On Friday August 30th 2013, lower middle market Business Development Company (BDC) Monroe Capital Corporation (MRCC) announced a third quarter 2013 dividend of $0.34, unchanged from the prior period. Since going public MRCC will now have paid the same $0.34 quarterly dividend on four occasions. The latest distribution is to be paid out on September 27th to shareholders of record as of September 13th.
Important Of Dividend Sustainability: Many investors buy Business Development Company stocks for stable, recurring income. Rightly or wrongly, investors regard BDC common stock investments as a bond substitute, and look to a steady income stream over the long term. We've been investing in the BDC sector for over a decade, and our experience is that most BDCs, due to the structure of the business model as originally set-up by Congress in 1980 (requirement to distribute all earnings without any bad debt provisions) are unlikely to maintain their distribution levels over time. Some BDCs may go years with their pay-outs unchanged or even growing before a sudden cut occurs, usually of 20% or more. We undertook a study of the 21 BDCs in operation at December 2007, and found that only 4 were able to maintain their dividend unchanged through the Great Recession. In fact, the average dividend cut was 50%! However, in the 5 years prior to the Great Recession essentially no BDC ever reduced its pay-out.
We're in another period similar to 2003-2007 when virtually all the BDCs we track are able to maintain or increase their distributions from period to period. Nonetheless, investors should not become complacent. Solar Capital (SLRC) reduced its dividend by one-third this month out of a clear blue sky and only weeks after raising additional equity from investors. Inevitably there will be others, and perhaps many more when the next recession strikes. Therefore it's important for investors to ask themselves periodically if the dividends that they are counting on will still be there in the future. That's far more important than seeking to determine a BDC's earnings per share a quarter out.
In this regard, we are initiating a recurring series,where we analyze a given BDC and ask if the current dividend level is sustainable in the short and long term. We hope in the next few months to assess all three dozen dividend-paying BDCs that we track. We begin with Monroe Capital only because the Company happened to make a dividend announcement as we began this series.
Background: Monroe Capital is a Chicago-based, newly minted BDC, which went public on October 24, 2012. The Company had no prior investment activity before it's initial public offering. However, the BDC's external manager, Monroe Capital LLC, has been around since 2004 and manages $1.2 billion of assets, principally in middle market credit.
Business: 99% of MRCC's $144 million of investment assets (valued at fair market at June 30th) are in the form of 32 unitranche, senior and junior loans to lower middle market companies, usually to finance buy-outs, acquisitions or recaps. At quarter's end, the Company reports the "effective yield" on its loan portfolio was 10.9%. ("Effective yield" is a combination of the contractual loan yield, plus various fees received up-front or at repayment). Net Investment Income, as adjusted by the Company, was $1.7 million or $0.30 a share at the quarter ended June 2013. The Company's sole debt source at the moment is an ING Capital $65,000,000 Revolver. However, in July Monroe received a Green Light letter from the Small Business Administration ("SBA") "inviting us to continue our application process to obtain a license to form and operate a Small Business Investment Company ("SBIC") subsidiary…If approved the license would provide us with an incremental source of attractive long term capital through the use of SBA debentures".
Short Term: Is MRCC's $0.34 distribution sustainable in the short term? (We define "short term" here as the next four quarters). Between three options of Probably, Likely or Unlikely, we say Likely.
Earnings Don't Cover Dividend: However, there is a healthy amount of uncertainty here. The obvious initial problem is that the Company's recurring Net Investment at $0.30, even adjusted for items that GAAP requires but do not apply in real-life, does not cover the distribution at $0.34.
More Dividend Mouths To Feed: What's more, MRCC raised a boatload of new equity in early July that nearly doubled the Company's share count from 5.8 million shares to 9.8 million shares, and its dividend-paying obligation. The equity was raised for the very reasonable purpose of having capital to take advantage of the opportunity to launch an SBIC subsidiary, and borrow $2 for every $1 of capital on very favorable terms. However, any material contribution from SBIC lending is several quarters away. No wonder then that the analyst consensus for earnings in the next two quarters is $0.28 per share, 6 cents below the dividend. We believe even that number is optimistic. Net new loan activity has been only moderate in recent quarters, and loan yields have been under pressure from the competition for new loans, so we expect only a modest increase in investment income in the rest of 2013 at a time when the dividend liability is rocketing upwards (assuming the $0.34 payout remains unchanged). As a result, a substantial portion of the dividend in the short term will be a return of capital, as MRCC borrows under the Revolver to maintain the dividend.
Monroe Commitment To The Dividend: In fact, the only reason we regard the current dividend as sustainable in the short term is that management appears to be committed to a stable dividend strategy, and they have a reason to expect earnings will catch up with the payout in good time. As Solar Capital and Kohlberg Capital (KCAP) have proven recently by either cutting their dividend, or preparing investors for a future cut, is that the impact on the stock price can be devastating. SLRC is down 12% from the pre-announcement high, and KCAP is down 20% since their latest lukewarm earnings release.
What Could Go Wrong : What if the SBA nixes the Monroe SBIC application? It's happened before (re Horizon Technology Finance September 2011), but we're not terribly worried it's going to happen. The parent already has another affiliate which has been granted a license, so the Monroe management is presumably on good terms with the bureaucrats at the SBA. Should it happen, though, MRCC is going to have to develop a new business strategy. In the short term, that would probably involve more of the same type of lending, as they are involved with at the moment. Unfortunately, the leverage and yields achievable without the extra fillip of the SBIC, even when all the new capital would be fully invested, is unlikely to achieve earnings per share of greater than $0.30 a quarter, using the latest quarter's results as a model. In that case, a dividend cut to $0.28-$0.30 would be probable.
Long Term Outlook: Let's look three years out, and assume another recession occurs in America. That's our definition of long term. Unfortunately, we believe the prospects of Monroe Capital maintaining the dividend under highly unfavorable business conditions is Unlikely.
We Do The Numbers: Even if everything goes to plan and the SBIC license is received and all capital deployed, the Company's earnings are unlikely to max out at much above the current dividend level. We ran some numbers and assumed a debt to equity of 1:1, average yields of 12.0%, and a cost of debt of just 4%, and came out with a very ball-park annual earnings per share of $1.30. The analyst consensus for next calendar year is similar: $1.34 versus an annual dividend liability of $1.36.
Layer on that the realistic prospect that a number of the 70 or so loans that MRCC should have on it's books, when the future recession comes to town, will go south, and you have the recipe for a dividend cut. Unlike some other BDCs that can occasionally offset credit losses with gains on the sale of equity investments in their portfolio (we're talking about Main Street Capital (MAIN) and Triangle Capital (TCAP) mostly), MRCC has no such option as they are exclusively focused on being a lender.
Reliance On Revolver: What's more, we're a little worried that the ING-led Revolver, with relatively conservative covenants and borrowing base calculations, may cause Monroe some problems if the credit market went sideways. ING and the banking group may be enthusiastic today, but they may not be in the future (the Revolver matures in 2015), which may place pressure on Monroe at some point to bring down total assets financed by the facility. If that happened (as it did to a myriad number of BDCs which were financed by bank Revolvers in the Great Recession) that would reduce earnings, and thus the dividend. We'd be happier if Monroe had longer dated debt capital, with fewer covenants, but as a relative newbie this appears to be as good as it gets at the moment.
How We Could Be Wrong? To be fair we seek to point out what could happen to protect the dividend, and keep our prediction of a likely dividend cut long term from happening:
1. Short-term interest rates could increase-a lot. A very marked increase in LIBOR rates would benefit the Company, as most of it's current loan assets are tied to the floating inter-bank rate. The 10-Q shows clearly that a 3% increase in LIBOR could increase Net Investment Income by 15%. Yes, borrowing costs on the Revolver would increase but there are more floating rate assets than liabilities. Unfortunately, though, the likely shift towards match funding fixed rate loans and fixed rate SBIC debentures would mean that much of the loan portfolio would not benefit from this development.
2. Monroe could avoid making any material credit missteps. There is nothing written that any lender has to make "bad loans". While we have very little track record from MRCC, to date the credit blotter has been kept immaculately clean. The external manager is experienced and well staffed. The current portfolio principally consists of medium risk loans, judging by the yields involved. Nonetheless, you'd have to be very bullish to assume the Company will bat 100% over the long term.
3. The SBIC program could be enlarged. If that happens, MRCC may be able to borrow even more from the SBIC than we have envisaged. That would allow Monroe to increase leverage, and earnings well above the $1.30 per share a year we're projecting. However, this remote prospect (and which is complicated by how Monroe might allocate SBIC capital over it's entire franchise) would also increase shareholders exposure to credit risk.
4. Loan yields for new loans could increase. We are assuming only a 12.0% yield on new SBIC-funded loans, and 10.0% on regular loans funded by ING. If MRCC is able to charge 13%-15%, virtually all that increase drops to the bottom line. Just a 1% increase in the average yield could mean an extra $0.24 in net earnings per share.
Summaary: Monroe Capital's dividend is Likely to be sustained in the next 12 months. In the longer term, maintaining the current payout is Unlikely.