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MVC Capital: Publishes A Plan By The Board

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On October 10, 2017 , the Board of Directors of MVC Capital (MVC) issued a press release announcing the results of a meeting held on August 2, 2017 where a plan to increase dividends and yield bearing investments was approved. The BDC News Of The Day  reviews the key elements of what is being called the “Board’s plan”; analyzes the likely implications of the measures for the BDC and its shareholders and provides the BDC Reporter’s own view on a subject that has been discussed here before.


NEWS

According to the press release, the Board of Directors of MVC met on August 2, 2017 and unanimously approved the following measures. Given their importance, the BDC Reporter is quoting generously from the press release:

  • “Redeploying Capital from Equity to Yield Investments Following the USG&E Monetization: The July 2017 sale of U.S. Gas & Electric, Inc. (USG&E) for $173 million is a milestone transaction for MVC and its shareholders. The sale price represented a 29% premium over fair market value2 and generated nearly a $115 million capital gain. USG&E was the largest investment in the Company’s equity portfolio, and MVC is now focused on monetizing its remaining non-yield investments. Redeploying capital into high yield investments should result in increased net operating income and shareholder distributions. 

  • Increasing the Quarterly Dividend: MVC’s Board has approved an 11% increase in the Company’s quarterly dividend. Beginning this month with the fourth quarter dividend, MVC will increase its quarterly dividend to $0.15 per share from $0.135 per share. The increased dividend is payable on October 31, 2017 to shareholders of record on October 24, 2017. 

  • Capitalizing on High Yield Pipeline Investments Sourced by TTGA Lending Team: MVC holds over $100 million in cash, and we believe the Company is well positioned to execute on a pipeline of high yield opportunities. The lending team of TTGA remains focused on the underserved lower middle market, an area that is ripe with significant transactions and fewer sophisticated competitors. The Company strongly believes this strategy offers better risk adjusted returns for MVC shareholders than typical junior debt providers, and that the team’s unique mix of private equity and lending backgrounds provides MVC with a distinct advantage in the industry. Since the lending team joined TTGA, MVC has made 13 loans and has also successfully exited six of these investments, for an IRR of greater than 14% on each investment over the life of the investment.3 

  • Leveraging MVC’s Balance Sheet with Low-Cost Debt CapitalHistorically, MVC has had comparatively low leverage given the Company’s focus on realizing its $160 million of capital loss carryforwards and unrealized losses through its focus on private equity investments. The Company believes that adding reasonable leverage, at relatively low cost, should increase MVC’s return on equity (ROE) and yield to shareholders.

  • Revising Fee Structure to Further Align the Interests of Management and MVC Shareholders: Effective November 1, 2017 (the next fiscal quarter), and in place through October 31, 2019, TTGA has agreed to implement a management fee structure that ties fees to the NAV discount, conditioned upon the Company’s ability to make new investments. The MVC Board believes this fee structure is unique in the BDC sector.  

    • If the Company’s NAV discount is greater than 20%4, the management fee for the current quarter is reduced to 1.25%. If the NAV discount is between 10% and 20%, the management fee will be 1.50%.
    • If the NAV discount is less than 10% or eliminated, the 1.50% management fee would be re-examined, but in no event would it exceed 1.75%. It would therefore always remain lower than the contractual management fee, even if the NAV discount is eliminated.
    • In addition, to further align the Company’s and TTGA’s interests with shareholders, the Company and TTGA have committed to revisiting the structure for calculating incentive fees on investment income for fiscal 2018, particularly the hurdle required for any such fee to be paid to TTGA.
    • As further reflection of the continued alignment of shareholder interests, the Independent Directors have agreed to reduce their current compensation by 25%, until such time as the NAV discount ‎falls to 10% or less.
  • Repurchasing Common Shares: MVC is actively exploring opportunities to repurchase common shares”.    

Chairman of MVC and its “Portfolio Manager” Michael Tokarz concluded the press release by indicating the BDC’s current portfolio is 60% debt investments and 40% equity. This represents – in Mr Tokarz’s view – a clear opportunity to increase income by adding a greater proportion of loans to the books, which will then reduce the market discount to book that MVC is operating under.


ANALYSIS

Nothing Happening

The press release suggests MVC is “now focused on monetizing its remaining non-yield investments”,  but with the one notable exception of Biogenic Reagents  there has been no announcement of any transaction for several months.

When the BDC Reporter reviewed the portfolio a few weeks ago, here was our impression in summary:

“We’re guessing that management will have to convert more non-income and non-performing loans to normal yield generating instruments before MVC can realistically hope to be consistently profitable like most other BDCs.

Unfortunately, there are very few investments on the books whose valuation trends suggest much upside. We noted only 3 and nothing very material or needle moving in the same way as Biogenic Reagents or USG&E”.

Investment Quality Questions

Our review – admittedly based on very thin publicly available information – suggests many of the remaining equity investments are under-performing and/or MVC is the sole lender or lender-of-last-resort. Most have been on the books for years and it is not clear – given that MVC has ben committed to making the switch from being an equity BDC to a yield BDC for two years at least – what will be different going forward in selling off any position.

Distribution Increase

The increase in the distribution to $0.15 per share a quarter ($0.60 a year) will result in over $1mn in additional annual outgoings.

Incomplete

The press release reiterates its faith in the lower middle market lending team acquired by the Investment Advisor and its ability going forward to deliver superior returns from making mezzanine loans to smaller sized borrowers.

The press release mentions that the lending team has made 13 loans and exited 6 for a 14% IRR. However, there’s no update on the status of the remaining 7 loans. Moreover, the BDC Reporter – judging by the investment pace  of other lower middle market focused BDCs – would suggest that booking 13 loans in three years (the team joined in October 2014) is a somewhat slow pace.

Finally, re-deploying capital into unsecured debt at this point in the cycle must be a questionable strategy, with so many of the BDC’s peers making noises about “moving up the balance sheet”.

Lever Up

The press release suggests – without giving any details – that MVC intends to double down on its lending strategy by adding additional capital through leveraging up its balance sheet.

This might involve some mix of senior secured debt (presumably collateralized by existing and new loans on the books as banks are unlikely to give much value to equity investments – especially overseas ones) and Baby Bonds.

We would suppose – given what we’ve seen elsewhere with Harvest Capital (HCAP) and KCAP Financial (KCAP), that MVC might retain its existing Baby Bond (MVCB) and add another.

Or refinance the existing issue with a bigger, cheaper Baby Bond. There’s no way to know.

Stranger Things

The proposed fee structure truly is a one-off, and only underscores how different MVC’s approach has been and remains from most of its BDC peers. We have never seen in the BDC space in the BDC Reporter’s editor’s now 18 years of reviewing compensation packages anything like what is now being proposed for a two year period.

Till now, the Investment Advisor has regularly waived fees so that the compensation cost has varied widely from quarter to quarter. This new arrangement -which we have not had the time to assess the varying potential costs of – will still result in compensation costs fluctuating from period to period. However, the Investment Advisor is seeking to point out that whatever happens the fee charged would be lower than the nominal management fee currently.

Moreover, the press release suggests – but gives no details – about how the Incentive Fee might be altered in the future.

Buying Back Capital

Without committing itself and using language that makes no commitment as to amounts or periods, the Board also expressed a willingness to repurchase more shares.


VIEWS

What A Little Activism Can Do

Clearly, MVC’s Investment Advisor has been spooked by the challenge from dissident shareholder Metage Capital.

Just the fact that it has taken two months for the BDC to reveal to shareholders critical decisions about strategy, distributions and compensation is very strange.

Unequal Investment Field

Between August 2 and today, Board members who are also shareholders have had the opportunity to buy and sell, presumably with the benefit of knowledge about these Board decisions.

For example, back on August 232, 2017 Director Philip Goldstein sold nearly 400,000 shares for over $4mn.

Meh

Setting that aside and just looking at the merits – or otherwise – of the Board decisions, the BDC Reporter is unimpressed by the arguments made and the changes made.

More important than what is said in the press release is what was left out.

The BDC did not directly address the issue of its being a frequent loss maker on an operating income basis.

Our own analysis in the past has suggested that even increasing total loans on the books by $75mn is unlikely to even get MVC to break-even on an operating income basis.

Not Sensible

Increasing the distribution – while attractive to shareholders who look only at the distribution level – does not make any sense if the BDC is seeking to become consistently profitable.

Likewise, while promises about buying back shares are popular with investors, using up the BDC’s valuable cash at a time when a commitment to growing the loan portfolio has been made is contradictory and confusing.

Missing

Nor did the press release address the comprehensive track record of its lending team (a similar technique to what BlackRock Investment has been doing) nor explained why new deal activity has been so low over the past 3 years (one of the busiest periods in leveraged lending history) and why – with every report suggesting competition is at a fevered level for new loans – MVC believes itself capable of generating “better risk adjusted returns for MVC shareholders than typical junior debt providers”.

No mention was made about the BDC’s plans for that other unusual investment of theirs: their controlling interest in Equus Total Return, itself a publicly traded BDC which is sitting on the shelf.

Overall, this sudden appearance of a Board Plan for MVC leaves the BDC Reporter cold, and with more questions than answers.

A Pox On Both Your Houses

Nonetheless, we’re not enamored of the possible consequences from adopting the Metage Capital proposal either.

In real life, taking away the authority from an Investment Advisor as to where and when to deploy its capital is a recipe for other kinds of problems.

When In Doubt…

MVC’s stock price might get a short term boost for all this jousting between the Investment Advisor and its shareholder activist.

Shareholders will shortly be getting a small dividend increase, to boot.

However, in the medium and long term, all the uncertainties surrounding MVC which have caused the BDC to trade at a discount despite the USG&E transaction and a red hot (till  few weeks ago) BDC market, will remain:

  • Can existing equity investments ever be sold in any meaningful number and for any meaningful amount ?
  • Can new mezzanine loans be made with low-to-mid teen yields on a consistently successful basis ?
  • How big does MVC’s loan book have to grow for the BDC to consistently generate a decent return on equity ?

The BDC Reporter always keeps an open mind (really !) but our current view – based on years of following the BDC and deep dives into the filings- is that the odds of favorable answers are low.

The principals are masters of financial engineering (just look at that new management fee arrangement and the USG&E deal) but have not demonstrated the ability to rebuild MVC into a “normal” BDC, despite plenty of capital and years of a free rein before Metage Capital started asking uncomfortable questions.


Disclosure

For the BDC Reporter’s holdings of all public BDC common stock and fixed income issues – including MVC – see the attached Disclosure Table. 

For details on MVC’s Baby Bond with the ticker MVCB, see the Fixed Income Table attached.

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