2023-11-21 23:41:24 ET
Summary
- Monroe Capital trades at a 26% discount to its net asset value, with persistent NAV headwinds affecting total returns.
- Investment income is declining as the BDC currently pays out 100% of NII.
- Credit underwriting is stable, but payment-in-kind income is rising, and the dividend could be reduced once the Fed starts cutting interest rates.
There are dozens of publicly traded business development companies offering investors compelling yields and Monroe Capital ( MRCC ) is no different. Whether or not to chase the yield is dependent on several factors including the net asset value, credit underwriting quality, and the outlook for investment income growth against broader considerations for the direction of the US economy over the next calendar year 2024 and beyond. I last covered MRCC in the summer stating that the quarterly distributions were safe but that continued NAV headwinds prevented the BDC from being a buy. Following the NAV is key to understanding why a BDC trades at a premium or discount with MRCC's fiscal 2023 third quarter NAV coming in at $207.6 million, around $9.58 per share.
BRCC currently trades for $ 7.08 per share, a 26% discount to NAV. This discount has been persistent year-to-date, putting MRCC at odds with a broader macro environment where a Fed funds rate at 5.25% to 5.50% has driven significant NAV gains for credit portfolios out-earning their dividends. BRCC's 8% NAV decline per share over the last year has not been driven by an expansion of its share count as the BDC has essentially kept this frozen at 21.7 million for the last 2 years and with growth of just 6% over the last half-decade. The core headwinds come from an extremely tight coverage ratio, loans on non-accrual status, and rising payment-in-kind income. The BDC last paid out a $0.25 per share quarterly dividend, sequentially unchanged and for a 14% annualized dividend yield.
Payment-In-Kind Income, Dividend Coverage, And Flagging Growth
MRCC recorded a total investment income of $15.64 million , down 1.8% over its year-ago comp and a miss by $540,000 on consensus estimates. Net investment income of $5.4 million, around $0.25 per share dipped by 4 cents per share from its year-ago comp. It means the BDC is currently paying out 100% of its dividend to common shareholders. The dip in NII came with no new investments being placed on non-accrual status during the quarter. MRCC currently has four investments valued at $6.2 million marked as non-accrual; Arcstor Midco, Forman Mills, Education Corporation of America, and NECB Collections. This was around 1.2% of the BDC's portfolio fair market value.
Payment-in-kind income is spiking and at $2.4 million for the third quarter accounted for 15.5% of total investment income. This was up from 7.8% in the year-ago comp. Rising PIK income infers the specter of a higher portion of loans being placed on non-accrual status in future quarters. Critically, MRCC recording a decline in investment income whilst operating in extremely optimal macroeconomic conditions for BDCs highlights why the discount to NAV has stayed so constant. The BDC's 99 company investment portfolio had a fair value of $518 million at the end of the third quarter, down from $541 million at the end of December 2022.
Critically, MRCC only made a $2 million investment in one new portfolio company during the third quarter. There was also $10.7 million of delayed draw fundings and add-ons to existing portfolio companies against $6.7 million in repayments. The BDC's growth is slowing down on the broad reduction of its credit portfolio, a deceleration that could become more acute once interest rates start to peel back in the second half of next year.
Credit Underwriting, Leverage, And 2024 Outlook
MRCC has placed 83.7% of its portfolio at a grade 2 risk rating, the second lowest on its risk scale. This describes investments exhibiting an acceptable level of risk that is similar to the risk at the time of origination with the issuer also generally performing as expected. Hence, around 16.2% of the portfolio companies with a rating of grade 3 to grade 5 have seen a deterioration versus origination. This was a sequential improvement from 17.6% in the second quarter.
It's hard to recommend the ticker as a buy on the back of negative investment income growth, NAV weakness, and a tight dividend coverage ratio. Credit underwriting looks stable but the BDC will be more exposed to the potential downward drift impact on yield once the Fed funds rate starts being cut. This will come as the BDC's debt-to-equity ratio is rising and at 1.6x at the end of the third quarter was amongst the highest debt ratios in the BDC space.
Future total returns are likely set to be negative as the long elusive dovish Fed pivot is realized. The Fed's 25 basis points hike in July is now likely to be the final of the current tightening cycle with 30-Day Fed Funds futures pricing in a 100% chance rates remain unchanged at the upcoming December and January Federal Open Market Committee meetings. In light of the more dovish macroeconomic environment and the extremely tight dividend coverage, MRCC is being rated as a sell.
For further details see:
Monroe Capital: Limit Your Exposure To This 14% Yield