QUARTER ENDED JANUARY 2018
Total assets dropped to $374mn from $403mn in prior quarter even as investment assets at both cost and FMV grew to $377mn and $363mn respectively. The most notable change is that Cash dropped from $100mn to $55mn due to new investments and the stock buy-back program which decreased shares outstanding by 2.3mn to 18,820,528. Debt was all in the form of Baby Bonds, but a new issue (MVCD) which replaced MVCB and had a cost of $111mn. Shareholder’s equity dropped $26mn due to the buyback, another $3mn paid out to shareholders and offset by a slight increase in Unrealized Depreciation. No material Realized Losses or Gains.
On the Income Statement revenues (called Operating Income) was up sharply from the prior year to $5.2mn. However$0.06mn was PIK or Deferred and $539mn was Dividend Income from Non-Control/Non Affiliated companies. Interest Income was $3.6mn versus $2.2mn a year ago. On the expense side, Interest cost was high at $3.117mn, not helped by having two Baby Bonds outstanding for a time. Then there was the occasional cost of debt redemption of $1.8mn. Management Fee was $1.4mn, down from the prior year due to the sale of the U.S. Gas And Electric asset. There was also $0.266mn in Incentive Fees, down from $0.759mn. These were offset by$0.4mn in expense and fee waivers by the Manager. All other expenses came in at $1.5mn, which annualizes at $6.0mn or 0.4% of Total Assets and 29% of Operating Income.
Like in most recent quarters this left MVC with ($2.5mn) of an Operating Loss for the quarter, compare to ($3.0mn) the prior year. Even when adjusting for “Loss on extinguishment of debt” and normal “interest and other borrowing costs”, which we’ve estimated at $2mn versus $3.117, the pro-forma Operating Income is a modest $0.410mn. Net of PIK, the BDC is still not generating positive cash income. To achieve an 8% return on equity, MVC would have to generate $5mn a quarter in Net Investment Income versus $0.41mn on our pro-forma basis.
With only about $30mn-$40mn available to invest in terms of cash remaining on the balance sheet and assuming a 11% yield that would add $3.85mn of Investment Income. Net of 2% in Management Fees and an assumed 1% in Incentive Fees (cost $1.0mn) and another $1mn a year in operating costs, that would drop $1.80mn to the bottom line and bring the Net Investment Income up to $2.210mn on a pro-forma basis or a 1% ROE over a full year.
We don’t believe the BDC is likely to seek to grow the portfolio – and earnings – by drawing on its small and expensive Revolver. Even if that occurred, the contribution to the bottom line would be muted by the Management and Incentive Fees, operating costs and cost of debt.
All this shows up on page 6 which shows all distributions made are from Return of Capital.
There are 18,820,528 shares outstanding.
Page 7 shows that the Share Repurchase program boosted book value by $0.28 a share. Without that boost NAV Per Share, which started at $13.24 would not be up to $13.42.
Another intriguing statistic and reflective of a long MVC tradition of very slow deal doing is the quarter’s Portfolio Turnover Ratio: just 1%. That’s still better than 0.47% a year before and in line with 4% in all of Fiscal 2017.
From a balance sheet standpoint, the reduction by half in cash is a negative , partially offset by having a couple more loans in portfolio: 27 versus 25. However, the portfolio remains heavily concentrated, especially with the investment in the related Crius Energy Trust and its now subsidiary U.S. Gas And Electric, which total $63mn or a fifth of portfolio assets and a quarter of MVC’s book value. This is called out in Concentration Of Credit Risk on page 19 of the 10-Q.
In addition, at least 10 of the 27 companies do not pay cash income. Even amongst the 17 that do many include non income producing or non cash producing investments. Also a negative is that 20% of the portfolio remains in Control investments whose valuations are more suspect.
Also a negative from a Risk profile standpoint is that virtually all the income producing investments are at very high rates (12.0% or higher) and/or in a mixture of cash and PIK or all PIK. As a result earnings quality – which is another way of saying earnings sustainability – remains highly questionable.
We count $128mn in “normal” loans to non-Control companies that are not on our Watch List. Virtually all are Second or Third Lien loans and bear rates of 12% or higher. In a Worst Case, the small number of companies involved and the junior position in the balance sheet result in a risk of loss of 30-50%. On the plus side, most of the loans booked by the specialist team that was hired a few years ago have performed well.
In the quarter there was no Realized Gain or Loss and no loans were on non-accrual and none were taken off. In fact, Unrealized Appreciation was $2.6mn in the period as several assets were written up.
However, the Watch List remains unchanged at 7 companies. As before, 6 of these are rated CCR 4. Most notable is Custom Alloy which was restructured in the quarter and to which MVC added more capital. The only debt tranche (second lien) is supposed to begin paying 10.0% interest in 2018, after being PIK in 2017. There are two Preferred Stock tranches with coupons of 10% and 12% valued close to cost. However, the Convertible Preferred is discounted 42%. This credit could still return to non-performing status and given the junior form of capital involved be at risk for a major or total write-off.
Foliofn is an investment made back in 2000 (!) and which pays no current income. The discount to cost was increased again this quarter bringing the FMV down to $4.86mn from $5.407mn. Not a good sign and at risk of total loss.
JSC Tekers, MVC Environmental , Security Holdings B/V. and MVC Automotive Group are long standing, under performing Control companies – mostly situated overseas. Most generate no income except for bridge loans made by the BDC, which are worrying both by their very existence and their non-cash nature which suggests these companies are not self sustaining. There is $70mn of value tied up in these companies, or 28% of book value. All $70mn must be considered at risk given the valuations and what little we know of underlying performance.
We calculate that $1.8mn of Investment Income is at risk between these various CCR 4 investments. That’s equal to 16% of MVC’s Total Investment Income in 2017.
The least worrisome name on the Watch List is Initials, Inc. – a monogrammed gifts retailer – which was written down more than 10% in the October 2017 quarter and still remains at a discount. The $5.3mn in Subordinated Debt yields 15% (including 3% PIK) and has been on the books for a couple of years. We will be tracking the Company’s progress closely as any interruption in income would be material: $0.800mn a year.
On our Pre-Watch List is the newest loan to Black Diamond Equipment Rentals, LLC. This oil services company was a Capitala Finance (CPTA) borrower till late and had been on non-accrual. We imagine the Company has been restrctured but remains in the volatile oil services sector and is in second lien position.
EXTRACTS FROM THE 10-Q
New Investment Activity-Page 26
“During the quarter ended January 31, 2018, the Company made two new investments, committing capital that totaled approximately $11.2 million. Pursuant to an exemptive order received by the Company from the SEC (the “Order”), that allows the Company to co-invest, subject to certain conditions, with certain affiliated private funds as described in the Order, each of the Company and TTGA C-I LP (the “Private Fund”) co-invested in Essner Manufacturing (“Essner”) ($3.7 million investment for the Company) and Black Diamond Equipment Rental (“Black Diamond”) ($7.5 million investment for the Company).
During the quarter ended January 31, 2018, the Company made 3 follow-on investments that totaled approximately $3.4 million. On November 8, 2017, the Company loaned an additional $1.5 million to U.S. Spray Drying Holding Company (“SCSD”) in the form of a senior secured loan. The loan has an interest rate of 12% and a maturity date of November 7, 2020. On December 21, 2017, the Company loaned approximately $526,000 to Initials, Inc. (“Initials”) increasing the senior subordinated loan amount to approximately $5.3 million. On December 22, 2017, the Company loaned $1.4 million to Turf Products, LLC (“Turf”) in the form of a third lien loan. The loan has an interest rate of 10% and a maturity date of August 7, 2020.
On November 28, 2017, the Company restructured the Custom Alloy Corporation (“Custom Alloy”) second lien loan and unsecured subordinated loan. The second lien loan was restructured into a $3.5 million second lien loan with an interest rate of 10% and a maturity date of December 31, 2020, 6,500 shares of series B preferred Stock with a 10% PIK coupon and a maturity date of December 31, 2020 and 17,935 shares of series C preferred Stock. The unsecured subordinated loan was restructured into 3,617 shares of series A preferred Stock with a 12% PIK coupon and a maturity date of April 30, 2020. The Company also provided a $2.0 million and $1.4 million letter of credit.
On November 29, 2017, the Company received a principal payment of $3.0 million from Dukane IAS, LLC (“Dukane”) resulting in a balance outstanding of approximately $4.3 million as of January 31, 2018.
On December 29, 2017, the Company received a principal payment of $200,000 from Vestal Manufacturing Enterprises, Inc. (“Vestal”) resulting in a balance outstanding of approximately $2.3 million as of January 31, 2018.
At October 31, 2017, the provision for estimated incentive compensation was approximately $2.0 million. During the quarter ended January 31, 2018, this provision for incentive compensation was increased by a net amount of approximately $267,000 to approximately $2.3 million, including both the pre-incentive fee net operating income and the capital gain incentive fee. The net increase in the provision for incentive compensation reflects the Valuation Committee’s determination to decrease the fair values of eight of the Company’s portfolio investments (Advantage, Dukane, HTI, MVC Environmental, RuMe, Turf, U.S. Gas and SCSD) by a total of approximately $3.9 million. The net decrease in the provision also reflects the Valuation Committee’s determination to increase the fair values of nine of the Company’s portfolio investments (Centile, Custom Alloy, Highpoint, Initials, JSC Tekers, Legal Solutions, MVC Automotive, Security Holdings and Crius) by a total of approximately $7.4 million. Also, for the quarter ended January 31, 2018, no provision was recorded for the net operating income portion of the incentive fee as pre-incentive fee net operating income for the quarter did not exceed the hurdle rate.
On February 9, 2018, FDS, Inc. repaid its loan in full including all accrued interest.
On February 26, 2018, in connection with the U.S. Gas Sale, Credit Facility III was amended, effective as of July 5, 2017, to exclude from pledged collateral the U.S. Gas second lien loan. All other material terms of Credit Facility III remained unchanged.
On February 28, 2018, the Company committed $6.0 million in the form of a first lien loan with an interest rate of 10% and a maturity date of August 31, 2018 to Custom Alloy. The funded amount as of March 12, 2018 was approximately $2.6 million with $3.4 million unfunded on the commitment.
On March 9, 2018, pursuant to the Order, each of the Company and the Private Fund co-invested in first lien notes issued by Apex Industrial Technologies, LLC. The Company and the Private Fund invested $15.0 million and $5.0 million, respectively, in such notes with an interest rate of 12% and a maturity date of March 9, 2022. In accordance with the conditions of the Order, the Board, including a majority of the Independent Directors, approved, in advance, the Company’s investment in the loan.
An uneventful quarter overall. Unfortunately MVC remains far from becoming earnings positive despite a larger loan portfolio, and even further away from making a “normal” return on capital. As a result the distributions being paid are just a return of shareholders capital. Little progress was made in reducing the BDC’s Risk Profile which remains VERY HIGH, the highest rating on our four level scale. Credit Risk remains HIGH with 6 investments in our Worry List (CCR 4) and with $1.8mn of income at risk of interruption and another $0.8mn in CCR 3. With cash on the balance sheet reducing, MVC’s room for maneuver is smaller but the BDC still has $30-$35mn to spend. The credit TREND is stable. Earnings quality remains very poor with many investments generating no income and few valued at a material premium to cost. That leaves MVC as neither a very good lender or equity investor and moving very slowly -besides in the area of stock buy-backs – to make any positive changes.
As always, continue to stay away from the common stock at any price. With MVC trading over $10 while generating recurring losses, valuation is unduly high. Given the uncertainty about the true value of many Control investments and the high risk involved in the loans on the books the appropriate discount is unknowable.
Although the only debt are the $111mn of Unsecured Notes, with income producing assets of only $128mn at FMV concentrated in second lien and in small numbers, we remain concerned that in a Worst Case (where asset values drop 30%), the BDC might have neither the income or the assets to support its debt. This will be even more the case if and when most of the remaining cash is deployed or used to finance operating losses and distributions or applied to support illiquid Control companies. There is also refinancing risk when MVCD does come up for repayment in 2022 if credit conditions have deteriorated given the nature of the portfolio. We will continue to stay away from MVCD.