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New Mountain Finance: Earnings Quality In Question

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NEWS 

On February 28, 2018 New Mountain Finance (NMFC) announced IVQ and full year 2017 results in a press release and in its 10-K. See above. For the last quarter of the year, NMFC achieved Net Investment Income Per Share of $0.35, and NAV Per Share increased by two cents to $13.63 from IIIQ 2017 and 17 cents up on the year. During the subsequent Conference Call CEO Robert Hamwee commented as follows about the BDC’s credit quality at the end of 2017:

Credit quality remains particularly strong as for the third consecutive quarter not only was there no new non-accruals but we had no portfolio companies on our credit watch list.

In the 10-K NMFC’s internal Investment Rating, which has a 4 point scale from best to worst, showed only $0.4mn of assets in the lowest category, indicating almost 100% of the portfolio was performing at or above expectations.


ANALYSIS

Back in December 2017, the BDC Reporter undertook an in-depth analysis of NMFC’s portfolio and earnings following the third quarter 2017 results, and the reporting of a similar “clean sheet”. Click here for the full article.

As we pointed out at the time, the BDC Reporter’s own independently assessed Watch List for NMFC is longer than the BDC’s.

We continue to continue to track the performance of several companies which have been subject to restructurings in the past and remain on the books – sometimes after incurring significant Realized Losses.

Moreover – in a related context – the BDC Reporter expressed concern about the “earnings quality” of numerous NMFC investments, and the prospect of eventually being repaid in full and in cash.

Here is what we wrote at the time :

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 PinnaclHoldco (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.

That Was Then. This Is Now

One quarter on, not much has changed.

Tenawa

Tenawa Resource Holdings has seen its Ordinary Shares written up slightly and NMFC has invested another $0.621mn, valued at $1.00mn.

Edmentum

Edmentum Ultimate Holdings – a 2015 restructured debt-for-equity deal dating back to 2015 – was written down on an unrealized basis by ($3.9mn) in 2017. NMFC added more capital and received repayment of some other and ended 2017 with – more or less – the same amount at fair market value as before.

The ultimate success of this for-profit education company – owned by multiple BDCs (Prospect Capital owns 31% of the common stock) – remains a question mark.

NMFC itself – for another quarter – carried its 2020 Subordinated Debt at a 20% discount.

Moreover, the $30mn in Subordinated Debt is paying interest only in non-cash form with Pay In Kind rates of 8.5% and 10.0%.

Permian

Permian Holdco 1 and 2 remain on the books, with the debt valued at par and the equity at a premium.

Yet all the income from the debt remains in non-cash form at that elevated 14.0%.

HI Technology

HI Technology is still there, with the major exposure ($105mn) all in the form of Preferred shares. That portfolio company is accruing Preferred dividend at 15.0% – all in non-cash form.

The investment contributed $11.7mn in Investment Income in 2017, or 5.9% of the BDC’s entire revenues for the year and two-thirds of its non-cash income.

Notwithstanding that the investment is carried at par, both its size (equal to 10% of NMFC’s net assets) and the non-cash nature of the income ensures HI Technology remains on our Watch List.

Bach Special

Bach Special, too, remains on the books with a virtually unchanged valuation close to par, but also only generates income in non-cash form at 12.25%.

UniTek Global 

NMFC continues to hold first lien, subordinated and Preferred stakes in Unitek Global Services. The valuations are essentially unchanged.

In one Preferred tranche NMFC still charges 19.0% (see Note 19), as well as rates of 13.5% and 15.0%.

Avatar

Likewise Avatar Topco (a new addition to the portfolio in the IVQ 2017) includes a Preferred investment, also receiving a non-cash Preferred dividend at LIBOR + 11.0%.

Avatar is a former Golub Capital portfolio company which was on non-accrual before being bought by a new group in 2016. Click here for a company alert we wrote at the time.

High Yield

(The only deletion from our IIIQ Watch List  in the quarter appears to be Pinnacle Holdco, which was sold during the IVQ 2017).

All these high rates and their PIK form (whether interest or dividends) as well as their position in the companies balance sheets do not suggest these are “safe” investments, and thus on our Watch List.

We don’t know enough about the business performance of the  companies mentioned above to comment about the credit risk involved in each.

[Frankly, we’ve not yet done a “deep-dive” research into them given that we’re not invested in NMFC, and all appear to be closely-held private companies].

Big Earners. On Paper. 

What we do know, though, is that these investments contribute an inordinate amount of non-cash income to the BDC.

Here are the numbers for 2017 from the 10-K. See page 87.

Total “Non-cash dividend income” is $17.9mn or 9% of Total Investment Income and a not insignificant 17.5% of Net Investment Income.

In fact, if you deduct the $17.9mn from Net Investment Income and the $7.9mn in fee waivers granted by the Investment Advisor, the recurring “cash” Net Investment Income of NMFC is $76.4mn versus $102.2mn reported.

That’s a material difference.

Nor did the IVQ 2017 results suggest any improvement. From what we read in the press release non-cash income accounted for 14.8% of total Investment Income.


VIEWS

By no means is the BDC Reporter suggesting that NMFC has misclassified the internal rating of its portfolio investments in this quarter or others.

However, investors should be aware that the BDC has managed to maintain steady earnings and an unchanged distribution for 24 straight quarters partly by booking an above average level of both non-cash income and fee waivers.

2017 was the worst year for NMFC – from a credit standpoint and despite what was said on the Conference Call – with ($40mn) of Realized Losses, which brought cumulative write-offs to ($77mn).

Those aggregate losses are equal to 7% of total equity capital raised.

In most cases those sort of losses would have caused a BDC – especially one which is almost always fully invested – to reduce its dividend.

However, NMFC has deftly dodged that bullet by bulking up on these PIK paying debt and Preferred investments.

Back in 2015, NMFC earned non-cash dividend income of just $2.6mn , or 1.7% of Investment Income.

As we’ve seen non-cash income has jumped to $17.9mn two years later or nearly seven fold !

Fee waivers, too, have increased: by 33%.

Down the road – if fee waivers go away and/or credit issues pop up at these non-cash paying companies the result could be a lower NAV and a big drop in recurring earnings.

BDCs have a huge amount of latitude to support the valuation of portfolio companies by providing additional capital and through the quarterly valuation process.

If troubles do occur, though, shareholders should not be unduly surprised.

Companies do not pay out interest or dividends at 12.5%, 14% or 15% rates without good reason in a market where “safe” below investment grade credits borrow are paying an average of 4.72%.

Risk-Return

Currently NMFC is trading at a $13.15 price (at the open on February 5, 2018), and pays out a distribution of $1.36 annually, which represents a yield of 10.3%.

Is that yield appropriate for the hidden risks involved in the BDC’s recurring earnings ?

From our standpoint the answer is No, but NMFC may be able to carry on indefinitely in this manner and revisit its 52 Week High of $15.00.

We just play the odds and stay away when we perceive that risk and return are not in sync.

Notwithstanding the pedigree of the Investment Advisor and its long track record of an unchanged earnings/dividend stream, we’d rather be careful.

Others may be prepared to presume that NMFC’s “Steady Eddie” performance – however achieved – will continue indefinitely.

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