Last week, Vertical Capital Income Fund (VCIF) ($98MM market cap) announced a proposed manager and strategy change, if approved, Carlyle Group (CG) will assume management of the closed end fund and transition the portfolio from residential whole loans to CLO equity and debt. To encourage the proposal passing, Carlyle will make a one-time payment to VCIF holders of $10MM or $0.96/share. Then to ensure alignment, Carlyle will tender for $25MM at NAV and invest an additional $25MM in the fund through a private placement done at NAV. Following these transactions, Carlyle will own ~40% of the fund.
CLO stands for collateralized loan obligation, these are securitized pools of below-investment grade senior secured bank loans made to corporations (largely PE sponsored). CLO equity sits at the bottom of the securitization’s capital structure and receives the residual cash flow after all expenses and interest is paid to senior noteholders in the transaction. CLO notes feature term financing with no mark-to-market, meaning CLOs can withstand volatility in the underlying bank loan market and often the manager can “build par” to offset any losses in the portfolio by purchasing loans at a discount and holding them through repayment at par. CLO equity is generally underwritten to a mid-teens IRR. There are several publicly traded CLO equity funds today, two prominent ones are Eagle Point Credit Company (ECC) and Oxford Lane Capital (OXLC), both trade roughly inline with NAV or slightly ahead (NAV is lagging, loans are up 1.80% to date, CLO equity values are likely up a bit).
Carlyle is one of the largest CLO managers, by taking over this fund, the PE giant will have a permanent source of equity capital for future CLOs. This is important for future fund formation and why Carlyle is willing to pay $10MM to holders directly. Fees to fund holders are going up in the transition as well (but roughly on par with similar funds/BDCs), VCIF currently pays 1.25% of assets, now will pay 1.75% of assets plus a 17.5% incentive fee above an 8% hurdle rate. Carlyle does get to double dip a bit, they’ll likely purchase Carlyle Group managed CLOs where they also earn a management fee.
VCIF currently trades for $9.38/share against a 12/31 NAV of $10.25/share, or an 8.5% discount (without factoring in the $0.96/share payment). The vote is mostly secured at this point, 36% of shareholders have signed a support agreement. I quickly sketched out what the return stream might look like in the next six months (the deal is set to close in the first half of 2023):
The biggest assumptions I’m making:
- NAV is constant, the portfolio is marked monthly, the current holdings are mortgages with interest rate sensitivity, it’ll move inversely with rate expectations (mortgage rates are flat-to-slightly down YTD). As part of the transaction, current management has committed liquidating to cash at least 95% of the gross assets in the portfolio, thus reducing the NAV risk.
- Only the January distribution is made and it doesn’t erode NAV. Additional interest income we’ll assume goes to pay for any deal expenses the fund is expected to pay.
- All holders participate at 100% in the tender offer. If less than 100% participate, it improves the realized IRR.
- Following the transition, the shares trade at a 15% discount to NAV. In the last 12 months, the fund’s shares have traded at an average discount of 12% and as mentioned earlier, the prominent CLO equity funds trade roughly in line with NAV.
I come up with a ~18% IRR for the 5+ months it’ll take to close this deal (feels like it should happen sooner pushing the IRR above 20%) and might hold after closing when it will be rebranded as Carlyle Credit Income since CLO equity is reasonably cheap today.
Disclosure: I own shares of VCIF
