- Since its IPO on October 25, 2013 MRCC has outperformed BDCS by over 8% cumulative while yielding, on average, higher than the BDC universe.
- Outstanding balance sheet will provide protection during a downturn, while benefitting from rising rates, as 97% of loans are floating.
- Strong potential for capital appreciation as the market recognizes that this BDC trades well below comparable peers, plus a 9.2% yield!
Monroe Capital Corp. (MRCC), headquartered in Chicago, Illinois, is a business development company (BDC) that invests in lower middle-market companies with EBITDA up to $25 million and revenues up to $250 million located in the U.S. and Canada. The fund invests across a broad range of sectors. It provides senior, junior, and mezzanine debt and equity co-investments for recapitalization, refinancing, acquisition, and expansion capital requirements with an investment size ranging between $2 million and $18 million each. It also makes minority equity co-investments. The BDC is part of the larger Monroe Capital LLC platform.
MRCC uses the larger “Monroe Capital” platform to boost its deal flow and internal operations. This relationship allows MRCC to achieve a level of brand recognition to increase deal flow. MRCC, the BDC, is the public face of the $4 billion assets under management (AUM) Monroe platform. The platform allows the BDC to compete in sponsored and non-sponsored deals and offer better certainty of execution. Moreover, as the only public entity in the platform, the BDC is likely to invest in the highest credit quality and yields of the platform, as its performance is used as an indicator for the other private funds in the platform.
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The BDC universe, as a whole, is trading at 1.04x P/Book Value, with MRCC right smack dab in the middle trading at 1.05x P/B. For peers we chose HTGC, MAIN, and GLAD. Though these BDCs are slightly different in nature, they have the highest exposures to REAL first-lien investments. For explanation on this, please see the section below called “Portfolio Composition” because many BDCs are misleading on how they categorize and present investments on their balance sheet. When comparing MRCC to this small group of peers, who have an average P/B multiple of 1.41x, they appear to be trading at a discount.
For the yield and quality of MRCC, we are surprised that it is trading in-line with BDC peers who tend to have riskier balance sheets and higher exposure to fixed asset loans. MRCC is also cheap on a dividend yield metric. They trade above book and can raise equity without shareholder approval (for dilution purposes). We think they have been given a lower valuation due to a bad/dilutive equity offering in 2013. This has caused NAV growth to be stagnant since inception, but if it wasn’t for this dilutive raise, NAV growth would be very healthy and would have grown year-over-year.
If you calculate NAV growth from the beginning of 2014, after the dilutive equity raise, they have grown NAV from approximately $14.00 on 1/31/2014 to over $14.50 at the end of the year. Again, if you were to show NAV growth from their IPO, it would appear to be a flat-liner. MRCC may be yielding a lower valuation compared to peers due to this poor management choice.
The company presented their change in per share NAV from 12/2014 – 12/2016 as shown in the adjacent table:
Though this graph does not tell the entire story of the dilutive raise in 2013, it shows that the company has made progress over the last two years, growing shareholder value. For the credit environment that BDCs have encountered over the past few years, keeping a stable NAV since IPO, is still quite a strong accomplishment, especially having a higher yield, on average, against the BDC universe.
Monroe Capital has not increased their dividend since March 2015, when they increased it by $0.01 to $0.35. Their current yield is 9.19%, trades above the BDC universe average of 8.41%. Since they have not recently grown their dividend, their current and 1-YR future dividend coverage ratios sit at 113.58% and 111.18%, respectively. These ratios have come down and remain well below their BDC peer’s current coverage ratio of 100.01%.
Main Street Capital Corp (“MAIN”), which is internally managed, has a track record of repetitive and outsized realized gains at exit, which has led to its 12.3% GAAP ROE. On the other hand, on 3/31/2017, MRCC has the eighth highest GAAP ROE amongst the BDC universe (a total of 50 BDCs), at 11.5%.
MRCC has had an ROE consistently higher than peers, a material indicator of sector outperformance.
MRCC’s normal target regulatory leverage level is 75%, which embeds a cushion from the actual limit of 100% (1:1x). MRCC utilizes SBA debentures (off-balance sheet) to lever up further as they do not count towards the regulatory debt limit for BDCs. Total leverage (including SBA debt) was 88% at the end of 12/31/16.
We used our proprietary method to estimate, on a fair value basis, MRCC’s true portfolio risk as of 12/31/2016. Their balance sheet consisted of 66.7% first-lien senior secured loans, 12.5% unitranche loans, 14.4% junior secured debt, and 6.4% equity investments. This is a much more secure portfolio than the BDC universe that averages approximately 60% senior debt investments (MRCC’s senior debt is 79.2%, as unitranche is considered a senior debt product). We calculate that the average exposure to “first-lien” loans for the BDC universe is closer to 39.5%, well below MRCC’s exposure. Senior positions in the capital structure of portfolio companies allows the BDC to incorporate beneficial covenants like higher origination fees and prepayment fees. The company has minimal exposure to oil and gas investments. Oil and gas is 1.9% of the portfolio, and other energy-related investments like metals and mining and automotive are under 3.1%, in total. Moreover, its retail investments of 5% of the portfolio are in asset backed lending structures and thus do not represent the current cyclical trend concerns of the rest of the retail space.
The numbers in red are what the company presents its allocation to each category, but we dug into the 10-K and separated the second lien/unitranche loans out of the Stated Secured and placed them into Mezz/Sub debt. Our calculations are in black and are how I think these assets should be grouped. These second lien and unitranche loans react more like sub-debt than senior secured debt in an asset recoverability test. Unitranche has a slightly higher recoverability rate than second lien.
Moody’s data indicates that from 1982 to 2010 the expected recovery rate from first- or second-lien debt differs substantially (as measured by post-default trading prices rather than ultimate recovered dollars) – the first-lien debt expected recovery rate was 60%, second-lien was 28%. A second-lien position has a substantially lower recovery rate in the event of a default than a first-lien position (and not much different than a mezzanine or junior position).
MRCC has the 4th highest exposure to first-lien in the BDC universe. The top 10 largest exposures to first-lien have an average BDC yield of 9.30% right now.
MRCC’s predominantly first-lien assets should weather recessionary pressures better than the industry average, with almost 67% first-lien loans and 80% senior secured. The dividend over-coverage also gives extra comfort that even in a recessionary stressed economy with high losses/non-accruals MRCC has a better than average chance of sustaining the current dividend level.
Management Fee Structure
While the fees are in line with BDC averages, the structure does include an eleven quarter look back feature to calculate incentive fees and capital gains fees. Moreover, the capital gains fees are net of realized losses and unrealized depreciation. This alignment will allocate the impact of credit losses (realized or unrealized) between the manager and investors, rather than the full earnings burden affecting the shareholders. The structure also includes a catch-up provision for management to recoup previously lower fees if there is a material improvement in asset performance.
Another way that we look at fee structure is its “Economic Profits Paid to Managers” which is 34.30%, slightly below the average for externally managed BDCs at 35.39%.
Interest Rate Sensitivity
MRCC has a significant amount of their assets in floating rate loans (97%).
The Fortune Teller did a study on BDCs and how they actually react in a rising interest rate environments. The FT did a great job applying what conceptually is expected to happen during certain environments to what actually happens during these environments (H/T Fortune Teller for doing a great job on the BDC and REIT study). I suggest that everyone reads his findings. In the study, MRCC, surprisingly, did not do as well as the BDC universe, even with their high allocation to floating rate assets. Though this could not be accounted for in the study, I believe that one of the periods used for MRCC had an idiosyncratic event for MRCC, the dilutive equity raise in 2013. If this period is excluded, MRCC would have had average performance against the BDC universe in a rising interest rate environment.
Management Alignment with Shareholders
During this recent disappointing quarter, management credited $273,000 so that adjusted NII covered the dividend. There is no guarantee the manager will do this in the future, but it shows how strongly the managers is aligned with shareholders. Prepayment fee income was lower than expected, which may persist for a few quarters.
MRCC has a conservative investment mix, with outsized yields. The investment mix of first-lien investments would provide higher downside protection than most of the BDCs in the universe. MRCC has a strong management team that leverages Monroe’s loan platform, which has a history of excellent underwriting practices.
Non-accruals did increase over 2016 from 0.00% to 2.52% as of year-end. This was due to a loan to TPP Acquisition, Inc. (aka The Picture People), who is a retail investment that saw issues with client contracts and a slowdown in mall traffic (a big driver for the company is holiday photos at the mall). They had another non-accrual from Answers, Corp. MRCC has been a public BDC for almost four years now and has only had three credit constrained portfolio investments. This is an outstanding track record compared to its peers over the same period.
The BDC may see some headwinds with lower than expected prepayment fee income, which hurt them in Q4 2016. The business has one of its most profitable asset being sold, Rockdale, in early 2018 which will result in a NII decline due to lower dividend income. The fourth quarter saw a decline in total dividends at $251,000, below the expected $1M. Dividends from Rockdale, who did not pay dividends in Q4, totaled $3.5M for the first nine months ($0.21/per share). Rockdale’s dividends are tax-driven, creating lumpy payouts. Rockdale is about 2.5% of FV investments. Once Rockdale is sold, we may see a supplemental dividend. Rockdale is marked conservatively (it’s marked at 3.3x EBITDA according to the 10K disclosures).
MRCC remains well positioned to grow given we estimate it has $167M in untapped lending potential (including SBA borrowings), or 40% of 4Q16 investment assets at fair value. Spill over income at year-end was $0.42/per share, which can be used to cover a future shortfall in the dividend.
MRCC is trading at the top of its normal trading window, but relative to the entire universe, they are trading in line.
I believe MRCC will be re-rated for its higher-quality balance sheet that will lead not only to dividend growth, but capital appreciation. Furthermore, in the case of a credit crisis, MRCC’s quality should insulate it relative to riskier BDCs, providing downside protection.
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Article by David W. Wagner III – Opus Capital Management