Description

NGPC is a BDC trading below Net Asset Value, when it really should be trading at a premium. It’s been slow investing the money raised in its 2004 IPO, but even at the historically slow pace of deployment, it should reach fully invested status within a couple of years and at that point, I expect that it’ll trade around 1.2x NAV, for a total return of 40-45%. There could very well be a quicker short-term bounce in the share price, as likely year-end tax selling abates, the pace of capital deployment picks up, and/or investors realize that there’s nothing wrong with the company except that it’s cautious.

You are probably sick of reading about Business Development Companies (BDCs) here on VIC, but as long as these animals continue to be misunderstood, they can be a lucrative area to spend some time in. NGPC is a specialized BDC focusing on energy-related investments, primarily in upstream and midstream oil and gas. Its sweet spot is mezzanine financing, with senior loans, subordinated loans, and equity kickers such as warrants and overriding royalty interests providing some capital gain potential. By and large, the economic model is similar to most other BDCs, with targeted gross returns in the mid-teens, and net returns on equity perhaps slightly higher after expenses and leverage are factored in. For those of familiar with other BDCs, NGPC targets a net return on equity lower than junior-security-heavy BDCs like ACAS, but higher than senior-debt-heavy BDCs like GLAD. The risk level is commensurately in between. It IPO’d in November of 2004, raising $244 million in net proceeds for a starting NAV of $14.04/share. It’s an externally managed BDC and one aspect I like is that it probably sports the most favorable (for shareholders, that is) fee structure out there: 1.8% and 20%, with the 20% of NII taken only after an 8% hurdle rate is met with no catch-up provision. This compares to most others at 2 and 20, with the latter either with no hurdle or with a catch-up which effectively negates the hurdle for all practical purposes.

To evaluate a BDC for investment, there are really only two things you need to figure out – what price should it trade at in relation to NAV or dividend if it is managed properly, and is the investment advisor capable of managing it properly?


VALUATION

As of the end of September 2005, NGPC had an NAV of $14.02/share. I think it will be up slightly at December end, but not by any meaningful amount, so $14.02 is a good number to use. With the share price at $13.11, you can buy the stock at a 6.5% discount to the NAV. The discount won’t last. BDCs don’t trade below NAV for long unless there is a real problem. Here are the P/NAVs for other BDCs:

ACAS 1.56x
AINV 1.26x
ALD 1.67x
GLAD 1.58x
GAIN 0.97x
PSEC 1.04x

NGPC 0.94x

Judging purely from these comps, a 1.2x NAV for NGPC seems reasonable. The high multiples for ACAS and ALD stem from their established status, greater emphasis on equity returns, and internally managed structure. PSEC is an interesting comp because it’s also energy-focused, but its low multiple is partly attributable to some legal and staff turnover woes, which NGPC doesn’t have. GAIN is even earlier in its ramp stage than NGPC, partly accounting for its low valuation. Both PSEC and GAIN have been written up on VIC over the past couple weeks, and are interesting opportunities themselves.

The 1.2x NAV is also validated by looking at the potential dividend from NGPC’s return profile. It’s currently only 42% invested, and is paying a core dividend at a $0.60 annualized run rate. NGPC can lever up to a 100% debt-equity ratio, although it will stop short of that. I assume that full leverage is 50%, although management is likely to try going a little further. Fully invested at a 50% debt/equity, NGCP should be able to earn and pay a core dividend of about $1.20-1.25/share. Capital gains should eventually add another $0.30-0.35 a year, although it could be very lumpy for a few years (note that it’s already paying a 12.5 ct special divvie this year). Thus, I think $1.50-1.60 in annual dividends is a sufficiently conservative number to project for NGPC once it hits full stride. I say conservative, because it could easily 1) lever up more, 2) raise equity at a premium to NAV, which would help, and 3) experience greater capital gains than I project. So 1.2x the $14.02 NAV is $16.82, implying a mature dividend yield of 8.9-9.5%, a more-than-fair expectation. If they can get to that mature run rate in two years, that should give you capital appreciation of 28%, and after adding in dividends, you should get a total return of around 40-45%.

There’s a good chance that return could be front-loaded, since once investors see even a glimpse of a pick up in the capital deployment, they tend to cast away their hesitation and pile into the shares. This is fairly typical of BDCs, because a lot of investors are income-oriented, and they often wait to invest until the dividend ramps up. If you look at the list above of the P/NAVs for BDCs, you’ll notice an interesting pattern – the relative P/NAV is in virtual lock-step with how long the BDC has been public. In other words, if you rank the BDCs from highest to lowest P/NAV, you’ll have ranked them basically in chronological order of when they went public. That’s just the nature of the BDC investor base. You can take advantage of this predictability by buying BDCs whose share prices have dropped to the level of net asset value, and anyone that did so over the past several years would rarely have regretted it. NGPC’s discount makes it all the more attractive, making the downside minimal.


INVESTMENT ADVISER

As I mentioned above, the main reason NGPC trades at a discount to NAV is that investors are discouraged by the slow pace of deal activity. It originally thought that it could have the entire $240 million IPO proceeds invested by now. It clearly missed that target, but assuming the same pace of investments for the past year as for the next year, it should get there by the end of 2006. However, I think they could potentially do a little better, since they’ve ramped up staff considerably since the IPO, when they only had three people total. They now have 16, with nine investment professionals. It’s hard to see how a full year of nine investment professionals can’t do more volume than a year in which they were just ramping up from three to nine.

What really provides me with comfort that NGPC will turn out just fine is the management pedigree. NGPC is externally managed, and its investment adviser is sponsored by Natural Gas Partners, one of the premier firms, if not THE premier firm, in the oil and gas private equity arena. Natural Gas Partners (a.k.a. NGP Energy Capital Management) is run by Ken Hersh and David Albin, who co-founded it in 1988 with the backing of Richard Rainwater, and the returns on their funds have been north of 30%, an eye-popping figure even if no doubt boosted by the recent boom in energy prices. Neither Hersh nor Albin are the primary day-to-day guys for NGPC, but Hersh and other Natural Gas Partners members are on the investment committee and the Board, and their oversight and involvement are nothing but big plusses. The actual guy running the show is CEO John Homier. He’s been no slouch either, with a long history of alleged 20%-type returns with Banc of America and Deutsche Bank in the energy mezzanine space. If they happen to knock the cover off the ball with NGPC, then the stock could eventually get a valuation more like 1.4x or 1.5x NAV. But just doing average should get them to 1.2x.

For those wondering, I don’t think NGPC should be looked at as a play on energy prices. Booming energy prices are probably close to a wash for NGPC, since it would help the performance of portfolio investments, but also makes it tougher to close on potential investments, given that more capital enters the space and target companies have less need for outside capital. So the appeal of NPGC is not that it will benefit tremendously from rising energy prices, but that the mid-market mezzanine segment in the energy industry is still relatively underserved, and you get to team up with one of the premier private equity players in the energy field.

One positive is a moderate level of insider buying. Ken Hersh bought 30,000 shares in August at prices between $13.6 and $14.0, and three other officers bought a combined 7,000 shares at similar prices around the same time.

One detail you should know if you buy the stock: The stock is flagged to reinvest dividends automatically, even for shares held in broker accounts, so unless you want to participate in the DRIP, you should call your broker and opt out.

Catalyst

Continued deployment of investment capital should do it.