Chicago Atlantic's BDC: The Rubble of The Midwest
Disclaimer: This post is for informational purposes only and does not constitute financial advice; readers should conduct their own research and consult a professional advisor before making investment decisions.
Several weeks ago I wrote about Trulieve's potential breach of covenant, and trigger of an Event of Default under its bonds. I thought it would be rather interesting to follow-up that piece given all the near term distressed debt maturities, and have a look at Chicago Atlantic's business development corp. (“LIEN”) The tiger tail ice cream of BDCs.
To preface, Chicago Atlantic is the largest lender within the U.S. cannabis industry, and a business development corp. (“BDC”) is a US-listed vehicle to lend through. There are several benefits to a BDC structure, such as its pass-through taxes, but we won’t get into that now.
Chicago Atlantic BDC, Inc. (LIEN US Equity) is an "externally" managed BDC focused on credit investments to "esoteric" borrowers, namely US-based cannabis companies.
The BDC is "externally" managed by Chicago Atlantic BDC Advisors, which is a majority owned subsidiary of Chicago Atlantic Group, with the investment team consisting of Peter Sack (CEO of Chicago Atlantic) and Martin Rodgers (Managing Director of Chicago Atlantic), to name a few of the investment professionals. To me, this seems as internally managed as they come. But we won’t get caught up on the management structure as there are far more pressing issues.
As mentioned, the BDC is focused on lending to the cannabis sector through first-lien and senior secured fixed and floating rate structures. LIEN provides lending solutions to cash flow-based and asset-backed borrowers, like most other private credit providers. The BDC's total loan book sits at $289 MM with a weighted average gross yield of 16.5%, while paying a 13.33% dividend yield. 76% of the portfolio is floating rate, of which 99% of the loans have a floating rate floor (that is a positive).
LIEN takes pride in having an uncorrelated, idiosyncratic credit portfolio of the lower middle-market, primarily non-sponsored backed – "other BDCs and private credit funds tend to overlap on sponsor-backed, middle-market lending with similar risk profiles that are typically correlated and lack differentiation" - management of LIEN.
This is correct, there is correlation and a lack of differentiation. The drive is because most quality underwriting standards across North America lack a level of differentiation. If we analyze default rates for sponsored versus non-sponsored backed private credit, we note a materially higher default rate for non-sponsored back private credit loans (15% of total private credit defaults in 2024 were sponsored back, with the balance being non-sponsored backed). To refresh the reader, sponsored backed deals typically see lower default rates because the sponsor, or private equity firm, typically has excess cash that they are willing to use to support the company's troubles. Rather than see their portfolio company potentially file for bankruptcy, they are more incentivized to put good dollars in after bad (there are a number of other reasons, but in it's simplest form, this is the cause of lower default rates).
Coming back to Chicago Atlantic's BDC, there are two key points I intend on driving home:
1) the quality of the portfolio is sub-prime…at best; and
2) the representation of the quality of the portfolio is not marked remotely close to the underlying value or risk of the credit.
There are 31 portfolio companies held by LIEN, with a stated average position size of 3% of total investments fair value (per the investor presentation). Being the diligent investor I am, with one click we open the quarterly financials and see the note "Concentrations of Credit Risk". A quick read and we notice "three portfolio companies [represent] 42.9% […] of our investments, at fair value […] our largest portfolio company represented 17.9% […] of our investments, at fair value." These seem like two contradictory statements. I would love to hear how management explains the stark difference in concentration risk presented in the investor deck and in the financial statements.
Moving on.
5% of the portfolio's total annual interest income comes in the form of PIK (or, payment-in-kind). For those new to sub-prime or stressed credit, PIK is an interest toggle a lender will offer a borrower when there is a need for the borrower to create cash interest “breathing room” i.e. we, the borrower, cannot afford to pay cash interest, can we accrue interest through the form of increasing the debt owed at maturity? In some cases this works, in most cases, this creates a problem at maturity (tomorrow's problem).
BDC's typically rank the investment performance risk rating of their loan book on a scale of 1-5. 1 being investments that present the least amount of risk, where the borrower is performing above expectations; and 5 where the investments are performing substantially below expectations, and the lender may realize a loss upon exit. If you look at a BDC like Blue Owl Capital Corp., one of the largest private credit lenders in the world with a $17 billion loan book and 236 portfolio companies, you will notice there are investments bucketed towards the 3,4 and 5 risk rating. This is why Blue Owl set-up a work out department to manage these loans under-performing loans. Now let’s look at Chicago Atlantic's BDC - you will notice the ENTIRE loan book is sitting within the 2 risk rating. Despite the loan book being classified as a 2, the gross unrealized depreciation of the loan book decreased 106% year over year. Something doesn't add up. Mark an unrealized loss on your loan portfolio year over year, yet maintain an above average risk rating across the portfolio.
Blue Owl’s BDC:
Chicago Atlantic’s BDC:
Please don’t try to explain how a private cannabis borrower with limited access to capital markets is of higher risk quality than multi-billion dollar SaaS companies. And if you’re thinking Chicago Atlantic is a better underwriter, stop yourself.
Similarly, when comparing Blue Owl to Chicago Atlantic, we highlight Chicago Atlantic’s nil non-accruals in the portfolio. Meanwhile, Blue Owl reported 1.6% in non-accruals. Non-accruals are when there is reasonable doubt the principal or interest will be collected in full. As a risk manager collecting PIK interest, there should be a part of you that has reasonable doubt of collection.
Next let's look at the loan book maturity profile. Given the poor quality of the underlying credit, this will be a good tell at:
a) when does the loan book roll off?;
b) will the BDC realize a gain or loss on the maturing loans?; and
c) will the BDC continue to kick the can on maturing loans, placing further risk on the dividend of the BDC?
When there is significant refinancing risk to a loan, you typically want longer-dated terms.
Across the 31 portfolio companies, the weighted average years to maturity is 1.6 years. Likely why Chicago Atlantic opted not to highlight this feature in the investor presentation. Thankfully they uploaded the Excel file to their financials on their website so that I could calculate the years to maturity on my own time.
Tying it all together, what we have is the following:
A BDC trading at a ~30% discount to stated net asset value;
A $289 MM non-sponsored backed loan portfolio of mainly private companies with limited access to capital markets, and 17.9% concentration to one borrower, and 42.9% to three borrowers;
$45 MM of annualized interest income, paying $31 MM of annual dividend distributions to BDC holders;
Mis-characterized risk ratings across the loan portfolio, and likely an overstatement of the fair value of the loans (if Curaleaf bonds are marked at 95% of face value, Oasis – AZ GOAT AZ LLC (whoever they are), shouldn’t be marked at 98%); and
A less than 2-year loan book duration, with significant refinancing risk and likely liquidity risk across the underlying credit.
To conclude, I leave you with an analogy: You are driving a Mini Cooper Sport with one hand on the wheel, zooming down a country road at 110 km/h. The sun is shining, the windows are down, the breeze is blowing in your hair, the Eagles are playing on the radio. Meanwhile, in your other hand you are holding an over-dressed all-beef Chicago-style hot dog in a bun just too small for the dog, but you didn’t want to say anything to the vendor as you prefer to maintain your polite mid-west appearance. The dog is dressed with extra ketchup, mustard and relish. A bit too much for your liking. You are a bit nervous about spillage, but you persist. Take It Easy is playing. Next thing you know a speed bump is approaching. The locals in the area complained to the city about out-of-towners speed cruising in the area so they had an excessive undulation installed. You realize you are wearing a fresh white shirt. You are faced with a key decision in a moment of panic: Save the hot dog at risk of keeping your shirt unscathed, or throw the coney out the window and complete the drive hungry? You must decide quickly.
Spoiler: The hot dog is the yield on the BDC.
Cheers,
G.G.