investment portfolio proceeds, partially offset by continued share repurchases. Fitch views the decline in leverage favorably and expects the firm will manage leverage at-or-near current levels as the portfolio transitions into more senior, yielding debt investments. Since the establishment of the share repurchase program in August 2015 through Dec. 31, 2016, Apollo repurchased approximately $100.4 million of stock. This yielded $0.13 of per share accretion to NAV. Fitch believes share repurchase activity is likely to moderate over the near term given the improvement in the firm's share price performance in recent months. At March 3, 2017, Apollo's stock was trading at a 6.3% discount to NAV, which is a significant improvement from a year ago. Fitch believes Apollo has been successful improving its funding flexibility in recent years, and 61.7% of its total debt was unsecured as of Dec. 31, 2016, which is above-average for the peer group. The firm recently amended and extended its corporate revolver, reducing commitments to $1.14 billion from $1.31 billion and extending the maturity to December 2021. Borrowing capacity was approximately $753.2 million at Dec. 31, 2016. Apollo has no debt maturities until September 2018, when $16 million of secured term debt matures. In its 1Q17 earnings announcement, Apollo cut its dividend to $0.15 per share from $0.20 per share, in an effort to improve earnings coverage, which Fitch viewed as prudent. Dividends were fully covered by NII in the first three quarters of 2017, but fee waivers continue to be in place, which reduces the expense base. The waivers are set to expire on March 31, 2017, but Fitch believes these waivers will either be extended or made permanent to ensure strong dividend coverage. Fitch also considers coverage of the dividend adjusting for non-cash paid-in-kind (PIK) income, which weakens coverage on a current cash basis, as PIK, net of repayments, accounted for 9% of total investment income in the first nine months of 2017, which is above the peer average. Fitch believes non-cash income is likely to remain elevated over the near to medium term, as PIK is prevalent on several oil & gas investments and Solarplicity (the firm's second largest investment at Dec. 31, 2016). Fitch would view a decline in non-cash income favorably. RATING SENSITIVITIES IDRs AND SENIOR DEBT Apollo's ratings could be downgraded if the firm is unable to make progress on its new strategic plan in the coming year, as measured by an improvement in the portfolio risk profile, an increase in yielding investments, and demonstrated platform benefits from exemptive order relief. While the firm may recognize losses on the exit of certain legacy investments, as part of the portfolio rotation, this will be viewed in the context of potential upside provided by redeploying proceeds into a yielding investment. Deterioration in asset quality (particularly in non-energy investments), an increase in leverage above 0.75x, a weakening liquidity profile, and/or an inability to cover dividends with core earnings could also result in a ratings downgrade. A revision of the Outlook to Stable would be dependent upon improved earnings and NAV consistency along with solid credit performance of 2014-2016 portfolio vintages, which have been originated in a more challenging market environment. A reduction in portfolio concentrations, particularly Merx, and an improvement in dividend coverage on a cash basis could also contribute to positive rating momentum. Headquartered in New York, NY, Apollo is an externally managed BDC, organized on Feb. 2, 2004. As of Dec. 31, 2016, the company had investments in 85 portfolio companies amounting to approximately $2.5 billion. Fitch has affirmed the following ratings: Apollo Investment Corporation --Long-Term IDR at 'BBB-'; --Senior secured debt and revolver at 'BBB-'; --Senior unsecured debt at 'BBB-'. The Rating Outlook is Negative. 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