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Medley Capital: IIQ 2019 Credit Review

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In our most recent BDC Common Stocks Market Recap, we promised to share with readers our in-depth credit assessment of Medley Capital’s (MCC) portfolio after the BDC posted its results. This is a critical juncture in the ever shrinking BDC’s history, with its Board both undertaking a “Go Shop” process for a new external manager and proceeding with much amended plans for a three way merger with two related companies. How MCC’s portfolio is performing will greatly affect the outcome of those initiatives and the values involved. This is what we found :


NEWS

We reviewed the Medley Capital (MCC)  IIQ 2019 earnings release10-Q and Conference Call (no public transcript available) to prepare the Credit Review.


ANALYSIS

Quarter And YTD Losses

In the second quarter 2019, MCC booked Realized Losses of ($9.0mn).

In the 10-Q, the specifics of the losses were not revealed. The 10-Q said the following:

The realized losses were primarily attributable to the non-cash restructuring of one of our portfolio investments, partially offset by a realized gain resulting from exercising warrants and converting junior preferred equity in one portfolio company into common shares of a new portfolio company. 

In the first none months of the fiscal year, MCC has booked Realized Losses of ($76.3mn).

That’s 11% of all equity capital at par.

In the IIQ 2019, Unrealized Losses were ($15.6mn).

For the three months ended June 30, 2019, we had $15.6 million of net unrealized depreciation of investments. The net unrealized depreciation comprised of $23.1 million of net unrealized depreciation on investments offset by $7.5 million of net unrealized appreciation that resulted from the reversal of previously recorded unrealized depreciation on investments that were realized or written-off during the period.

For the quarter total losses added up to ($26.4mn), including a one time debt extinguishment charge.

In the first none months of FY 2019, total losses amounted to ($52.3mn).

Total Losses

To date, since coming to market in 2011, MCC’s  aggregate “Distributable Losses” (as per the terminology used in the 10-Q) is ($451mn), or 65% of equity capital at par.

Under-Performing Companies 

At the end of IIQ 2019, investment assets had an aggregate cost of $559mn, and an FMV of $476mn.

We focused upon a company by company review of the 54 company portfolio , as well as the BDC’s own investment credit evaluation system for the period.

Based on the valuation of the MCC investments and other publicly available information, we have identified 16 companies that are under-performing, and 38 that are performing.

Of the under-performing, according to MCC ( see page F-23 of the 10-Q)  loans to 8 companies are on non accrual, and rated a 5 on on our Corporate Credit Rating scale.

According to MCC, the FMV of non-accruing investments was $33.8mn. 

Non Accrual Names

The companies involved are  Point.360; Ship Supply Acquisition; 1888 Industrial Services, Access Media; Brantley Transportation; Dynamic Energy Services; Capstone Nutrition and NVTN, LLC.

Of those, Point.360 and Ship Supply Acquisition are non-material having been written down below $1mn and to zero respectively, and neither generates any income.

However, 1888 Industrial Services (FMV $14.7mn) includes 3 debt facilities with a cost of $14mn that are still accruing income.

Ditto for Brantley Transportation, Dynamic Energy, Capstone Nutrition and NVTN.

As a result, the possibility exists that these already stressed companies could see further or complete interruption in their investment income in the near future.

Worry List

There are four companies which are rated Corporate Credit Rating 4 – our Worry List – where the likelihood of loss is greater than that of full recovery.

These are Be Green Packaging, Watermill-QMC Midco, Lighting Science Group and CT Technologies.

The first three are non-material.

However, the CT Technologies second lien debt MCC holds has a cost of $7.9mn and was valued at a (24%) discount at June 2019.

The company was added to our Watch List only in the IQ 2019, based on lower valuations.

Over $0.800mn of annual investment income is involved.

Watch List

There are four MCC companies that are rated CCR 3 – our Watch List – where the likelihood of full recovery is greater than eventual loss.

The companies involved are The Imagine Group,LLC; Path Medical LLC, TPG Plastics LLC and URT Acquisition Holdings.

On a FMV basis, the aggregate value of the CCR 3 company investments is $43mn.

Path Medical has been under-performing – by our standard – since 2017 but was also written down by its biggest discount to date in the latest quarter by MCC.

The cost is $13.1mn and the income at risk is $1.5mn.

Most of all in this category we are concerned about URT Acquisition.

MCC has advanced $37.4mn to the company in second lien, preferred and equity.

Income involved is $2.2mn.

As of the IQ 2019, the equity was written down by (84%), after having been carried at par just two quarters before.

In toto, the aggregate value of under-performing investments is just short of $100mn, according to our count.

Company Ratings Recap

Of the 16  under-performing investments on the BDC’s books MCC has 8 investments in CCR 5 ; 4 with a CCR 4 rating and 4 rated CCR 3.

Balance Sheet Impact

The BDC Reporter values all under-performing assets at $98mn  or 21% of total portfolio assets at fair market value.

MCC’s own  Investment Rating system values, in its 5 point chart,  is even more conservative about portfolio value:

 
                             
 
 
June 30, 2019
 
September 30, 2018
Investment Performance Rating
Fair Value
Percentage
Fair Value
Percentage
1
$
126,494
26.6
%
$
50,245
7.7
%
2
162,245
34.1
448,240
68.4
3
151,322
31.8
106,236
16.2
4
503
0.1
5
35,718
7.5
50,206
7.6
Total
$
475,779
 
 
100.0
%
 
$
655,430
 
 
100.0
%

As the chart above shows, investments rated 3-5 by MCC have increased substantially as a percentage of total portfolio assets since the end of the prior fiscal year in September 2018.

9 months ago, under-performing assets were $157mn, or 24% of the total portfolio.

Currently, both the absolute value of under-performing assets and the percentage of the total have increased markedly to $187mn and 39.5% respectively.

The increase has occurred even as MCC has written off or written down ($52mn).

Unlike the BDC Reporter, BDCs like MCC do not identify which companies are included in which ratings.

Potential Losses

We have not yet undertaken a company-by-company loss assessment given the large number of troubled portfolio companies involved.

Judging by the large proportion of companies already partly or completely on non accrual further losses from the current FMV in excess of $50mn or more is plausible.

That’s equal to 50% of the assets identified by the BDC Credit Reporter and one-third of those by MCC itself.

The loss of FMV on a per share basis would be just under $1, or about a fifth of net book value.

Realized Losses are likely to be substantially higher.

On a pro-forma basis, if all MCC’s under-performing assets – as per the Table above – were written to zero, the net book value would drop to $61mn or $1.11 a share.

Investment Income Impact

The amount of investment income at risk is substantial, with 9 companies potentially at risk of not paying investment income that is currently being accrued.

Our rough count places $6.9mn of investment income at risk.

That’s equal to 15% of IIQ 2019 Investment Income annualized.

Conclusion

The numbers scream for themselves.

MCC’s credit performance has gone from very bad to worse.

More than one-third of the BDC’s portfolio – both by company count and the fair market value of investment assets – is under-performing to some degree.

Half the under-performers are, at least partly, non-performing.

Moreover, there is no sign that there is any change in the downward credit trend.

Predicting either the likely loss of investment income or fair market value of assets even one or two quarters out is very difficult for two reasons.

First, many of the companies are still in the throes of whatever has caused them to be performing below expectations.

Second, these are mostly private companies and no other BDC has exposure.

With MCC providing little color – either in the quarterly filings or in its Conference Call – about developments at the companies, investors are largely flying blind in assessing credit outcomes.


VIEWS

No Light At End Of Tunnel

The current and future value of the MCC portfolio is important both to existing shareholders of the now non-dividend paying BDC and to prospective future investors in a possible merger with Sierra Income and Medley Management; or to the BDC by itself under new management.

This latest quarterly snapshot suggests that the long promised improvement in the credit quality of the portfolio has not yet occurred, despite record write-offs and write-downs.

Volatile

Furthermore, the fluidity of the under-performing investment values makes assessing the portfolio’s “real value” highly problematic.

Likewise, the likely income the portfolio generates could swing in a wide range.

Unknowable

MCC’s book value – a key element in how the BDC will be valued in its potential merger with the two other sister companies or if turned over to a new asset manager – is more fiction than fact at this stage.

That is going to make life very difficult both for the parties cobbling together the transactions and investors seeking to benefit therefrom.

This is the classic credit “falling knife” and nobody – including the insiders or those with access to all the investment information – can be certain what the ultimate value or income generation will be.

Do The Best We Can

We will continue to track the individual under-performing companies – both those mentioned above and any new ones – in the weeks ahead to keep readers apprised of what changes we can determine.

Also, we’ll undertake a new Credit Review after the calendar IIIQ 2019 results are made public.

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