MCG Capital (MCGC) – Part 1 - Introduction

MCGC Capital Corporation (MCGC), a Business Development Company (BDC) provides debt financing to small as well as mid-capitalization companies. They are required to invest at least 70% of their total assets in private or thinly traded public companies. The company has elected to be treated as a Regulated Investment Company (RIC) as of January 2002 and is thus exempted from paying corporate taxes on any income they distribute to their stockholders as dividends. To qualify as an RIC, it is required to distribute at least 90% (98% to avoid a 4% excise tax) of the taxable income and also continue to qualify as a BDC. There are also certain other miscellaneous restrictions.

BDC Primer:

BDC’s stimulate public capital to private businesses in an efficient manner. They are structured like a closed end mutual fund, the variation being instead of investing in public companies, the fund invests in private enterprises. As with closed end mutual funds, the Net Asset Value (NAV) is an important measure of valuation for these companies. The unknown for BDC’s is the level of difficulty in asset valuation, as they are not generally traded.

BDCs are very risky as it invests in high-yielding sub-ordinate and mezzanine debt. Further, the investments are on small-cap enterprises that by its very nature are risky. These risks are somewhat mitigated by the following factors:

• Regulations limit leverage to be 1:1, and
• BDC’s provide a way to gain exposure to small-caps along with high dividend yield.

Correlation to small caps and high-yield debt make BDC investments more risky in a recession.

Financing Options for Small Private Businesses Primer:

There are three types of financing options for small enterprises:

• Senior debt (Bank Loan) – least expensive, but needs collateral.
• Mezannine/Sub-Ordinated Debt – more expensive with interest rates in the range of 10-14%. No collateral is required per se, but is usually secured through warrants on the equity in the company. With warrants, a put-option is usually executed where there is an agreement for the company to buy back the warrants at a pre-arranged price based on the valuation of the company. With warrants, investors (usually funds) try to realize an internal rate of return in the 20-25% range. Recommended for relatively high-growth businesses with established revenues and are on a path to positive operating income. In priority of payment, this type of debt falls right in the middle – before equity but after senior debt. It can act as an equity cushion that supports the senior bank debt.
• Equity – most expensive. Ownership in one’s company is diluted and can potentially lose control as the financers could seek board representation, etc. Recommended for high-growth high investment risk business – operating cash flow may not be substantial.

MCG Capital is active in all three of these financing categories. They have focused on optimizing asset mix for risk and returns, as shown in the following table:

Year	2003	2004	2005	2006	2007
Senior Debt	71.9	70.4	49.5	31	32.6
Secured Sub-debt	14.7	16	30	39.3	34.2
Unsecured Sub-debt	0	0	5.6	2.0	2.5
Equity	13.4	13.4	14.9	27.7	30.7

The following table indicates the portfolio diversification achieved by the company over the years:

Year	2003	2004	2005	2006	2007
Media	54.4%	42.1%	25.9%	20.8%	19.9%
Communications	27.5%	21.7%	25.7%	28.5%	21.5%
Information Services	9.4%	10.9%	6.9%	3.8%	2.9%
Technology	5.6%	7.2%	6.0%	2.9%	3.0%
Diversified / Other	1 3.1%	18.1%	35.5%	44.0%	52.7%

MCG Capital’s business is dependent on acquiring capital efficiently and then allocating it so as to enhance NAV and interest income. The total borrowings and minimum rental obligations together stands at $761.9M and the total of all investments at fair value are about $1.56B as of EOY 2007. That makes the ratio of debt-to-equity very close to the regulatory requirement of 1:1.

Related Posts:

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