MCG Capital (MCGC) – Part 2 – Business Issues

MCGC has built up a good business over the years with debt acquired at 6.6% and the yield on investments averaging approximately at twice that amount. The arbitrage income, yield achieved from equity capital along with opportunity for appreciation on equity investments, has a good return potential.

A large portion of its debt is due in 1-3 years. In a tightening credit environment, odds are that the company will have to capitalize at less favorable terms. As their recent rights issue suggests they may have to resort to issuing equity for raising capital to avoid unfavorable terms. The Broadview IPO expected sometime in 2008 could improve this situation dramatically. The ownership interest of 46% valued at $266.9M should benefit the company as it tries to restructure its shorter-term debt.

Risks:

MCG Capital’s investments will under perform in a recession and that could result in portfolio companies being unable to satisfy their debt and interest payment obligations. MCG Capital might have to write off such investments and reckon with the big losses that directly affects the company’s bottom line. Worst case, MCG Capital’s equity can end up being worthless if the value of its investments in private companies deteriorates to a level below the total issued debt. Currently such write-offs and assets in non-accrual status are fairly contained at less than 5%. The 1:1 debt-to-equity regulatory requirement contains these risks somewhat but since the investments are in high risk mid-market private companies, in an extended downturn the risk is very much real.

More than two-third of MCG Capital’s total investments are in the subordinate secured/unsecured debt and equity categories. This ranks the entire portfolio as higher risk compared to less than one-third of the total investments in these categories in the 2003-2004 timeframe. But then again, with higher risk comes the prospect of better returns – MCGC gets to participate in any increase in the profitability of the portfolio companies.

The net cash from operating activities dropped dramatically from $70M in 2006 to $55M in 2007 following realized losses in investments due to write-downs in its Cleartel investments and increased Payments-In-Kind amounts. Operating cash requirement for the coming year should be around $150M given dividend payments at the current level add up to about $110M and interest payments come to above $40M. Assuming the same level of net cash from operating activities for next year, the gap of about $80M will need to be bridged efficiently. The alternative in a tight-credit situation is to slice dividends. However MCGC may not be able to drop dividends dramatically as it could lose its preferred tax treatment due to the RIC status.

Related Posts:

1. MCG Capital (MCGC) - Part 1 - Introduction.
2. MCG Capital (MCGC) - Part 2 - Business Issues.
3. MCG Capital (MCGC) - Part 3 - Outlook.