Medley Capital: Just How Bad Is Their Underwriting?

| About: Medley Capital (MCC)

Summary

A discussion on why certain metrics are not suitable in evaluating underwriting performance.

A comparative analysis of the quality of MCC's portfolio using more suitable metrics.

A conclusion that MCC's underwriting takes on a higher level of risk, but not without reward.

Many critics have called into question the quality Medley Capital Corporation (NYSE:MCC)'s loan portfolio citing many "suspect loans" and a high rate of non-accrual that will eventually lead to substantial losses. While the portfolio certainly has its problems, much of the criticism leveled at MCC is based off of conclusions inappropriately drawn from a poor understanding of the metrics used. I offer a fair approach to evaluating MCC's portfolio performance.

So just how bad is MCC's underwriting?

Perhaps the most frequently cited metric is the percentage of non-accrual at fair value. As of 2016Q2, non-accruals represented 6.2% of MCC's portfolio at fair value. The figure itself is indeed high if we compare to some other BDCs reporting for the quarter ended 03/2016:

Non-Accruals as a Percentage of FV Quarter Ended 03/2016.

While in general, a higher percentage of non-accruals is a sign of poor underwriting, the metric itself is very misleading, especially when being used to compare performance across sector companies. Firstly, readers should keep in mind that this figure is a percentage of portfolio value at fair value and so the percentage is directly influenced by a companies book-keeping practices. If loans on non-accrual status are not appropriately written down, they will have a larger weight in the portfolio as opposed to those that are properly written down. Secondly, when using a metric such as fair value, healthier non-accrual loans (i.e. those more likely to recover) are actually worth more on the books than their less likely to recover counterparts and thus a portfolio with a few "healthier" non-accrual loans will actually have a higher rate of non-accrual compared to a portfolio with more loans on non-accrual that are all basically dead. In short, a "less-bad" loan actually bears more weight than a terrible loan.

So what, if anything, does this metric actually tell us? It is an indicator of overall portfolio risk. Given two portfolios with identical fair values, the one with a higher percentage of non-accrual will bear a higher risk, in other words, there will be a greater variance in the potential returns. Keep in mind that since we are talking fair value, the expected value for both portfolios remains the same, and so for someone who is risk neutral, they should be absolutely indifferent between the two. However, most of us are risk averse and so, all else equal, we tend to lean towards portfolios with lower risk.

Coming back to our original task, a better metric to use would be percentage of portfolio value at cost. This would at least address the issue of inaccurate valuations, but only partially addresses the problem of weighting "more-bad" and "less-bad" loans. Further, this metric also fails to address risk-weighting; if a company makes deployments very conservatively, they will have a much lower non-accrual rate but will see smaller returns as well.

Return on asset is a good metric that addresses all of these issues, though here "return" is defined only as total investment income net of realized or unrealized gains (losses). Note that this is different from the commonly reported return on asset metric which takes into account income net of expenses (such as interest expense) which are irrelevant to us. In summary, this metric is a comparison of the amount returned to the amount of capital that was deployed.

Using this metric, we can see that MCC's portfolio has consistently generated a positive return since inception. To give you some benchmark for comparison, I have (NYSE:MAIN)'s return on asset over a similar time period.

MAIN Return on Asset 2013-2015

From these numbers I think a much better description of MCC's underwriting tactics is "high risk high reward".

Conclusions:

Firstly, it is clear that, at the very least, MCC's management is able to generate a positive return on the capital it deploys. While MCC currently does not have the best returns in the sector, its current and historical performance in underwriting is a far cry from cataclysmic. In fact, I do not believe poor underwriting played much, if any, a role in the poor returns for shareholders as this was largely due to rising costs and excessive management fees.

I believe investor sentiment is overly negative at the moment largely in part due to some fallacious beliefs stemming from erroneous interpretation of data trends and metrics used. For example, critics will frequently cite declining dividends and poor dividend coverage as reasons to avoid this stock, while neither of those, taken in context, should be a reason to deter investors. And so I believe this leads us to the classic value case (some might call it contrarian) where sentiment is far worse than reality.

My original investment thesis was that MCC is priced for catastrophe when the reality is not great but not terrible either. Again, I believe that this remains true and thus I am still of the opinion that given its current discount, MCC is undervalued. You can read further on my original arguments, as well as responses to what I believe are fallacious critiques, in my previous article on MCC.

Disclosure: I am/we are long MCC, PSEC, MAIN, FSC.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.