KCAP Financial Targeted by an Activist; What the Smart Money Thinks about the Stock?

According to a recent 13D filing with the U.S. Securities and Exchange Commission, Dov Gertzulin’s DG Capital Management holds an ownership stake of 1.15 million shares in KCAP Financial Inc. (NASDAQ:KCAP), accouting for 3.1% of the company’s outstanding common stock. This marks an increase of 43,723 shares from the position reported through the fund’s latest 13F filing. All these shares were acquired through open-market transactions during the period of April 9 – October 5, 2015. DG Capital outlined that the shares of KCAP represent an attractive investment opportunity and pinpointed potential alternatives of how to unlock shareholder value. The following article will discuss in greater detail DG Capital’s letter to KCAP’s Board of Directors and the actual performance of the company over the last year or so.

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Prior to proceeding with the discussion on the DG Capital’s activist target, we will provide a brief introduction to this investment firm. DG Capital Management is an even-driven hedge fund established by its current managing member Dov Gertzulin in 1996. The Boston-based investment firm primarily invests in core and growth stocks of mid- and large-cap companies. DG Capital manages capital for high net-worth individuals, foundations, pensions, and family offices. As stated by its latest 13F with the SEC, Dov Gertzulin’s investment firm manages an equity portfolio with a market value of $113.07 million as of June 30.

Let’s now turn our attention to KCAP Financial Inc. (NASDAQ:KCAP), an internally-managed business development company that specializes in mid-market, buyouts, and mezzanine investments. The shares of KCAP have been riding a downtrend since early-March and have lost 23% year-to-date. However, it seems that the stock is bouncing back at the moment, thanks to the broader market rally and to DG Capital’s activist stance. When it comes to the hedge fund sentiment, KCAP Financial did not receive too much attention from the hedge fund industry during the second quarter, as the number of investors with positions in the stock decreased to five from six quarter-over-quarter. However, the value of these positions increased to $8.66 million from the $2.06 million reported at the end of the first quarter. The handful of hedge funds invested in the stock accumulated 3.90% of the company’s outstanding shares at the end of June. Meanwhile, John Fichthorn’s Dialectic Capital Management acquired a 127,000-share position in KCAP Financial during the June quarter.

Dov Gertzulin and his team believe that the market has not fully priced in the potential and “true” intrinsic value of KCAP Financial Inc. (NASDAQ:KCAP), claiming that the company is not fully apprehended by most investors. In fact, the activist investment firm suggests that a potential sale of the entire company to another business development company, or a potential share buyback program, using the proceeds from the sale of particular assets, represent two alternatives that could maximize shareholder value.

Furthermore, DG Capital reckons that the shares of KCAP have greatly underperformed the broader market and its peers over past five-year period, mainly due to its “complex collection of assets”, which actually caused a restatement of the company’s financial results. To be more specific on that, the Audit Committee of KCAP’s Board decided earlier this year that some of the company’s previously-released financial results had to be rectified because of some errors related to its investment income from equity investments in CLO (i.e. collateralized loan obligation) funds and its dividend income. This announcement put even more downward pressure on the stock, which is allegedly trading at material discount compared to its peers.

We will now briefly discuss the company’s point of view regarding one of the alternatives proposed by DG Capital Management. On KCAP Financial’s second quarter earnings call, President and CEO Dayl W. Pearson asserted that the company had eschewed from implementing a share buyback program primarily due to leverage limitations, among other things. In fact, it appears that Carl Icahn shares the same point of view with the CEO regarding share buyback programs. The reputable activist investor recently stressed that this move is simply weakening companies’ balance sheets without providing any long-term benefits (read more details here). Going back to our case, Dayl Pearson and the company’s Board of Directors fear potential “unseen evens such as what happened in 2008”, so they prefer to sit on the company’s piles of cash rather than spend them on share buybacks.

Disclosure: None