2023-12-22 05:39:20 ET
Summary
- MidCap Financial Investment is a floating-rate business development company with exposure to declining returns in a lower-rate environment.
- The company's merger with other BDCs provides opportunities for growth and expense advantages.
- The stock is currently selling at a discount to net asset value and is not expected to appreciate significantly in a low-rate environment. Hold.
MidCap Financial Investment Corporation ( MFIC ) is a well-performing business development company with considerable exposure to floating-rate investments which can be expected to produce declining returns in a lower-rate environment.
Besides lower net investment income I see a narrower margin of dividend safety for MidCap Financial Investment moving forward. MidCap Financial Investment did, however, decide to engage in a merger transaction with other business development companies which I will touch on.
Taking into account the central bank's changing approach to interest rates that is set to create a new narrative in the market, I think MidCap Financial Investment as a 100% floating-rate BDC is only a Hold for passive income investors.
My Rating History
I pointed to MidCap Financial Investment's floating-rate exposure during the summer months as a major reason to buy the business development company's 11% covered dividend yield.
Though MidCap Financial Investment's dividend coverage still looks rather good, I don't think that the business development company will be able to produce major net investment income and dividend growth in 2024. A neutral stock classification, thus, seems much more appropriate.
My Key Issue With MidCap Financial Investment
MidCap Financial Investment is a 100% floating-rate business development company which has served the BDC well during the last phases of the rate-hiking cycle. With the central bank now set to depart from its interest rate policy, I think pure floating-rate BDC are becoming substantially less compelling for passive income investors to invest in.
MidCap Financial Investment's main business is corporate lending which includes $2.2 billion worth of investments. The corporate lending part of MidCap Financial Investment's business consists mainly of First Liens (95%) and Second Liens (3%) and 100% of debt investments are floating-rate.
In addition, the business development company has an investment in Merx Aviation which leases aircraft to customers. This business was valued at $195 million in the third quarter.
Dividend Margin Of Safety Set To Be Lower Moving Forward
My concern with MidCap Financial Investment primarily relates to the notion that the business development company is overly dependent on the central bank to produce net investment income growth. With 100% of the BDC's corporate lending investments allocated to floating-rate products, MidCap Financial Investment is not in a great spot now that the central bank is pushing for lower key interest rates.
However, this does not mean that the dividend right now is not well-covered, because it is: MidCap Financial Investment produced $0.43 per share in net investment income in the third quarter and had an 86% pay-out ratio. The pay-out ratio also has remained fairly steady in the last year, moving only between 84% and 88%.
With that being said though, a lower margin of dividend safety needs to be expected for those BDCs that made aggressive bets on the floating-rate loan market in recent years.
Why An Investment In MidCap Financial Investment Might Do Well After All: BDC Merger
MidCap Financial Investment signed merger agreements with Apollo Senior Floating Rate Fund Inc. and Apollo Tactical Income Fund Inc. BDCs are merged in order to create a larger business development company with access to more investment opportunities and that can eliminate duplicate corporate functions.
Post-merger, MidCap Financial Investment's portfolio will grow by $1.0 billion and the BDC will own $1.42 billion in net assets. The merger provides MidCap Financial Investment with the opportunity to grow its scale and its corporate lending percentage from 92% to 94%.
In addition to increased portfolio diversification, MidCap Financial Investment expects to garner expense advantages by cutting duplicate corporate functions as they pertain to running a business development company. MidCap Financial Investment pre-announced a $0.20 per share special cash dividend once the merger closes.
MidCap Financial Investment Might Be Set For A Larger Discount To Net Asset Value
Business development companies with large investment allocations to floating-rate loan products are at risk of seeing not only narrower margins of safety, but also higher discounts to net asset value moving forward.
Business development companies that have very high allocations (in percentage terms) to floating-rate loans are Goldman Sachs BDC ( GSBD ) , which is 100% floating-rate, Golub Capital BDC ( GBDC ) , which has a 100% floating-rate portfolio and Blue Owl Capital Corporation ( OBDC ) , which is 98% floating-rate. Presently, MidCap Financial Investment sells for an 10% discount to book value while other BDCs do slightly better (but not by a lot).
Moving into 2024, I think that MidCap Financial Investment, as the effect of lower key interest rates becomes visible, will start to sell at higher net asset value discounts.
Headwinds, Risks And Mistake Potential
MidCap Financial Investment's floating-rate positioning is clearly posing a challenge for the business development companies and other BDCs that also made the strategic decision to invest in floating-rate products.
From a net investment income and dividend margin perspective, I see headwinds in 2023, as just discussed. The merger between MidCap Financial Investment and the mentioned BDCs is expected to yield a special dividend payment of $0.20 per share for MFIC holders. Cost savings and other benefits associated with the merger might help MidCap Financial Investment compensate for slower NII growth in a low-rate environment.
My Conclusion
MidCap Financial Investment is a 100% floating-rate positioned business development company and thus at risk of producing weak net investment income growth in the next year.
The central bank has made clear that the rate-hiking cycle is heading for an end, therefore a major profit tailwind for business development companies will fall by the wayside and the margin of dividend safety, in my view, is set to thin as well.
MidCap Financial Investment's stock is selling at an 11% discount to net asset value and with the lack of a major profit catalyst in a low-rate environment, I also don't see the BDC's stock appreciate much at all. Hold.
For further details see:
MidCap Financial Investment: Avoid This 100% Floating-Rate BDC (Downgrade)