October 11, 2022
Right now the BDC Credit Reporter is on the look-out for BDC-financed companies that might be showing wear and tear from the effect of high inflation; wage increases and supply chain difficulties. These are the conditions that have emerged very quickly in 2022 and - on paper - threaten to create credit problems. With three quarters of the year gone - but those issues still very much at the forefront of everyone's mind - we've identified very few companies that have fallen and can't get up because of these changes in the macro environment.
However, Pepper Palace - a portfolio company of Saratoga Investment (SAR) - does seem to fit the bill. At the end of 2021 the BDC had invested $34.6mn at cost in this retailer of sauces and spices, including $1mn in equity and the rest in first lien debt. Both debt and equity were valued at par. In 2022, though, SAR has been applying ever bigger discounts to the value of the investments. As of August 2022, the equity has been written to zero and the first lien debt (19%).
SAR gave us some sense of what's going wrong at Pepper Palace on its most recent earnings conference call. Here is the full exchange between analyst Mickey Schleien of Ladenburg and SAR's CIO about the company. The highlights are ours:
"Okay. I understand, Henri. My last question, flipping back to Pepper Palace, it was funded only about a year ago, and you’ve discussed its current mark is relatively low. So I’d like to understand how its performance has deviated from your expectations? And what’s its outlook in the current economic environment?
Mickey, I think one of the things that I’d emphasize is that we still believe in the fundamentals of the concept and the unit economics for the retail concept work very well, we think, especially when located in the right locations. The business has been affected by a number of things, but they face some higher infrastructure costs to run the overall business. They are certainly facing higher input cost for their product as well as higher labor. And then that’s happening in a marketplace where there are consumers that are buying the product, that have a little less discretionary income than they did when we underwrote the deal. So those things are affecting their performance. But fundamentally, we still are believers and continue to be believers in the concept, and it’s a sponsored transaction. The sponsor is continuing to be highly supportive of the business, and we’re working with them to continue to grow the platform and hopefully get it back on track.
So Mike, that sounds like their margins are under pressure. Do you think it’s at the point where that balance sheet needs to be restructured to take into account everything you just talked about?
No. I wouldn’t say that necessarily. I think we’re working to try to continue to grow the business and improve its performance that way. But we will continue to evaluate it. It’s something that we’re definitely focused on, for sure. I think what you see in this business, and it’s not uncommon if you look at the broader marketplace for retail or restaurants or people that are out selling to consumers in a lot of those models right now, you see revenue growth, but you see costs rising faster than that. So you’re seeing the revenue increase, but spread compression, and that’s one of the things that they are facing. We don’t think that’s permanent, but it’s certainly something they are facing now."
We have rated the company CCR 3 on our 5 point scale, which means we believe the chances of a full recovery for SAR are greater than slipping into an ultimate loss. However, the investment seems to be on a knife's edge, especially as there are no signs that inflation; wage pressures and discretionary income are improving any time soon. We could see a downgrade to CCR 4, or even CCR 5 if the company defaults. As is often the case, we just don't have enough information to more than speculate, but we are reassured by the opening of a new store in August. We'll have a clearer picture next time SAR reports results at the turn of the year. In the interim, we'll continue to look for more companies like Pepper Palace impacted by this much-changed economic environment.