8/10/2018: We sold 100% of our Special Situation investment in Medley Capital Corp (MCC)

Purchase Price /Date (s): $3.65 on May 17, 2018

Sale Price: $3.68

Reason For Sale

We had purchased under-performing MCC in the anticipation that the External Manager might sell the investment advisory contract to a third party asset manager.

Our premise was that a change in the management of the BDC would be likely to result in better results in the long term and a higher stock price.

At the time of the purchase, MCC was trading at a (48%) discount to the then book value per share of $7.02 at March 31, 2018.

We relied heavily on the stock price performance of the two Oaktree Capital BDC funds (OCSL and OCSI) following the management contract sale by Fifth Street Asset Management.

OCSL was our key comparable given that MCC has a comparable history of serial credit problems, substantial loss of book value, multiple dividend reductions and a history of a major drop in the stock price.

Currently – after the Oaktree Capital takeover of the Investment Advisory contract – OCSL has traded up to 85% of book value.

We anticipated that a re-positioned MCC under the tutelage of any major asset manager might trade at a discount of 15%-25%.

Even at the bigger discount, that would have resulted in a MCC stock price of $5.27, a 44% increase over our purchase price.

Catalyst

We were relatively certain – notwithstanding that MCC itself made no mention thereof – that some sort of corporate change was likely to happen at the BDC and its parent, Medley Management (MDLY).

We concluded that the insiders were likely to take some action given that the financial performance at MCC was deteriorating and its distribution in danger of being reduced.

That was likely to put pressure on an arcane arrangement between MDLY and Fortress Investment in which a special purpose vehicle established by both parties had acquired large amounts of MCC’s shares.

The BDC Reporter has written extensively on the subject since 2016. Just type in “Medley” in our Search Box for a large number of articles on this complex subject.

However, that transaction was itself based on the assumption that dividend income would be sufficient to service a preferred return to Fortress investors.

That return, though, was in jeopardy due to continuing losses at MCC. As of the IQ 2018, Net Investment Income Per Share had dropped to $0.07 per share versus a distribution of $0.10 per quarter.

When the Fortress transaction was first launched in June 2016, MCC’s quarterly distribution had just been reduced to $0.22 from $0.30.

Since then, MCC has undertaken two further reductions bringing the quarterly distribution to $0.16 and then to $0.10.

We anticipated that MCC might eventually be forced to reduce the dividend yet again, as we had predicted in our Dividend Outlook.

Further Assumptions

Our assumption was that MDLY – which has a large amount of debt outstanding and ever lower management fees (and no incentive fees) from its management contracts at MCC and Sierra Income – would be forced to take action.

We considered unlikely that MDLY would seek to sell the management rights of Sierra – which is performing marginally better than MCC.

Instead, we assumed the likeliest asset for sale would be MCC’s management rights – which have considerable value despite the BDC’s poor performance.

We expected proceeds might be used to repay all or some of the $127mn of debt at MDLY.

While MCC shareholders would not benefit directly from the sale of management rights, the stock price would likely be boosted by the introduction of a new Investment Advisor.

Another Direction

Instead – in a transaction announced on August 9, 2018 after the close and which we listened to the presentation thereof before the open on August 10, 2019 – MDLY has gone in a different direction than we anticipated.

In a complex three way transaction, Sierra Income is to become a publicly traded internally managed BDC, listed on the NYSE.

MCC is to merge into Sierra Income, with its shareholders receiving shares in the new entity.

MDLY is to become a wholly owned subsidiary of Sierra Income, and its shareholders will receive cash and stock in the new entity as well.

This will leave an enlarged Sierra Income (containing MCC’s assets and its own, and a wholly owned asset management subsidiary) still managed by the same principals who are in charge of both BDCs and of MDLY currently.

The new Sierra Income will have debt – presumably both secured borrowings and unsecured debt issued by MCC and MDLY – estimated at 0.62x of book equity.

See the Merger Presentation here.

Pushing The Button

We decided to sell our position in MCC for the following reasons:

1. Our initial premise – although correct in that MDLY has taken action – has not played out as expected.
2. An initial review of the proposed merger – and without benefit of the Proxy which might be weeks away – suggests MCC shareholders will not gain much from the transaction.
3. The proposed merger leaves the insiders at Medley Management – who are responsible for the massive destruction of shareholder value at MCC – still in charge.

As a reminder, here is the stock chart for MCC, which shows that the stock price has dropped by four-fifths in the last 5 years:

4. The latest results of MCC – published concurrently with the merger announcement – suggest the financial performance of the BDC continues to deteriorate.

Book value per share was reduced again to $6.43 from $7.02

Net Investment Income Per Share has dropped by three quarters since the March 2018 results to $0.02, yet the dividend was maintained at $0.10 a quarter.

5. A brief review of Sierra Income’s latest 10-Q is not wholly encouraging, with over a fifth of portfolio investments marked as under-performing to varying degrees.

6. The ultimate completion of the merger remains questionable – even though insiders have loaded up on shares in various ways – given that the structure – in our opinion – seems unduly favorable to the unitholders of MDLY, and far less so to the shareholders of Sierra Income and MCC.

In that regard, we point readers to the respective stock price of MDLY and MCC following the news.

At time of writing MDLY, which closed at $3.50, is trading over $5.00 a share, an increase of over 40%.

MCC, which closed at $3.38, has traded between $3.44-$3.70. As we write this, MCC is at $3.46, or up just 2%.

We fear that the stock price could drop even further. At a 10x multiple of current earnings MCC is worth only $0.8 a share.

Conclusion

For all the reasons above, we unwound our Special Situation investment in MCC at the market open.