Description

Overview

MVC has been written up before (most recently by zeke375 in 10’ and britt12 in 13’) – and it is worth revisiting those writeups for background – but the basic thesis today is as follows:  MVC has a stated NAV of just under ~$16 while the stock trades at a little under $10 (just over 60% of TBV).  The market appears to be (in my mind rightly) skeptical about the value of MVC’s largest investment, which accounts for ~$4.15/share of the stated NAV.  But at the current stock price you are playing a “heads I win, tails I don’t lose much” game since this investment could go to $0 (unlikely) with MVC still trading at a discount to NAV.  Insiders seem to agree, buying ~$10m+ of stock in 2014 (all at higher prices).  The stock also has a medium term catalyst as MVC continues to convert its portfolio from a growth equity focus to a more traditional BDC yield strategy, which should narrow the P/NAV gap over the next few years.  

Background

I will quote the management of the company on how they came to manage and grow this vehicle.  The below is abridged/quoted from the linked doc – which also includes some colorful case studies on prior successful investments: 

http://files.shareholder.com/downloads/MVC/3500420645x0x753869/A4046911-E01C-466C-B939-FB2950F979BD/MVC%20Transcript%20-%20Maxim%20Presentation%20FINAL.pdf

Scott Schuenke - CFO:

MVC Capital was actually founded as meVC Draper Fisher Jurvetson. It was a BDC focused on venture investments and technology companies back in the early 2000s. It was a way for widows and orphans to take advantage of the tech boom that was going on in Silicon Valley.  In March of 2000, meVC Draper Fisher Jurvetson raised approximately $310 million in an IPO, net of offering costs.  By October 31, 2003, they had eroded roughly $173 million dollars of NAV. So the stock price traded as low as $7.25 off the IPO of $20.00, which was basically trading at cash. NAV per share dropped to $8.48. A proxy battle ensued over performance in February 2003.

A new board was elected, and they went to go find a new manager for this fund. They found Mike Tokarz, who is our current Chairman and Portfolio Manager. Mike had just retired from KKR in 2002. He was partner number six or seven, and he did some of those legendary ‘80s buyouts.  He did Safeway. He did Beatrice. He did Walter Industries. When Mike was brought in, he and the board had a tough decision on their hands. The decision was, “Are we going to liquidate this fund and the $113 million of cash? Or, are we going to try to revamp meVC?”  So, Mike did his due diligence and saw that there was a very valuable off balance sheet asset at meVC and that was a capital loss carryforward of roughly $160 million. Now, a capital loss carryforward is not a net operating loss. It can only be used to offset realized capital gains. So capital loss carryforwards allow a BDC to offset realized capital gains and retain them without having to be distributed, meaning you can grow NAV organically.

So with that in mind and wanting to offset this capital loss carryforward, the Board, along with Mike, changed the investment objective. What they tried to do is focus more on both equity and debt investments with a program of trying to offset these capital loss carryforwards

…

So ten years later, we have grown NAV organically by over $265 million. We have net assets today of roughly $400 million. We’ve returned over $150 million to our shareholders between dividends, share repurchases and tenders,4 and we’ve increased NAV per share from $8.48 to $17.40 a share.

 So where do we go from here?  Well, those capital loss carryforwards that we talked about at the beginning of the presentation have been used up with the exception of $10 million.  We decided that over the course of ten years, we’ve seen that the BDC is not really a great place to do these types of investments. As Mike mentioned, there are rules and regulations that make it very tough to do control investing. So we have determined to transition the portfolio to more of a yielding portfolio.

So if you look at our portfolio today, you’ll see we’ve started to make that transition. We showed you the case study on Summit. It Sold in April 2013 for a roughly $50 million gain, and we have one other investment with a large embedded gain in U.S. Gas & Electric.  What would that sale look like if we hypothetically sold U.S. Gas & Electric at its fair market value? Our $500,000 investment is valued today at roughly $92 million, so we would use up the remaining $10 million of the capital loss carryforward.

Then, hypothetically, we would have $82 million which would be required to be distributed to our shareholders. That’s $3.65 a share on a $13.50 stock. That would be over a 25% yield. Also, those distributions would retain their character because we’re a BDC, and they would be distributed to our shareholders as long-term capital gains. So you’d be taxed at much lower rates than a typical BDC distributing ordinary income…

We’re in a transformative period. We’re in a period where with this increased investment and capacity, we’re going to focus on yielding investments and seek to increase our yield going forward.  In addition to growing the yield, we believe there is additional equity upside, as we have portfolio companies that currently have large embedded unrealized gains.

Because of our equity focus and the nature of our portfolio, we trade at roughly a 20 percent discount to NAV in today’s current market dynamics.  Hopefully what we can provide to somebody who buys the stock today is a growing yield and a discount that will narrow over time.

MVC has not done well since Scott gave the above quotes, partially as a result of asset value writedowns taking NAV from almost $18/share to just under $16/share and partially as the discount to NAV has widened from just over ~20% to nearly 40%, as that ~$13.50 stock is now $9.72.

Issues:

MVC’s largest investment is in a company called US Gas and Electric (USGE) held on their books for $94m, or ~$4.15/share.  USGE is an ESCO that got hammered last year in the Polar Vortex (which put both the company and that industry in a very tough spot).  MVC had tried to sell the position and actually announced a sale near their marked price but the buyer pulled out of the deal and MVC subsequently wrote down the position by $9m (from $103 to $94m, which I think is probably too small a write-down), replaced the CEO and have been losing customers/meters.

MVC should be more forthcoming with the details of USGE’s issues given its size in the investment book.  But you can at least use their Level 3 disclosure metrics (from the last 10Q) to see that they’re predicting a recovery in 2015.  In their 10K from last year, the weighted average EBITDA multiple for the category where the USGE investment is held was 6.5x (reasonable) while they provided little additional info (forward multiples, etc).  In their latest 10Q, they show a weighted average LTM EBITDA multiple of 9x and an EBT multiple of ~15x (for a category that includes more than just the USGE investment).  Clearly eyebrow raising at best….  However, they now cite a multiple of forward EBITDA in their disclosure as well, which shows a weighted average of 5.5x EBITDA, implying an expectation for improved results in 2015. 

A decent comparable for USGE (informationally) is Genie Energy’s ESCO, which summarized what happened to their business during the Polar Vortex below:   

“As we discussed last quarter, like other retail energy providers, IDT Energy experienced unprecedented spikes in the cost of our electricity and gas supplies during the recent winter’s ‘polar vortex.’  To mitigate the impact of these increases on our customers, we significantly reduced our margins and, in addition, are rebating approximately $3.5 million directly to hard hit customers.  As a result, IDT Energy sustained its first quarterly loss from operations since inception nine years ago.  We expect that this past winter’s price volatility will continue to impact us somewhat in the second quarter, with modest additional rebate expense, lower rates of customer acquisition, and higher than average churn rates.   However, we remain bullish about IDT Energy’s growth prospects in the second half of the year and beyond.  We are developing new products to better protect customers from wholesale energy price volatility, and have excellent expansion opportunities as we gear up our sales efforts in Illinois and prepare to enter several new gas and dual meter territories.  By year’s end, we also expect that our Epiq marketing channel will begin contributing to RCE, meter and revenue growth.”

And while not setting any profit records, Genie’s ESCO has largely recovered from an EBITDA perspective

And Genie gave the below commentary for that business last quarter

“Genie Retail Energy had a solid quarter generating $5.8 million in Adjusted EBITDA on strong margins for electric sales. The number of meters served has stabilized after declines in recent quarters, and we are confident that Epiq Energy, our network marketing subsidiary which we acquired less than a year ago, will help put us on the path to resume growing our customer base in the year ahead.”

Perhaps Genie is also cheap (and you get all the oil in Mongolia thrown in for free) but that’s not what this writeup is about... 

Additional issues in the portfolio: MVC has taken a large write-down (from $43m to $27m in 14’) on its European car dealership investment and this subsidiary is having issues.  MVC also funded a ~$6m 2^nd lien loan this year to a company which was perpetrating a fraud.  They immediately wrote the loan down to $0 and began an investigation, but this raises obvious questions about their diligence process.  Generally speaking though, that is a footnote on what is basically a fine long-term track record. 

So I am currently skeptical about their reluctance to more aggressively mark USGE down, but if the governance here wasn’t fairly solid this would worry me much more.  Bulldog Investors is the largest shareholder and Phil Goldstein is on the board along with Robert Knapp, the PM of Ironside Partners, who is also a top shareholder.

Insider Buying

MVC had very substantial insider buying in 2014 by sophisticated board members, namely Robert Knapp who chairs the valuation committee.  Knapp bought ~$9m of stock in 14’ and Phil Goldstein (Bulldog) accumulated as well (albeit not as aggressively as in the year before).  It seems unlikely that if MVC was aggressively overstating its asset values, Knapp (who is the PM of Ironsides Partners and whose fund “specializ[es] in asset value investing. Ironsides focuses on closed end funds, holding companies and corporate restructurings.”) would have been so active in the stock at higher prices. 

Valuation

If the stated NAV is accurate (USGE recovers) and compounds at 8% with the stock re-rating to ~0.95x TBV (based on switching to yield focused investments) over 2 years that would provide close to ~80% upside.  Lets call that the upside case – I think it is on the optimistic side but not outlandish. 

Lets say a gloomy base case is one where they take a $40m haircut on USGE and an additional $20m write-down (for conservatism) on other assets with no upside surprise in the rest of the book.  Then (pretend those writedowns all happen tomorrow) NAV compounds at 5% (including the current ~5.5% dividend yield in that compounding/not double counting) for two years before becoming a yield vehicle and trading at 90% of TBV.  That would produce about a ~35% return in 2 years.

Working backwards, assuming this should trade at 90% of NAV – the market is implying that there are ~$5/share (~$115m) of writeoffs not reflected in their books.  They wrote off $21m from their Auto Dealerships as well and $9m from USGE this year.  Writing off 100% of USGE and the rest of their auto dealerships would get you about a ~$120m writedown, pretty close to that $115m amount implied for MVC to be trading at 90% of NAV. 

Illustratively, if the market is principally worried about the USGE, lets see what happens with various haircuts to the value of that investment:

So we would need an additional ~$45m write-downs, after writing down all of USGE, to have the new NAV equal to the stock price. 

Risks

·         Large portfolio writedowns

·         Longer transition period to a higher yield portfolio

DISCLOSURE

There are no plans to provide future updates on the authors buying or selling activities for this or other stocks. The author may buy or sell shares of MVC Capital without notice for any reason at any time.

Catalyst

Over the next few years, MVC should be able to shift its portfolio towards more traditional BDC yield investments (vs. growth equity) and trade closer to its peer group based on a higher dividend yield.