A few days ago, the BDC Reporter mentioned there are at least two new Business Development Companies getting ready to go public. We reviewed the initial Prospectus for Medley Capital Corporation (MCC) and prepared some thoughts for publication. In the interim, MCC went public and priced 11 million shares at a price of $12.00 on January 20. Since then the stock had traded higher to reach just over $13 as we write this. We thought it might be useful to look at the Good, the Not So Good and Unknown about this new BDC.
JUST THE FACTS
First, though, a few basic facts: Medley Capital focuses on direct lending, generally senior secured, in amounts from $10mn-$50mn to North American borrowers. From both yield and equity investments in private companies, MCC is targeting a “total return to investors on average of 15% over time.”
Medley is externally managed by MCC Advisors, which is affiliated with Medley Capital LLC, with offices in New York and San Francisco. The principals have worked together for seven years and have managed private loan funds (not BDCs) that have lent out $1.2bn in two limited partnerships.
MCC begins with a small portfolio (just 6 loans) purchased from its sister companies, with a yield of 14.6% (a portion in Pay In Kind interest). In addition, the new company has applied for a Small Business Investment Company (SBIC) license, through a new subsidiary. (If successful, MCC will be able to borrow $2 of debt capacity from the SBIC for every $1 of equity invested in the special subsidiary. Theoretically a borrower can access up to $150mn in SBIC financing from Uncle Sam).
MCC intends to pay a dividend of $1.0-$1.20 a year, but that is not guaranteed.
Their website is here.
Secured Lending Experience: On reading the Prospectus, we liked the experience MCC has in the secured lending area, which is their focus going forward. This is the pawn broking side of commercial lending where an understanding of the liquidation value of assets is critical to long-term success. In two partnerships, MCC’s sister companies have been active since 2006 and have been involved in 41 transactions, and have received $543mn in principal and interest on $1.2bn invested.
SBIC : The intention to use SBIC money makes sense, both for ready access to capital and to match assets with liabilities. We don’t know how much SBIC funding MCC is aiming at, but properly deployed SBIC capital should enhance shareholder returns, due to its relatively low interest rates and long maturities. If MCC access $150mn of SBIC money, total assets could increase from $224mn today to $374mn , a two-thirds increase.
Dividend Guidance: Investors will appreciate getting some direction on what the dividend will be in the first year. Many new BDCs keep that information close to the vest, but MCC has been explicit about its dividend target, and the Prospectus indicates that the company expects to spend the money raised in the IPO in the next 6 to 12 months, which should support the dividend. If the dividend reaches the upper end of the guidance, MCC’s current yield would be a middle of the BDC-pack of 9.2%.
THE NOT SO GOOD
Portfolio Attributes Undeterminable: MCC has decided to load its initial portfolio with only 6 existing loans purchased from its sister companies with a fair market value of $84mn, so any evaluation of the portfolio is premature at this stage. MCC still has another $139mn in cash to spend, and presumably even more monies should the SBIC financing kick in. Will the availability of the latter cause the company to at least partially divert from the senior secured lending which it knows and venture into unsecured mezzanine debt? Will the size of the companies in which MCC invests change? All that is hard to evaluate at this stage with so few companies.
Parent conflicts: We note that there are real potential conflicts of interest between MCC and its sister companies. The two limited partnership entities that sold the 6 loans to MCC retain equity interests and other interests in the underlying borrowers. For example, a portfolio company is Allied Cash Holdings. Sister entities own (through other holding entities) 60% of Allied Cash’s equity. Applied Natural Gas Fuels is 66% owned by MCC sister companies. Velum Global Credit Management is 100% owned by a subsidiary of MOF LP, one of the MCC sister companies. In fact five of the six portfolio companies that MCC lends to are also owned or partly owned by sister entities with different investors and different interests. Two of the borrowers have members of MCC’s parent in “senior management positions!"
The risk is spelt out in the Prospectus on page 22:
“The Principals of MCC Advisors may face conflicts of interests in connection with making business decisions for these portfolio companies to the extent that such decisions affect the debt and equity holders in these companies differently. In addition, the Principals of MCC Advisors may face conflicts of interests in connection with making investment or other decisions, including granting loan waivers or concessions, on our behalf with respect to these portfolio companies given that they also manage private investment funds that hold the equity interests in these portfolio companies.”
The nub of it is that MCC may not act as aggressively to protect its interests in a default or restructuring in order to protect its equity interests held in its sister entities. In fact, the managers (wearing different corporate hats) involved may represent both the underlying company as an owner and as a lender.
Management Fees on High Side: We note that base management fees have not followed the trend of some other recent BDC IPOs that have seen lowered fees, and are pegged at 2% of assets, as well as an incentive fee. The base management fee is to be calculated on total assets, including cash balances. There’s a waiver of the fee on the Company’s cash but only to June 2011. If MCC does not get its cash invested in the next six months fees wills be assessed on cash sitting at the balance sheet at 2% per annum, while earning next to nothing.
Reinvest Fees In Equity: Furthermore, MCC’s external manager has opted to be paid 50% of the fees owed to it in the form of common stock in the Company. This is an unusual approach, and we’re not sure if it’s a Good Thing or a Bad Thing. We’re not aware of any other BDC taking this approach. As the Prospectus spells out (page 34) if MCC trades below Net Asset Value, the issuing of new shares to the manager at the then-current stock price will be dilutive to existing shareholders. Conversely, one could argue that any new capital is a good thing and will help MCC grow. The Company is seeking SEC approval, so this subject is still up in the air.
Like most everybody else we fear the unknown and there are a couple of items here worth mentioning:
Prior performance opaque: We’ve referred earlier to the portfolios managed since 2006 by MCC’s sister entities. The Prospectus does not provide much in the way of detail about the performance of the loan portfolios managed by the principals, and most of the disclosures make one hungry for more. For example, the Prospectus indicates 12 of 41 portfolio loans made have been realized. What is the status of the other 29? How many are in default (if any)? How many loans have been written off (if any)? Or restructured (if any)?
The Prospectus also says that the Principals of the Adviser have “delivered a total average annual return of 14.8% (unleveraged), net of fees and expenses.” At first glance that’s a very creditable return. However, these results are achieved by combining the portfolios managed by sister companies from 2006-2009 (what about 2010?) and by a predecessor entity (called CN Opportunity Fund) from 2003-2005. No further details are given as to the relative size of the portfolios included in the calculations, so it’s hard to evaluate whether the prior performance gives us confidence or otherwise.
Portfolio Loans History Unclear: Going back to the 6 portfolio loans: the Prospectus, which weighs in at 109 pages, does not tell us everything we’d like to know. For example, go to page 58 of the Prospectus, which discusses the portfolio companies. There is a table giving name, rank and serial number, but there is no information on the date the loans were made. Moreover, besides a brief business description, there’s no color given on each company or about the loan. We don’t know if the loans have been restructured over time or much of anything else. We have no idea what the EBITDA leverage or interest coverage ratios might be, either individually or in aggregate.
Yield Goals Seem High: One of MCC’s key arguments in the Prospectus is that they believe senior secured loans “can generate equity-like returns with the risk profile of secured debt.” That’s heady stuff. MCC claims it intends to target deals with gross internal rates of return of 16-23% on an unleveraged basis. (See page 46 of the Prospectus for a more detailed discussion). MCC’s hopes to book loans with “contractual returns” (which we assume means coupons) of 15-16% (some in PIK form), and equity kickers of 2-7%. This is hard to evaluate as MCC has not booked any new deals, but is just buying old loans put on the books in earlier years. The Prospectus mentions many deals in the pipeline but does not refer to pricing.
Risk Goals Seem Low: On the risk side, MCC says it hopes to book loans to companies leveraged on a first lien debt basis at less than 3.5x debt to EBITDA, and with interest coverage ratios of 1.5X and higher. This is backed up in the Prospectus with S&P data showing “Average TOTAL (our emphasis) Leverage Multiples on Middle Market Loans” of 3.3x. , which is not the same thing. What’s more the table shows data only as far as back as 2009. Nothing is mentioned of 2010, but we’d guess leverage multiples were up last year, and will be even higher in 2011. If we take the data from this same table for the five years before the Great Recession (2003-2007), average total leverage was 4.6x.
Our guess is that MCC will struggle to find “stable or growing businesses” (page 53 of the Prospectus) which will pay the target rates of return and with such relatively low levels of debt. As the Prospectus itself seems to suggest MCC may have to fish for new business in “special situations, including bankruptcies and restructurings.” Sectors which the Company is targeting include “oil and gas services, exploration and production” and “real estate hard money transactions, first mortgage lending and distressed opportunities” amongst others. Clearly MCC’s management is comfortable in these high-risk areas and they have “direct experience in bankruptcy situations on both the creditor and debtor sides.”
We just don’t know how much risk Medley Capital will be taking on, and it will take several quarters before the risk-return profile of the new BDC will come into focus.
Wrap Up: In conclusion, we are here neither to praise or bury this latest addition to the BDC community, but to draw investors’ attention to matters that will either contribute to the company’s success or failure in the quarters ahead.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
Additional disclosure: Just went public on January 20th. It's up on Yahoo Finance.