If you take a big picture view of the Business Development Company (BDC) industry, there is no question that matters are looking up. Stock prices are jumping, dividends are being maintained or raised and balance sheets are being rejiggered to take advantage of the nascent recovery.
Nonetheless, it’s not all easy sailing for investors in this space as the news from three very different companies has underscored in recent weeks. We thought it would be interesting to compare and contrast recent developments at Main Street Capital (MAIN), Hercules Technology (HTGC) and Medallion Financial (TAXI).
Yesterday, after closing, Main Street Capital, which focuses on loans in the lower middle market financed by Small Business Investment Corporation (SBIC) capital, announced lukewarm results. Investment Income was down, and so was Distributable Income Per Share.
Like many BDCs, MAIN used the opportunity in this last quarter to “cleanse” its portfolio, selling off two under-performing deals in 2009 and another in 2010. That hurt earnings, as did the 3 non-accruing loans on the books at year end. The company’s principal problem, though, is just slow new asset formation. With two equity raises in recent months under its belt, a new Revolver, two new infusions of SBIC monies, MAIN Street has more money than sensible places to invest. Despite adding six new investments in 2010, total investment assets at cost only increased 6% in 2009.
In fact, Main Street has nearly twice as much “dry powder” as it has investment assets outstanding. This is a company whose future, for better or worse, is in front of it.
We were encouraged by Main Street Capital’s (MAIN) dividend announcement for the three months ended June 2010. The company announced a monthly pay-out of $0.125, 0r $0.375 for the quarter. The company has adopted an investor friendly policy of maintaining a stable dividend policy unrelated to latest earnings.
Still, that’s 11.5 cents more a quarter in distributions per share (and that’s before counting the new shares issued in the January 2010 capital raise) than in earnings per share. If you really believed MAIN could not increase its distributable income per share from the current level, the stock would be expensive. If you believe, as we do, that MAIN will ultimately earn at or above its current dividend level, its trading at 10x, which is reasonable but not a great bargain.
Unless we discover something untoward in the 10-K or the conference call, we’re digging in for the long haul with MAIN, assuming that it will take a couple of years to fully deploy its unused capital and boost its earnings. Next quarter we expect distributable net income per share to drop, thanks to the new stock issuance in 2010, but we should see earnings increases by the end of the year.
The elephant in the room is whether there will be enough new deals to be done. Companies like MAIN principally generate income from writing direct loans to smaller companies. They do not have access or interest to buying distressed loans, or participating in larger syndicated facilities. If the economy remains troubled, and LBO activity remains tepid, MAIN may have some problem finding the right deals for its portfolio. Time will tell.
A couple of weeks ago, as we’ve reported on earlier, Hercules Technology (HTGC) reduced its distribution by a third from 30 cents to 20 cents. We convinced ourselves this was a temporary aberration, to be made up later in 2010 as HTGC grows back its loan book.
The market seems to feel the same way as the stock is back above where it was before the announcement, despite the cut. Like MAIN, HTGC has plenty of capital to spend but is not yet closing that many new deals. In fact, total assets are actually shrinking as problematic credits booked during the boom times are worked through, closed down or sold.
Like Main Street, Hercules is getting ready to provide substantially more funds for new deals, but these are still slow in arriving. We don’t expect earnings to increase till the second quarter of 2010 at the earliest.
If we’re relatively sanguine about the longer term prospects for MAIN and HTGC, we are less so where our third BDC in the spotlight is concerned. Medallion Financial (TAXI) is a BDC which has both a finance company arm making medallion loans for taxis (hence the cute ticker) and commercial loans, as well as owning a bank.
More recently, and without much fanfare, Medallion Financial (TAXI) cut its long-standing quarterly pay-out of 19 cents a share to 15 cents for the IVQ of 2009. We had seen this one coming as Medallion has been de-leveraging its non-bank subsidiaries for several quarters, despite the good performance of its taxi medallion loans.
Then there was the reckoning TAXI had to take for its failed and quixotic investment in special purpose acquisition corporations (or SPACs), a feature of the go-go years. The company established a valuation allowance of $9.342mn for the SPACs, which have ceased operations. That suggests we shouldn’t be expecting any recoveries. To put this into perspective, the provision was equal to over 50% of the prior year’s Net Investment Income, and cut 2009’s returns in half.
Medallion is increasingly focusing its energies on growing assets in its wholly owned bank subsidiary, where low cost deposits fund the assets. The finance company, by contrast, is finding it difficult to find appropriate financing at a price that it can afford. The result is ever decreasing assets, either from run off or selling the loans to the bank or third parties.
For shareholders of TAXI, the increasing importance of the bank subsidiary makes the maintenance of the dividend more insecure. As a bank, TAXI has to defer to the FDIC, which has lent the bank funds under the famous TARP program. However, the regulators have put express and implicit limits on the amount of dividends the bank can pay to its parent, and thereby to its shareholders.
We’re worried that at some point TAXI might be forbidden by the regulators from paying out any dividend from its bank should concerns arise about capital adequacy or any number of other considerations.
Given the relatively low yield being received by TAXI shareholders at the current price of $8.07, and little prospects for growth outside the bank, we’re not sure Medallion Financial is worth the risk at this price level.
In conclusion, the BDC industry may be on the mend but there are many uncertainties ahead. Back in the “good old days” between 2003-2007 every BDC seemed able to maintain or increase its dividend, raise capital at will and continually expand.
In the post Great Recession environment, there is much greater uncertainty and the differentiation of outcomes will vary very much from company to company. In this case, Main Street and Hercules Technology with their plentiful liquidity, low leverage and seemingly patient approach to booking new deals should prosper if the economy perks up in the months ahead, but also have the resources to weather a “double dip” recession, or just an anemic economy for several quarters.
Medallion Financial, with its increasing reliance on earnings generated from its bank (paid out in dividends to the parent) and still de-leveraging balance sheet, does not inspire us with as much confidence.
Disclosure: Author holds long position in MAIN and HTGC, no position in TAXI
