New Mountain Finance: Dividend Outlook
At a first- and even at a second- glance New Mountain Finance’s (NMFC) dividend sustainability appears to be solid. We have reviewed the IIIQ 2017 10-Q (see attached) to analyze the BDC’s balance sheet, earnings quality, available liquidity and – most of all – to ascertain what the odds are of the current $0.34 quarterly distribution remaining unchanged for another 12 months. We won’t give away our conclusion here. Suffice to say, there are many positive factors to mention, many of which will be known to investors with even a passing interest in NMFC. However, there are also a number of negative factors which investors may want to take into account, and are less well known, and have required some drilling into the filing to bring to light.
NMFC came public in the spring of 2011. Since the second quarter of 2012, the BDC has paid out a regular distribution of $0.34 for 22 quarters in a row, including the pay-out announced for the fourth quarter of 2017. This is one of the best track records of any public BDC with its longevity. Shareholders of record on December 15, 2017 will be paid $0.34 on December 28 th, per the latest earnings press release.
NMFC ended the IIIQ 2017 with a 86 company portfolio, valued at $1.846bn and above cost of $1.814bn. (Page 3). Although NMFC’s investments are spread over First Lien, Second Lien, Subordinated and Equity/Other, their aggregate value in each group is higher than the cost. The only exception is Subordinated Debt where cost exceeds FMV by just $200K. (Page 35).
Furthermore, the BDC claims in its internal investment rating system, which has a four level valuation ranking, and in which ratings of 3 and 4 characterize companies that are under-performing to varying degrees, that all investments are performing “materially in line with expectations” or better.(see page 75). That’s an improvement over the prior quarter when $75mn of investments were rated 3 or 4: 4% of the total. (See page 75 of the IIQ 2017 10-Q).
Book value per share in the first nine months of 2017 is up from $13.46 to $13.63, boosted both by recently selling shares above book, which added to a third of the increase and the unrealized appreciation of the portfolio. (see page 3)
From an earnings standpoint, NMFC has posted very steady numbers this year, and every year since going public. Investment Income tends to be steady from quarter to quarter. For example, Total Investment Income was $50.0mn in the IIQ 2017 (see page 78 of the IIQ 2017 10-Q) and $51.2mn in the latest quarter. Net Investment Income Per Share in these two periods was $0.34 and $0.35 respectively.
This is partly achieved by keeping fully invested most all the time. In both the last quarters total liabilities were $918mn versus equity of $1.032bn. On occasion – as has become a common tactic amongst BDCs- the Investment Advisor will waive a portion of its compensation to smooth earnings. In 2017, NMFC has irrevocably waived $1.8mn of Incentive Fees. (See page 51).
All this data suggests that NMFC’s earnings and thus dividend sustainability remains as good as ever, as we seek auguries of future performance in historic results.
Nonetheless, the BDC Reporter does have a number of concerns that may add some grey to the black and white picture described above.
First, NMFC’s risk profile should not be ignored. The BDC’s business model requires the taking of material risks to achieve their earnings and ROE goals. As that chart on page 35 of the 10-Q shows, nearly two-thirds of the BDC’s investments are in the more junior tranches of leveraged investments, starting at second lien debt and headed downward. At the moment second lien loans and mezzanine loans are under the spotlight after a relatively long list of this type of debt has defaulted at other BDCs with disastrous consequences, especially as recovery rates do not seem promising. Check out the credit issues of Alcentra Capital, Capitala Finance, THL Credit, BlackRock Investment and Triangle Capital for dyed-in-the wool examples. In the case of NMFC, one-third of all investment assets are in this category.
Nor can NMFC claim that they can run through the rain and not get wet. This year alone, the BDC has had to write-off ($40mn) in bad debts. That represents over 50% of all Realized Losses incurred since going public in 2011. (See page 4). Most recently Sierra Hamilton – an energy deal – was restructured and a ($14mn) Realized Loss incurred. Now NMFC has a $12.8mn equity investment in the reborn entity. (See page 37). More on that later.
There have been big write-offs on Transtar’s second lien debt ($28mn written off and less than $4mn recovered) this quarter and last year another restructuring at Permian Tank and Manufacturing, which saw ($18mn) get written off, leaving a new investment with Permian Newco of $9.9mn.
Difference Of (Credit) Opinion
What’s more looking down NMFC’s portfolio with our BDC Credit Reporter hat on – and seeking to provide an independent view of potential credit risks, and using a similar methodology that NMFC uses, we are not as sanguine as they are. For example, we maintain on our own Watch List the investments in companies that have tripped up in the past and had to be restructured, some of whom we’ve mentioned above. We also keep on our list companies which were written down on an unrealized basis earlier and have now been written back up- at least for a quarter or two. Finally, we’re wary of companies that are carried at full value by BDCs but whose income is mostly or completely being booked in non-cash form and at very high or very low (i.e. not market) rates. Today’s borrower paying a 15% PIK yield is often tomorrow’s default.
By our criteria there are at least 7 portfolio companies worthy of being placed on our Watch List, where NMFC has only – by its count – 1 troubled company with a FMV of zero. (See page 75 again). These include – for those of you who want to go granular – names like Pinnacle Holdco (written up this quarter but written down 20% last period; Tenawa Resource Holdings and Tenawa Resource Management. NMFC effectively controls 98% of the equity of Tenawa Resource Holdings through an entity with the inelegant name of QID NGL, LLC. At the same time, NMFC is also a lender to Tenawa Resource Management, a wholly owned subsidiary of Tenawa Resource Holdings. Get all that ?
Then there are loans to Edmentum Ultimate Holdings and its own web of subsidiaries. The Subordinated Debt lent to Edmentum has been written down by 20% in aggregate. (Any write-down of 10% or more gets our attention). Moreover, all the interest is in PIK form with rates up to 10.0%.
Likewise the restructured Permian is receiving a loan which bears interest at 14%- all in PIK form.
Then there’s HI Technology, which has a cost and value of $105mn. We added this to our Watch List (which really means we need to know more to get comfortable in an industry where knowledge is power) because a footnote indicated all the income therefrom appears to be in the form of non-cash dividends accruing at 15.0%. (That number alone sets off alarm bells !).
Likewise Bach Special only pays out in preferred dividends at a 12.5% rate.
The winner in the high non-cash yield department is Unitek – see note 19 – where the non-cash preferred dividends are at a 19% interest rate.
There are a few other names that we’re trying to unwind, but that list should give you an idea abour our concerns.
This translates into a question mark about the quality of NMFC’s earnings. In the IIIQ the BDC started reporting a new line item in its P&L for the first time. We don’t know if this was required by the SEC or by accounting rules, but makes clear our worry that a large amount of the BDC’s income is not being received in cash and may not be collected for years, if at all. (You try compounding 12%, 15% or 19% payments for a few years and see what happens).
In the IIIQ 2017, 14% of NMFC’s income was non-cash, mostly in the form of “Non Cash Dividend Income” and PIK income on debt.. That’s equal to 27% of Net Investment Income. Most of the“Non Cash Dividend Income” – not surprisingly if you’re mostly negotiating with yourself – was in the Affiliated and Controlled companies categories. At first approach this seems to suggest a BDC desperately seeking to maintain GAAP earnings at historic levels – despite credit setbacks – but booking income that may not be sustainable. Just from the IIIQ 2016 to the IIIQ of 2017 total non-cash income jumped to $7.0mn from $1.7mn. (See pages 50 and 51 respectively).
HI Technology and Unitek alone combine for 15% of NMFC’s Net Investment Income in the first 9 months of the year: all in this “Non Cash Dividend” form.
We Could Be Wrong
Of course, all these names on our Watch List may turn out to be as reliable and safe payers as all the rest of NMFC’s loans. Maybe there is something about the accounting treatment that NMFC is using that we’ve missed. We recognize that the Investment Advisor comes out of a very successful and competent asset management group and , by no means, are we seeking to take anything away from the BDC’s multi-year track record of unchanged distributions.
However- from what we know so far and given that the BDC is already highly leveraged and more likely than not given its risk profile to have the normal credit losses that comes with the territory, we conclude that the dividend distribution is AT RISK in the next 12 months.
(Adding to our concern are other, more prosaic income shortfall issues. We can’t help noting dividend income from NMFC’s first Senior Loan JV has been dropping of late, as borrowing costs go up (that darn LIBOR), while investment portfolio yields narrow (that darn spread compression). Moreover, the BDC is embroiled in a dispute surrounding a $30mn CLO which it owns. A hedge fund was supposed to buy back the collateral supporting the CLO at par, but has gone into liquidation instead. That asset is now the subject of recoupment initiatives but has dropped $3.2mn in value already. The impact on income is unknown. (See page 32).
To the BDC Reporter an AT RISK rating means whether the dividend remains unchanged or gets cut is a toss up, like a coin flip. From our perspective- with NMFC trading at a price that indicates the market expects no distribution change- holding NMFC stock would be a disproportionately risky proposition. If all goes as Mr Market expects a 10% yield is likely. If Mr Market is caught flat footed by – say – a 20% dividend reduction – expect a 20%-30% drop in the price to follow. However, there’s no immediate catalyst that would cause NMFC earnings trouble in its portfolio so the BDC may be able to keep calm and carry on at $0.34 a quarter for some time to come. We don’t presume to know what the best action might be for readers who are shareholders in NMFC or plan to be. We can only report our investment response to the hours of work we’ve spent on the latest filings: We are staying away for the moment. BDC investing is a matter of playing the odds and despite NMFC’s enviable earnings and dividend history to date, the odds are not favorable enough for the return/risk involved.Already a Member? Log In
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