Description

MVC Capital caught my eye recently when I noticed that a fairly decent value investor- Michael F. Price-- tripled his stake in January of 2005 (his investment entity now owns about 5.2% of the company). Not ordinarily one to jump on a bandwagon-- unless it's rated above 5.5 on V.I.C.-- I nevertheless felt compelled to investigate further. Why would Price suddenly take an interest in high technology, and invest in Draper Fisher Jurvetson's software- and Internet-oriented public venture capital fund?

As it turns out, MVC has had a complete makeover in the past year or so. Gone are the high-flying wunderkinds of Draper, Fisher, Jurvetson. Gone is Draper, Fisher, Jurvetson's losing record (in an admittedly difficult tech climate) of 3 consecutive down years and a $182 million overall decrease in net asset value-- a 55% decline since inception (from $330 million at inception to $148 million at management's departure at the end of 2003).

In its place stands the newly revamped MVC capital. MVC is a closed-end fund with $178 million in net assets (as of 1/31/05) that looks a lot like a traditional private equity fund, specializing in $3 - $30 million mezzanine debt, growth equity, and buyout transactions. The high technology plays of the old fund have been largely written off; the new fund has made 8 investments in companies that even Michael Price could understand: a candy company; a manufacturer of iron and steel components; a manufacturer of landscaping equipment; a Ford dealership based in the U.S. that ships to Eastern Europe; a producer of frozen fruit juices; and so on.

The new MVC has four full time employees. The fearless leader is Michael Tokarz, a 17 year veteran of KKR, who arrived in November of 2003, and began investing MVC's capital early in 2004. Tokarz's resume includes KKR's largest-ever cash-on-cash return (Safeway); KKR's second largest buyout transaction, for $8.7 billion (Beatrice); KKR's first billion-dollar buyout (Wometco); and KKR's first large buyout of a public company, Houdaille ($380 million). This is not someone who just fell off the apple truck.

What's truly appealing (and refreshing) about the change in management is that Tokarz is compensated solely through the fund's carried interest. He personally takes no cash compensation: he is paid the lesser of a) 20% of the fund's net income or b) the sum of (net capital appreciation of investments made since Tokarz joined) + (any amount in operational expenses less than 2% of the funds net assets). A 20% carried interest for this type of vehicle is strictly middle of the fairway; the KKRs of the world routinely take 25 - 30% of the upside on much larger pools of capital. Tokarz's personal equity stake, in addition to the carried interest, is roughly 300,000 shares.

In contrast to some of the other "public private equity funds," Tokarz and team did not cash in by collecting multi-million dollar fees when the vehicle was brought public. In contrast to the prior management, he and his staff have incentives that are properly aligned with those of shareholders. Where Draper Fisher Jurvetson's expenses ran at roughly $7 million per year in 2000 - 2002 (adjusted for litigation and proxy expenses in 2002), Tokarz reduced operating expenses to $3.9 million in the year ended 10/31/04. The company's proxy statement shows that aside from Tokarz's $0 salary, the other FTEs draw princely sums ranging from $100,000 to $250,000 per year. I would expect operating expenses to decline further as the legal expenses and "cleanup" associated with the dispositions of Draper Fisher Jurvetson's investments diminishes over time.

As of 1/31/05, the fund has about $178 million in net assets. Of the $178 million, about 60% is in cash or T-Bills, 21% is in loans to the aforementioned private companies, and 19% is in equity investments made in private companies. The company raised over $60 million of dry powder in an over-subscribed rights offering to existing shareholders in January of 2005, at $9.10 per share.

MVC has slowly but surely written off, exited, divested, and expunged from memory the struggling technology investments of the previous regime-- a concern cited in the earlier VIC write-up on this company. At present, technology equity investments have been written down from the old management's cost of $72.5 million to a fair market value of about $9 million. That's $9 million in technology-related equity investments out of total assets of $178 million, which is a very important point: at this juncture, there's very little remaining potential downside associated with the legacy investments of the Draper Fisher Jurvetson technology gurus. I think that's the key to understanding the new MVC: even if remaining tech equity investments, which drove NAV into the dust from 2000- 2002, are completely written off, it only translates into a $9 million decline from net asset value as of January 31, 2005. Of the $9 million remaining on the books, $5.5 million is in a company called Sygate, a producer of security software (www.sygate.com). Sygate's value is carried on the books at a fair value of $5.5 million, up from Draper Fisher's cost of $4.0 million. I'll leave commentary on Sygate's prospects to the security software experts in the VIC community (?).

Tokarz's investment structures look a lot like a typical mezzanine/ buyout fund. MVC looks for the typical opportunities: management buyouts, recapitalizations, growth equity infusions, acquisition financing, operational turnarounds. The debt deals (again, about 21% of assets) generally carry 10 to 17% interest. They're looking for debt and equity investments in private companies operating in industries they understand: consumer products, food/ food service, industrial manufacturing, financial services, value-added distribution, and specialty chemicals.

So far, as of 1/31/05 they've made eight investments under Tokarz's watch, and seem to be sticking to their knitting. Importantly, all of the Tokarz-era equity investments are carried at cost. That's another important item to understand; any appreciation (or, to be fair, decline in value) of the Tokarz-era investments is not reflected in the NAV of the shares.

MVC's shift in investment strategy-- from high flying technology to old economy concerns with a heavy emphasis on steady, free cash flow-- has shown up in the results of the fund. In 2004, the fund showed the first increase in NAV per share in the history of the company. Under new management, the underlying NAV of the fund's shares increased from $8.48 to $9.24 per share for the year ended October 31, 2004.

As of this writing, MVC trades at $9.17, versus a fair market value of $9.41 (Fair market value is assigned by a committee of non-executive directors).

It's a good time to take a fresh look at MVC. Tokarz has reduced operating expenses, cleaned out the Draper Fisher Jurvetson refrigerator, and repositioned the company for growth. MVC is a buy at $9.17.

Catalyst

* Management overhaul (KKR veteran)
* Proper incentives for management; decreased expenses
* Writeoff of technology investments largely complete
* Investment refocused on steady FCF, old economy businesses