BACKGROUND: The BDC Reporter has been periodically updating readers about purchases of Medley Capital (MCC) stock by an entity controlled by the principals of Medley, LLC called Medley Seed Funding I, LLC. We first noted the material amount of MCC stock purchased in an article on September 14, 2016. At the time, Medley Seed Funding I had purchased 913,247 shares, with a market value of $7.5mn. On January 3, 2017, we revisited the subject, noting that total shares purchased had reached 2,327,342. On February 1, 2017, MCC filed yet another Form 4, with an increased stock ownership holding (see below). We have used the opportunity to dig deeper into the public record (which we should have from the outset, with the benefit of hindsight) to learn more about Medley Seed Funding I, LLC. We discovered that there’s much more going on than meets the eye.

FILING: For the Medley Capital Form 4 filing:” Statement of changes in beneficial ownership of securities”, click here.

UP TO DATE

As the Form 4 above shows, Medley Seed Funding I’s share purchases aggregate 2,536,685, as of February 1, 2017.

Plus, trusts controlled by Seth Taube- CEO of Medley, LCC- own another 177,510.

To put that into context, Medley Capital reported 54,747,189 average shares outstanding in the quarter ended September 30, 2016.

“WHO ARE THESE GUYS ?”

We had been under the impression that Medley Seed Funding I, LLC was an entity funded and controlled by the Taubes, using their personal capital. (We were wrong, as we’ll show in excruciating detail below).

After searching the public records, we find that Medley Seed Funding I  is actually a special purpose vehicle, which was established in June 2016.

The sole purpose of Medley Seed Funding I is to acquire the publicly-traded stock of Medley Capital.

The investors in Medley Seed Funding I are :

i) Investors of Fortress Credit Company, LLC, a subsidiary of Fortress Investment Group.

Of course, Fortress Investment Group is a publicly-traded (ticker: FIG)  “highly diversified global investment management firm”, with billions of dollars under management.

ii) Medley, LLC, which is the operating subsidiary of Medley Management Inc., the publicly traded (ticker: MDLY) asset management fir, whose subsidiary- MCC Advisors- serves as the Investment Advisor to Medley Capital, the publicly traded BDC.

Got that ?

THREE IS A CROWD

We reviewed the Master Investment Agreement between Fortress and Medley, LLC, dated as of June 3, 2016.

Apparently, there are 3 “Seed Funding” special purpose vehicles, aimed at purchasing not only Medley Capital’s stock but also that of another Medley Management-sponsored BDC, Sierra Income.

We will focus only on Medley Seed Funding I-which is the entity investing solely in Medley Capital stock.

(Frankly, we don’t understand-from a reading of the Master Investment Agreement what the purpose of Medley Seed Funding III is supposed to be).

HERE IS THE DEAL

The structure of the deal between the parties is as follows:

Fortress investors put up 75% of the capital and Medley, LLC 25%.

The proceeds are used to acquire the common stock of Medley Capital in the open market.

On a quarterly basis, the SPV pays the Fortress investors an 8% per annum “Preferred Return” on their investment. Here is the language for avoidance of any doubt:

“Medley shall cause the Fund Share SPVs to distribute to DMI I [The Fortress Investors] an aggregate amount equal to a rate of 8% per annum of the Outstanding Fortress Investment Amount (the “8% Preferred Distribution”), calculated on the basis of a 365-day year, which 8% Preferred Distribution shall begin accruing on the date on which the Initial Fortress Investment Amount is contributed to MSF I. “

Any net proceeds remaining are then divided according to a complex waterfall arrangement between the parties. For readers interested in all the details read Section 4.1 (c).

Likewise, any proceeds from the subsequent sale of MCC stock are divvied up according to a pre-agreed formula spelled out in 4.1 (d).

The intended period of the arrangement appears to be 7 years.

MORE DETAILS

As in any investment agreement, there are numerous other provisions in the Master Investment Agreement.

Those include Put Option Rights by the Fortress investors should a number of events of default get triggered and not cured in 90 days (a generous cure period-we should add).

Here is the list:

(b)          Medley ceasing to hold 100% of the Common Interests in the SPVs, without the unanimous prior written consent of the Fortress Investors;

(c)          MCC ceasing to be regulated as a business development company under the Investment Company Act;

(d)          MCC Advisors LLC ceasing to act as the sole investment advisor for MCC, or Medley ceasing to control, directly or indirectly, MCC Advisors LLC;

(e)          STRF Advisor ceasing to act as the sole investment advisor for STRF, or Medley ceasing to control, directly or indirectly, STRF Advisor;

(f)          Brook Taube and Seth Taube (directly or through their respective family members and family trusts) ceasing to have the power to vote or direct the vote of 50.1% or more of the voting power of the outstanding equity interests of Medley; or

(g)          Medley failing to cause the Fund Share SPVs to redeem the MSF I and MSF II Preferred Interests in full in accordance with Section 5.3 above on or prior to the ninetieth (90^th) day following a Redemption Election.

However, if the 8% Preferred distribution is not paid the cure period is only 5 days.

WHAT HAPPENS NEXT

Should the Put Option occur, the SPV is required to redeem all outstanding amounts owed to the Preferred (i.e. Fortress) holders.

Presumably-given that all dividend proceeds are paid out every quarter-that would require selling the MCC stock held by the SPV on the open market.

COMMENTARY

Even after over a decade devoted to investing in the sector, the BDC Reporter continues to be impressed by Wall Street’s ability to surprise and innovate.

This SPV may not be a positive development for Medley Capital’s shareholders (our major concern) or the public shareholders in Medley Management (which we don’t cover) . More on that in a minute.

However, we have to admire the chutzpah of Medley Management’s principals and investment bankers, and the financial creativity involved.

The SPV allows the Taubes-who control Medley Management-to acquire effective control of several million shares of Medley Capital without any direct investment of their personal capital.

Instead, the public shareholders of Medley Management are putting up $10mn (across all the SPVs) and the Fortress investors $40mn.

The purchase of MCC’s stock in this way boosts the stock price by adding a major buyer (as the ever increasing share count by Medley Seed Funding I referred to above shows).

We’re presuming-moreover-that the SPVs control of the stock helps to counter any challenges from “activist” shareholders at Medley Capital, as occurred in 2016.

WHAT COULD POSSIBLY GO WRONG ?

This arrangement works as long as Medley Capital is paying out dividends sufficient to pay the Fortress investors that magical 8% annual return.

Currently, the stock price is around $7.50 and the annualized distribution $0.84.

That’s obviously more than enough-especially with the 25% junior equity contribution from Medley LLC.

However-should MCC-whose credit underwriting record has been very poor in its short history-stumble in the future, things could get ugly.

If MCC was forced to greatly reduce or (even temporarily) suspend its distribution the Fortress investors would-in all likelihood-trigger the Put Option.

That would require the SPV to sell the MCC stock held at the very worst time.

The MDLY investment in the SPV would likely be wiped out and the Fortress investors might incur a partial loss of capital, depending on what the MCC stock price drops to.

For MCC shareholders, the result would likely be an even greater drop in the stock price than normal from the forced sale of millions of shares by the SPV to meet its obligations to the Fortress investors.

BENEFICIARIES

We understand how Fortress believes its investors will benefit from the SPV.  Moreover, we are assuming the principals of Medley Management have good reasons for initiating this transaction.

Less clear is how current or future shareholders of MCC  (or even MDLY) benefit from an arrangement that could greatly depress its stock price under certain circumstances.

CONFLICTS OF INTEREST

We recognize that conflicts of interest between principals, asset management managers and externally managed BDC shareholders are a fact of life.

The SEC does not seem terribly concerned judging by the continuous waiver of rules intended to legislate those relationships.

With the new administration, we are likely to have even more of a Wild West atmosphere as the principals and managers of asset management firms seek to maximize their profits.

We are waiting with bated breath for the likely doubling of BDC leverage that some of the best and brightest BDC asset managers have been lobbying for.

Many investors do not seem to care and take these arrangements as a cost of being invested.

SHINING A LIGHT

Nonetheless, the BDC Reporter will seek to bring these issues to light wherever possible, and let investors make up their own minds.

Certainly, investors cannot rely on the asset managers themselves to be fully transparent on these subjects.

We looked and looked but have found no press release at either Medley Management or Medley Capital about the formation of these SPVs, or any discussion about the risks that might be involved.

Just to be fair, we also read the latest Conference Call transcripts of both MCC and MDLY.

The only reference we found to the SPV was in answer to a direct question from an analyst on the MDLY CC.

No mention was made of the fact that MDLY’s position is subordinate to Fortress in the SPV or the full amount of the commitment.

Or most of the details that we have provided above.

OPM WRIT LARGE

Even some analysts continue to believe that the principals of Medley (the Taubes) are personally buying big slugs of MCC stock.

Here’s a brief quote from an analyst when asking a question on the  latest MCC Conference Call  (see page 2 of transcript) :

Meanwhile, some of the insiders including you, Brook, significantly bought big amounts of insider purchases, which is very positive and better aligns you with shareholders.

However, a look at MCC’s latest Proxy  (see page 3) shows that all the Taubes ownership in MCC is held through Medley Seed Funding I, or through their family trusts.

Did the CEO of Medley Management clarify to the analyst on the CC how the SPV was arranged and that any shares purchased of MCC were by a subsidiary of its public parent and not by himself or his sibling ?

He did not.