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MCG Capital (MCGC) is a business development company (BDC) that has gone through some rough times. It closed Friday at $3.89 a share and now yields 17.5%. Net asset value is roughly 496 million dollars but market cap is only 300 million dollars - MCGC is thus trading at a little more than 60% of book value. A cursory review of its recent financials reveals quite a bit of red ink and this would appear to explain the valuation. But a closer look reveals a company going through a painful transition and possibly reaching the point at which the light at the end of the tunnel is becoming visible.

MCGC has been burdened with a large equity investment (primarily in the form of preferred stock) in Broadview Networks - a competitive local exchange carrier (CLEC) with a large debt load. MCGC carried its interest in Broadview at a book value of $189 million as of the close of 2007 and has been writing it down since then. Broadview is currently carried on MCGC's books at a value of $29 million - meaning that some $160 million has been written off. In the last 9 months ending September 30, 2011, some $74 million in write-offs (unrealized depreciation in value) were attributable to Broadview (MCGC has taken a number of $25 million Broadview write-offs on a quarterly basis). In this period of time, MCGC's net loss was $44 million. Thus, without the Broadview write-offs, MCGC would have actually shown a net profit of roughly $30 million - in line with an annual profit of some 50 cents a share. MCGC also took a hefty restructuring charge in the quarter ending September 30, 2011.

MCGC apparently was originally organized to focus on certain industries - including the CLEC part of the telecom industry, and made some large equity bets. It recently changed its strategy to invest primarily in debt instruments and to diversify among a variety of industries - in other words, to perform like a typical BDC. Its recent originations have been heavily weighted toward senior secured debt and the percentage of its portfolio devoted to equity has been steadily declining.

The Broadview story has been a real trail of tears. The CLEC industry attracted a huge over investment in the late 1990s, (the broadband/internet/telecom bubble) and the business was very difficult because of the need to deal with incumbents and the emergence of internet telephony. I remember hearing one participant in the CLEC industry proclaim that "any businessman who does not form his own telephone company should be taken out and shot!" - similar to the statement of one investment pundit in early 2011 that "every single person in the World should short US Treasuries" - and similarly an excellent indication of exactly what NOT to do.

Over investment has led to lots of losses in the CLEC business. Because Broadview issued publicly traded debt, it has filed financial reports with the SEC. A review of these reports suggests that operations are stabilizing and that Broadview is profitable on an operating basis, but that it is difficult to foresee how Broadview will be able to manage its more than $300 million in debt - most of which matures in 2012. This suggests that the debt holders may wind up as the sole shareholders and that the current equity may be worthless I would not be surprised if MCGC has to write off the remaining $29 million of value attributable to Broadview in the near future. But the next large Broadview write-off will likely be the last.

An interesting question is whether or not the Broadview write-off should have been taken in one large hit at an earlier point in time. This might have created ratio problems for MCGC (as a BDC assets must be at least 200% of debt) or problems with lenders. On the other hand, it would have allowed MCGC to show the world that it is profitable much sooner.

At any rate, with the restructuring charges dumped in the quarter ending September 30, 2011, and with all but one last Broadview write-off behind it, MCGC is poised to start posting quarterly profits, either this quarter or the very next quarter. At that point, it is likely that it will trade up toward book value and toward a yield of 10%-12%, The final Broadview write off (if it comes) will reduce book value but the current market cap is almost $200 million below book value and the most Broadview can be written off is $29 million.

There are, of course, other risks. There could be other legacy assets that require write-offs although it appears that most of MCGC's debt instruments are performing well and equity investments are becoming a smaller and smaller fraction of the portfolio. MCGC has significant balance sheet cash so that it can probably deal with any reasonable difficulty presented by its lenders.

I have been investing in distressed BDCs on market dips - others are American Capital (ACAS), [which has resolved its ratio problems but has not started paying dividends], Kohlberg Capital (KCAP), [which seems to have its problems resolved], and Saratoga Investment (SAR) on the theory that limited leverage means limited downside risk and that buying assets substantially below book value generally works out well. The payoff is when the BDC emerges as a healthy entity posting profits and paying a large dividend. MCGC is already paying a dividend but there is a sense of disbelief in the market because of its failure to achieve consistent profitability. As demonstrated above, MCGC's problems in this regard are largely due to Broadview and will likely be resolved within the next quarter or two. At that point, investors may see a significant pop in the stock price.

Source: MCG Capital: Life After Broadview