BDC Update: Midcap Financial Investment

February 22, 2023

Doing Well

MidCap Financial (MFIC) has reported IVQ 2022 results, published its 10-K and Investor Presentation, and held its earnings conference call. In a nutshell, we were impressed by the performance across the board - in line with our expectations. If anything,  recurring earnings came in stronger than we expected but that may have much to do with the quirks of the "total return" compensation plan.

Re-Think

MFIC is doing so well that we considered increasing our dividend projection for 2023 and beyond. On reflection, though, we're sticking with the assumption that the BDC will bring its annual payout up to $1.5800 in 2023 and stay there through 2027. In IQ 2023, MFIC announced a distribution of $0.3800, up slightly from the prior quarter. That only annualizes to $1.5200, but we expect greater payouts as the year progresses.

Up To Date

Reviewing our prior writings, we realize that we'd not written an update since our last article on July 10, 2022. - see below. At that time we were projecting MFIC would pay out $1.4400 in 2023-2027. Somewhere along the way we upped the projection but failed to write an explanatory update. This brief update syncs up the Expected Return Table with our Update.

Valuation

July 10, 2022

Not Right

MFIC (till recently Apollo Investment, with the ticker AINV) is one of the oldest public BDCs, launched by its famous parent/sponsor/advisor Apollo Global (APO) back in 2004. Unfortunately, for many years the advisor could not find the right formula, circulating through strategies and managers, with little success.  MFIC initially invested heavily in second lien and junior capital investments and then went on to specializing in industries like shipping, alternative energy, and oil & gas.  As you might imagine, these initiatives did not go well.

Switch Up

Then, in 2013, APO acquired middle market senior lending platform Mid Cap Financial. This provided a platform for serving mid-sized borrowers - typically the bread and butter business of BDC activity.  In 2016, AINV also named the co-founder of Mid Cap - Howard Widra - as President (and later as CEO). The new manager's mandate has been to re-position the BDC's portfolio - by taking advantage of Mid Cap - into senior loans to middle-market private borrowers and dispose of those unsuccessful  "legacy" assets.

Sweet & Sour

In the six subsequent years, the MFIC team has successfully reshaped the portfolio into sponsor-backed first lien loans, originated almost completely by MidCap Financial. Just as intended - this "corporate loan portfolio" -  may yield substantially less than prior strategies, but has proven resilient from a credit standpoint, greatly reducing volatility in performance. Unfortunately, over this same time period, AINV has taken a great deal of time extracting itself from those "legacy assets" whose poor performance has weighed down book value and hampered earnings. Only in 2022  have these assets been dropped as a category, as their number and value have been whittled down to less than 5% of the total and still dropping.

Latest Problem

Unfortunately, just as the "legacy assets" are leaving, the BDC is facing another challenge inherited from an earlier period: its investment in aircraft leasing in the form of Merx Aviation.  Since 2012,  the BDC has been the vehicle chosen to finance and own this major commercial aircraft lessor. The airplanes themselves are financed by third-party securitizations, but the junior capital is provided by MFIN. The amounts involved are substantial, representing more than a tenth of the BDC's total assets.

Get Out

Merx was first battered by the impact of the pandemic on aviation and then by the loss of multiple aircraft in 2022 to Russian lessees after the U.S. imposed sanctions in the wake of the Ukraine conflict. Now, the BDC is negotiating with its insurers for the reimbursement of the loss. This setback seems to have compelled the Apollo organization to reconsider the aircraft leasing business. Since the spring of 2022, the BDC has formally committed itself to sell off the aircraft fleet, but it is unknown when the process will be complete.

However, when that does occur - and the "legacy assets" continue to slip away - MFIC's business model will be much simplified. Essentially, the BDC will be one of many pockets for tranches of senior secured loans booked by MidCap Financial, with a smattering of second lien and small equity stakes in these same businesses. Here is the most recent snapshot. Now assume that instead of 83% of the portfolio, this "corporate lending" becomes 95%-100% once Merx is removed.

The hard truth is that first-lien middle market lending does not generate a very high yield, as the table above makes clear. The BDC  has sought to boost its earnings since Mr. Widra took over by lowering compensation costs to the adviser (including agreeing to a total return calculation which cuts the incentive fee when net asset value drops). Nonetheless, the BDC remains in the middle of the pack where fee levels are concerned.  MFIC also targets a higher than the BDC average debt to equity of 1.6x (most BDCs of comparable size are targeting 1.0 - 1.25x).

Due to its checkered past,  MFIC is not yet able to borrow unsecured debt at rock-bottom yields and still relies on its one and only secured revolver for two-thirds of its debt financing.  We expect this will change over time as the Merx and "legacy assets" leave the scene, providing would-be lenders to the BDC with a highly granular and safer base of assets to lend against.

The good news - especially going into a recession - is that the senior loans in the corporate lending portfolio should hold up better than most. Certainly, since Mid Cap came on the scene there have been few credit missteps in this now dominant segment of AINV's portfolio. Furthermore, the loans are highly diversified by industry and by the number of companies involved so a credit mistake here or there won't upset the whole BDC apple cart. Moreover, when defaults do occur, sitting at the top of a balance sheet gives AINV/Mid Cap plenty of power to maximize debt recoupment through a sale of the business; restructuring or even liquidation.  

Long term, we are sanguine about the eventual turnaround of AINV, despite the many years already gone and the remaining challenges at Merx and in the last "legacy" assets. Ironically enough, we expect that credit losses at the BDC will be lower than the industry average in the next 5 years after years n the credit dog house.

PROJECTIONS

Over the next 5 years - from 2022 through 2026 inclusive - we expect AINV will maintain an unchanged annual distribution of $1.4400. However, the composition of the earnings will change as contributions from Merx and "legacy assets" shift to almost exclusively income from corporate loans. Maintaining the distribution during difficult times will be the "total return"