Wednesday, December 2, 2020

Medley Capital: Internalizing Management, Sale Seems Likely

Apologies for the recent string of relatively small and/or illiquid ideas, here is another one from the trash bin: Medley Capital (MCC) is an orphaned BDC that will likely be sold in the next several months.  The story begins in August 2018, when MCC's external manager, Medley Management (MDLY), orchestrated a three way merger that would combine the manager with its two BDCs, publicly traded MCC and non-traded Sierra Income.  That deal met a lot of resistance from shareholders as it appeared to be a non-arms length way to bailout the overleveraged MDLY at the expense of the BDC shareholders while ensuring underperforming management continued on top.  The deal was in limbo until May of this year, almost a full 2 years after the merger announcement, when the deal was finally put out of its misery and terminated.  I'm skipping a lot of drama in those two years including a proxy fight with the team from NexPoint, but following the termination, MCC continues to retained advisers to pursue strategic alternatives and recently announced that MDLY's management agreement would be allowed to expire at year-end and that MCC will internalize management.

After a 1-for-20 reverse split earlier this year, MCC is trading for ~$26.50 ($71MM market cap) with a 6/30 NAV of $54.83 (MCC's fiscal year end is 9/30, the 10-K should be coming out shortly), meaning MCC is trading at roughly a 50% discount to NAV.  For reference, despite the pandemic, the average BDC trades for 86% of NAV today.

For the uninitiated, BDC is an acronym for business development companies, which typical function as non-bank lenders to leveraged middle market (sub $50MM in EBITDA) companies, often providing financing for private equity buyouts or M&A transactions.  Following the financial crisis, banks can no longer provide these loans on reasonable terms, so non-bank lenders like BDCs of CLOs have filled much of the void.  These loans are all below investment grade and the leverage ratios of the underlying companies is typically 5-7x EBITDA, they can be a bit scummy and certainly shouldn't be pitched as safe dividend payers to retail investors.  There are some 45+ publicly traded BDCs (like REITs, there are also non-traded ones like Sierra Income that are sold through the investment advisor channel), most of them are externally managed, often by household names (at least to anyone reading this) like Ares, KKR, Oaktree, Apollo, BlackRock and others that can essentially use the BDC as a lender for their own PE activity.  If that wasn't enough, they charge hedge fund style fees to the BDC.  These management fee streams are highly valuable as a BDC is technically a closed end fund and the capital inside it is essentially permanent.  So the average BDC trades for 86% of NAV, roughly 10 of the 45 trade above NAV which allows the BDC to issue additional equity, anyone below NAV is generally restricted from issuing shares but they can still grow assets through M&A which has been fairly active in the bottom of the sector.

Given this dynamic of external managers wanting to grow fees and now that MDLY will be out of the way (MCC no longer has to serve two masters in a transaction), the orphaned BDC should make for an easy M&A target, especially considering the wide discount to NAV.  The buyer and MCC can essentially split the discount somehow and both come away happy.  Following the sale of their broadly syndicated loan (larger borrowers, more liquid loans) JV to Golub and paying off one of their two baby bonds, MCC is clearly too subscale (maybe the 40th largest BDC of the 45 by assets) to be internally managed and if the plan was a true go-it-alone strategy, they likely would have refinanced the baby bond versus pay it with cash on the balance sheet.  The new CEO is an activist in MCC, David Lorber of FrontFour Capital, he's also headed up the Special Committee, from the internalization press release they've hired a credit person on what seems like a temporary basis to oversee the remaining portfolio, all sort of signals to me that this is once again for sale.

Of course, everyone has seen the deal, it was shopped previously and the conflicted board (MDLY management on the MCC board) turned down other offers during the go-shop period in order to continue to push the MDLY-MCC-Sierra deal that would have preserved MDLY's management team.  However, now that MDLY is largely out of the way, debt markets are flush with capital (low rates is great for private debt, everyone will be reaching for yield), we're looking at a potential reopening and economic recovery, I'm guessing at least one of those suitors will come back and make a deal for MCC.

Other Thoughts:

  • I haven't discussed the portfolio, obviously given the turmoil this company has been through in the last two years as you'd expect, the portfolio is a bit of an unclear mess of assets.  It is more heavy on equities than most peer BDCs, including 764,040 shares of AVTR which is up ~66% since 6/30 or $8MM in NAV ($3ish per share).  On the downside, the JV they did sell to Golub is about -$7MM in the other direction.  The S&P/LSTA Leveraged Loan Index is now trading about 95 cents on the dollar, up significantly from the lows in March and April, and for reference, on 6/30 it was trading at 89.  Even the junkiest of loans, rated CCC, are today trading at 86.  We'll see in a few days where the 9/30 NAV is struck, but I don't think it should be materially below where it was on 6/30, but I'm not a credit analyst and only spent a little time thumbing through their holdings.
  • This situation reminds me a little bit of RESI, a broken deal, external management being pushed aside and no reasonable path to becoming an internally managed company for the long term.  That one ended very successfully with a quick deal that was then revised upwards after a competing offer came to light (I unfortunately was out by the time of the revised deal).
  • BDCs are no longer included in most indices, MCC doesn't pay a dividend, there really isn't a natural investor base for this and I think that partially explains how its languished here and really doesn't have a future outside of a deal.

Disclosure: I own shares of MCC

35 comments:

  1. What is the cost of caffeine the management agreement with MDLY? I thought generic bdc mgmt agreements had a termination penalty of 5 years of fees.

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    1. That's generally the case, usually I see 3 years of fees, but here the agreement just expired without being extended, so there is no termination fee.

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    2. Cool. Thanks for the reply.

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  2. Cancelling not caffeine

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  3. Thanks for writing the most lucid and concise intro to BDCs I've ever come across - it really is a joy to read.

    One thing I've never managed to wrap my head around is the calculation of NAV. As all the debt is private, it seems to me there is massive incentive for the manager to report a higher NAV in order to maximise fees. And while they're not valuing equity, valuing debt is still non-trivial and subject to a lot of discretion - especially in COVID times when nothing is normal. I'd be stunned if extend and pretend, PIKking etc. when the sh*t hits the fan is not part of the standard repertoire here. So I guess my question is do you have any idea by how much a determined management can inflate the NAV from a "real" NAV and get away with it during an audit process? Because you need to take that amount away from the NAV discount. Thanks.

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    1. They state in their filings they use an independent firm to value their assets at least twice a year, but clearly these NAVs are pretty squishy and you're right about incentives to inflate NAV and generate more fees. I haven't done the work, but I've seen others show the how wildly different BDCs can mark the same assets. Some skepticism is warranted, but given the recovery in credit since 6/30 and seeing where other BDCs trade, gain a little bit of confidence that things shouldn't be materially worse than they were in June. But it is certainly a risk.

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  4. Great to see this! I've built a position in MCC for the past few months as the likelihood of positive resolution seemed to grow.

    Once or twice a decade, BDCs offer a major opportunity when there's an economic wobble (and the rest of the time, they're kinda meh). They get whacked once with everything, whacked again if they cut or eliminate their dividend, and whacked a third time when they write down assets on a time lag. The great thing is that they'll write them up on a lag too, so you can have some confidence in an economic rebound and still buy stuff at a low multiple of "old" NAV. It's like a lot of things, including MREITs, but because of the bespoke nature of the assets in many of them, you maybe get a little more time.

    Really great opportunities in small ones, even though they're mostly kinda bad. I spent some time in HCAP as well in November, got comfortable with management, which has managed to manage NAV/leverage better than some, and heard in the last CC that they would "look at the possibility" of returning some cash this year after suspending their dividend. Was amazed that the stock didn't move on that. I was a dummy because I thought they wouldn't announce anything until later in Dec, and only had a few thousand shares when they announced a dividend (though unclear what it will be going forward) and the stock went up ~95% in a week. Oh well.

    Anyway, thanks for this and all the insightful posts.

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    1. Thanks ADL - appreciate the comments and always feel a little better about an idea knowing you got there first.

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    2. I am fairly confident I rarely get there first, and almost never with as cogent and elegant a thesis as those you generously share.

      I keep on trying to think of good ideas to share here, but all I have are junk ideas which are mostly working out because it's a junk market. I think there are decent odds that GLOP will be reabsorbed into GLOG in the first half of next year, and possibly GMLP into GLNG. I think AAIC will restart its dividend and trade up to a higher % of NAV than it actually deserves. And I think there is a good likelihood HCFT--which is actually a decent entity, despite its assets being mezz loans in a CLO--will announce a special dividend and/or increase in regular dividend next week.

      But these and other similar ideas are all to large extent dependent on nobody taking away the punch bowl, because the above cos (HCFT excepted) probably only have any value at all because of the environment of loose, sloshing money.

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    3. Thanks - I looked HCFT earlier in the pandemic, I need to revisit quickly by the sounds of it, but I did like their assets, and their CLO funding structured seemed okay to me given the multi-family exposure versus office/retail/leisure heavy deals at other mREITs.

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    4. I also like CLNC, have you looked at it? CLNY is super motivated to turn their balance sheet over to their new strategy, my best guess is they sell CLNC to another externally managed mREIT along with the management contract, versus internalizing and going it alone and then waiting for the market to continue to bid the shares up so they can sell out.

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    5. I have a small position in CLNC which, TBH, I have paid limited attention to since buying. I think your thinking is 100% right on CLNY, which has been pretty active. It does seem like there is interest in/capital available for the mREIT space right now, with all the recaps, and the interesting-but-not-really-relevant data point of RC buying ANH, so that's a very plausible/likely scenario. I wonder whether the planned dividend resumption by CLNC isn't "window dressing" to drive up the price a little for a potential acquirer.

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    6. I think that's the right on the dividend reinstatement, push the price up a little more, then a little bit more with the sale.

      My thinking is there will be a wave of deals in these little subscale non-bank lenders, then when the water is fully calm again, there will be a bunch of IPOs and new people on the scene, next crisis hit, cycle repeats itself. Like you said, about once a decade there a lot of opportunities.

      Took another look at HCFT, I like it but have two general worries: 1) they don't have any cash or investments from the looks of it outside of their CLOs, so if one of those 4 rated assets does indeed blow up, they can't easily replace it within the deal unless they do something creative with the manager. 2) just don't see a reason for this to trade at book value, maybe it does, but its small and externally managed, even if they run a tight credit ship don't see it getting there and they won't sell. But clean portfolio, covered fat dividend, a lot to like there, discount probably narrows some and you early mid-teens over the next 2 years.

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    7. That all sounds exactly right to me.

      I had the same worries re: HCFT, somewhat muted because of the environment, and also because Orix, I think, wants to build scale here (or is least figuring out whether they want to go with eth original plan of building scale or cut bait). But totally agree that if this trades at book that would be too rich, and that their good credit fortune may not last forever.

      Once company about which I am quite excited at this price is QCCO, which I have owned a few times over the past 15 years. But it is at best a cigar butt partially-soaked in what I hope is just rainwater (slim financials are on their website).

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    8. Have you looked at the RMR mREITs? TRMT trades less than 50% of book, sort of a similar size to HCFT but more diversified across real estate sectors and funded with a repurchase agreement versus a CLO. Then there's also RMRM, which was a closed end fund but doing a REIT conversion to a commercial mREIT, also trading below 50% of NAV/book. Strange that they'd have two with the same strategy, maybe a tie up there is logical to gain some scale and of course any RMR affiliated entity comes with some hair.

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    9. Funny--I JUST looked at RMRM last month because the transition seemed like a setup for an interesting value-realizing opportunity. And I look at TRMT every few months because I am/was familiar with a few of the underlying assets here in NYC.

      But I just can't bring myself to do it (even though buys in either of these, esp TRMT, would have been good after March) because I have no idea what "Portnoy discount" to apply. It's probably dumb of me because it's not even the same Portnoys who've caused shareholders so much distress in the past.

      But I can't shake the memory of the insane secondary they did last year when right after doubling their dividend. They tried for 12.5 million shares, and managed to sell 5 million (still more than the then-outstanding total) at under 1/3 of the then-current NAV. It was basically a recap, but so poorly handled--as was their IPO--that it left me leery.

      Still, as noted above, I am often tempted!

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    10. (I fully realize the irony of having governance questions about anything, given some of the names I'm in. And it's possible they are not like the "old RMR" any more--asset/fee gathering first, nothing second--and the perception of them might itself create an opportunity. TBD on my regular check-ins of their assets!)

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  5. What kind of price target are you thinking of when a sale happens? Somewhere around NAV?

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    1. No, I don't think it will go for NAV, probably need to split the discount somehow with the buyer, maybe 80% of NAV? Something like that. Although if they sell it to an external firm, should be some value for MCC shareholders for the management contract, so maybe could be a touch higher.

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    2. Just wanted to add/follow on to this comment that these will likely trade/be valued on a discount to NAV per a conversation I had with a friend in the BDC/Mezz debt industry. I'm looking at a modest 5% increase in NAV for the next filing and then a price target for the assets at 75% to 80% of stated NAV assuming mid year 2021 close.

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    3. Thanks - that sounds about right

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  6. Hi,

    Nice write-up, it does sound v compelling.

    How do you think about incentives here? It looks like David Lorber has been in MCC for a while and won't be made whole. His fund is blowing up with subpar performance (AUM down from $200m to $40m according to ADV filings). He is now CEO of MCC making $450k base + $450k bonus. Does he want a quick deal do you think?

    Alex

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    1. That's a good thought, I hadn't looked at how his fund has performed recently. But you could have made the same argument at RESI, there are a number of large holders in MCC including Fortress that probably would welcome a quick deal. I think it just comes down to the current structure is unsustainable and they already have advisors shopping it, etc. But good question, thanks.

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  7. http://www.medleycapitalcorp.com/news-releases/news-release-details/medley-capital-corporation-announces-september-30-2020-financial

    NAV at 9/30 was $55.30, slight increase over 6/30. Sort of an odd press release, left out all the subsequent events following 9/30.

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  8. EQS is sort of interesting here. EQS sold a major division for what looks like slightly less than the listed mark on their balance sheet. You can find a lot more information on the acquiring companies (UFP Industries) SEC filings for the asset. But anyways the Net cash is going to be about $1.55 with about 0.0429 shares of MVC capital per EQS share. So you're looking at at least $1.93 even if you're paranoid about the quality of the other assets. The adjusted stated NAV is ~$2.75.

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  9. https://www.nasdaq.com/press-release/medley-capital-corporation-announces-transfer-of-listing-from-the-new-york-stock
    Cutting ties with Medley with the name change. However, switching listing to nasdaq doesn't sound like the act of company with an imminent sale coming up. Any thoughts?

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    1. I wouldn't read too much into it, likely just examining all costs as part of the internalization.

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    2. The name might actually worry me more, they had to change the name away from Medley, but PhenixFin? Rising from the ashes combined with a fintech/crypto twist, not sure what to make of that, hopefully they didn't pay anyone to come up with it.

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    3. Agree regarding the concern on the name change. I think the discount to NAV is still very attractive regardless of if they pursue a sale now/next year or want to turn the ship short term and make a go of it. A 3rd option is a long term strategic review where they turn and re-brand, sell assets in the portfolio and redeploy assets into quality investments.

      I was unaware of how low the NNI/Yield of the portfolio is and think that although the assets are impaired and distressed they are going to be B/C loans in most BDCs. (I've been trying to dive into the loan portfolio and do some research there, some real ugly loans some quality equity and a lot of mid level mezz loans/businesses). That's why I am giving weight to the 3rd option.

      -MAF

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  10. Could you briefly explain why this is so: "if the plan was a true go-it-alone strategy, they likely would have refinanced the baby bond versus pay it with cash on the balance sheet"?

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    1. Maybe I'm reading too much into it, but if they wanted to go-it-alone they wouldn't be shrinking their balance sheet and asset base -- becoming further subscale.

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    2. Thanks for the answear. That makes sense

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  11. What could be the upshot of the share repurchase authorization? It seems like they would have to do a tender if they want to buy any shares in volume, given the negligible daily trading volume. What do you guys think? I am thinking a tender at $32 will benefit both the leaving and staying shareholders.

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    1. Yeah, seems like a token authorization, not sure they could really execute on it given the volume. But maybe does speak to their liquidity position following quarter end.

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