By Jim Roumell :
Medley Capital ( MCC ) is a closed end fund that has elected to be regulated as a business development company ("BDC") under the 40 ACT. MCC is externally managed by MCC Advisors. MCC Advisors is controlled by Medley Management Inc., a publicly traded asset management firm, which in turn is controlled by Medley Group LLC, an entity wholly-owned by the Taube brothers. MCC's objective is to generate current income and capital appreciation by lending to privately-held middle market companies ($25 million to $250 million enterprise value). The portfolio consists of senior secured first lien term loans and senior secured second lien term loans.
At December 31, 2017, MCC had a reported NAV per share of $7.71. Given the higher risk nature of the underlying MCC investments, we applied additional loss assumptions to our original NAV analysis. Our stress case scenario assumes additional losses of 4%, 8%, 30% and 50% for Class 2, 3, 4 and 5 credits, respectively. Our base case assumes additional losses of 2%, 5%, 15% and 25% for Class 2, 3, 4 and 5 credits, respectively. See explanation of credit classifications below.
All amounts throughout are in thousands of $, except share amounts
- At the current $4.00 stock price, MCC shares trade at a significant 48% discount to reported NAV and a 38% discount to our stress case NAV. Our stress case analysis gives a high level of comfort that we have significant downside cushion at the current stock price.
- For the 40 Act leverage requirements and bank loan covenant requirements (explained below), MCC could absorb $112 million and $82 million of additional losses, respectively before there would be a breach. Both these amounts are more than our stress case analysis.
- Senior Management have been transparent about past problems. They fully acknowledged the legacy underwriting issues and did not try to sugar coat them. They changed their investment strategy and became more conservative starting in early 2016 by significantly reducing their second lien exposures. On the most recent earnings call Brook Taube noted his belief that most of the legacy issues are behind them.
- Senior secured first lien loan performance - in general this asset class has historically performed very well (even during the 2008/2009 financial crisis). MCC is migrating their portfolio more towards this asset class and as such, the loss volatility experienced in the past should mitigate.
- Higher risk nature of underlying loans - As with most credit BDCs, the credits in the underlying investment portfolio are highly leveraged and the second lien and equity positions (25% of the investment portfolio) would likely experience high loss severity upon default. Mitigating this is the fact that all investments are carried at fair value and subject to independent pricing service verification.
- Continued negative surprises - The legacy book continues to surprise investors with large losses. MCC had a net unrealized loss of $39.2 million in the forth quarter of 2017. Fortunately, Class 4 and 5 problem credits are becoming a smaller percentage of the portfolio (see table below for detail).
- Dividend - MCC may cut the dividend as they are consistently under earning it by a few cents per quarter. However, this is not of great concern as our thesis is based on the significant NAV discount and not the dividend. Additionally, Management may choose to retain the current distribution rate as a shareholder friendly means of passing the significantly discounted NAV along to owners.
Stress, regulatory and covenant scenarios:
From a pure NAV perspective, losses would have to be massive to erode the current NAV discount. However, a smaller amount of loss could cause issues with regards to the 40 Act leverage rule and bank debt covenant (explained below). Should MCC breach the 40 Act limits or bank covenants, they have levers they can pull to fix the situation. These include selling higher quality assets and repaying debt.
The scenarios that follow illustrate the impact on NAV and leverage ratios under various loss assumptions.
Loss needed to absorb NAV discount:
The above example illustrates that under the current company reported NAV, MCC could write-off all its assets classified 3, 4 and 5 and still not erode the entire NAV discount. See detail of asset classifications below.
The following tables show how much additional losses could be absorbed before there would be a 40 Act or bank debt covenant leverage breach:
Class 1 - Credit is performing better than expected.
Class 2 - Credit is performing as expected.
Class 3 - Credit is performing below expectations, but no loss is expected.
Class 4 - Credit is performing materially below expectations and while MCC does not expect a loss of principal, there could be a loss of interest payments. In many cases payments are delinquent, but normally not more than 180 days.
Class 5 - Credit is performing substantially below expectations, risk of loss has increased substantially, most or all covenants have been breached and payment is substantially delinquent. Some principal loss is expected.
Sum of class 3, 4 and 5 credits at December 31, 2017 is $187.4 million.
Investment portfolio components:
Though it appears from MCC's disclosures that MCC has 20% in equity, in substance it's really only 12%. MCC invested in a JV that purchases only senior secured loans with Great American Life (GALIC) wherein MCC has contributed $87.5 million and GALIC $12.5 million. As MCC is in a first loss position, accounting rules require them to categorize their investment as equity even though the loans in this JV are 1st lien, secured paper. If you adjust for this fact (if you choose), the portfolio goes to 75% 1st lien, 13% 2nd lien and 12% equity from what is often shown as 67%, 13% second lien and 20% equity.
BDC leverage rules:
BDC's are not permitted to incur indebtedness unless immediately after such borrowing they have an asset coverage for total borrowings of at least 200% (i.e., the amount of debt may not exceed 50% of the value of assets).
In addition to the 40 Act limitations, MCC is subject to compliance with certain restrictive covenants in their bank line of credit. The two primary covenants are as follows:
- Tangible net worth must be maintained at $325 million minimum
- 210% asset coverage ratio
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