Description

MVC Capital is a well-managed business development company (“BDC”) trading at a significant, and in our opinion unwarranted, discount to NAV. We believe upcoming catalysts are likely to unlock MVC’s fair value, which we appraise at a minimum to be the Company’s book value.  Moreover, if MVC is granted an SBIC license, the upside could be substantially higher.  Although MVC has historically traded at a discount to NAV, the Company’s portfolio composition has recently changed from a heavily weighted private equity portfolio, to a low risk, yield focused portfolio, as management has executed its plan to fully utilize NOLs inherited from the previous management team.  In the last several years MVC has divested the majority of their equity investments, including the two largest positions which had made up nearly 40% of the total portfolio in the last 6 months alone.  As a result of the divestitures, the Company is likely to pay a substantial special dividend as proceeds from the sale are received ($3.50+ / share).  MVC is run by an exceptional management team with a strong investment track record, whose returns are nearly double those of the S&P 500 over the last decade.  The Company added a well-known activist investor to the board of directors, Phil Goldstein, in late 2012, and instituted an unlimited share repurchase program which has been used to buyback ~$17 MM worth of equity to date.

MVC has been written up previously on VIC, so my description of the business, and overview of BDCs in general, will be fairly brief.  The Company was originally formed by a team of venture capital investors, with a particular focus on early stage technology investments.  The original management team proved to be very poor capital allocators, and the investment portfolio generated losses in excess of 50% over the next few years.   In late 2003, MVC was taken over by Michael Tokarz, a seasoned private equity investor, whose prior experience includes 17 years at KKR.

BDCs, like REITs, pay out substantially all of their taxable income to investors, and pay no taxes at the corporate level.  Most BDCs take advantage of this structure by investing primarily in yielding investments, such as providing financing to small- and mid-sized companies.  MVC, on the other hand, given the substantial losses already generated by the legacy management team, chose to focus primarily on equity investments, on which they would not be taxed due to the outstanding capital loss carryforwards generated by the legacy portfolio.

This strategy is currently in its final stages.  The Company has been divesting many of their successful equity investments over the last few years (as a point of reference, since the last VIC write-up in early 2010, MVC has sold 4 out of their 6 largest investments).  The gains on these sales have been applied to the capital loss carryforwards over time.  Within the last six months, MVC entered into agreements to sell their 2 largest investments.  In April, MVC sold their ownership in Summit Research Labs, for ~$66 MM, roughly equal to the value the investment was being held at on MVC’s balance sheet, as determined by their valuation committee.  In early October, the Company announced an agreement to sell their largest investment, U.S. Gas & Electric (“USG&E”), for ~$96 MM, or $5 MM above the value being ascribed to the Company’s investment.  These two sales represented nearly 40% of the investment portfolio.  The sale of USG&E resulted in a realized gain of ~$95 MM (their initial cost basis in the equity investment was $500k, made in 2007).   The Company had ~$10 MM of capital loss carryforwards remaining immediately before the sale, and will therefore need to pay out a $3.50+ / share dividend as the sale proceeds are received over the next 13 months.

So what will MVC look like going forward?  After the payout of a large dividend, the Company will still have a substantial cash balance that will need to be deployed into new investments, somewhere in the neighborhood of $150 MM (roughly 1/3 of the total post-dividend investment portfolio).  While past performance is, of course, no guarantee of future results, Mr. Tokarz and the MVC investment team seem well up to the task.  Since taking over at the end of 2003, the Company has generated annualized investment returns of ~11.3%, compared to ~6.1% for the S&P 500.  Using the current share price of $13.89, after the dividend payout, MVC will trade at ~75% of NAV.  While historically many had questioned, likely justifiably, the value of equity investments in small and middle market private companies for which very limited financial information was available, the recent sales indicate that the valuation methodology used by MVC is very reasonable, and they are not systematically marking up their investments to above true market values.

It would seem that management of MVC agrees with our conclusions.  The Company recently put in place an unlimited authorization share repurchase program, which they used to buyback $16.7 MM of stock so far this year.  Additionally, the Company invited Phillip Goldstein, of Bulldog Investors, to join the board.  Mr. Goldstein, a seasoned activist investor, is a management friendly board participant, but signals the board’s recognition of the value disconnect, and a willingness to engage in shareholder friendly activities.  Since joining the board, Mr. Goldstein’s Bulldog Investors have become the second largest shareholder, and currently own some 5% of the Company.

The peer group of BDCs with portfolios consisting of primarily yielding investments and high current pay to shareholders, generally trade right around book value.  Therefore, we set our price target at $17.40, our current estimate of NAV inclusive of gains on the sale of USG&E, and 25% above today’s price.  As mentioned above, one major upside lever that is not included in this target is an SBIC license granted by the SBA.  Although there are only a handful of BDCs with access to this exceptionally cheap funding, they trade on average at nearly 1.35X book value.  If we were to apply a similar multiple to MVC it would imply a price per share of ~$23.50, roughly 70% above today’s price.  We are hopeful that the recent events cause the market to recognize that the discount being applied to MVC’s NAV is no longer justified.  In the meantime, we are happy to own, for 75 cents on the dollar, a diversified portfolio of investments, headed by an investment team that has nearly doubled the returns of the S&P 500 (net of fees) over the last decade.

Catalyst

• Large ($3.50+ / share) special dividend announcement
• Portfolio shift into lower risk, yielding investments, and the accompanying higher future dividends
• Additional share repurchases