MCG Capital returning to its roots

March 11, 2012

MCG Capital, an Arlington-based business development company, announced a strategy to reduce its risk profile and return to its roots as a lender to mid-size businesses.

A series of large equity investments at the height of the market crippled MCG in the wake of the downturn, a blow from which the company is still trying to recover. Troubles at the firm mounted as a shareholder fought to gain control of the board, employees were laid off and the chief executive resigned.

As a part of its turnaround efforts, MCG plans to cut up to 12 of its 37 employees by the close of the year. It initially slashed the staff by 42 percent last August. The company anticipates the latest reduction will generate a savings of $3 million to $4 million in 2013.

MCG also plans to sell $75 million of its equity positions this year. The company made its first move in February with the $25 million exit from software provider Jenzabar, resulting in an internal rate of return in excess of 20 percent over its eight-year investment period. That deal, however, was $11.7 million below the fair value of the investment.

Significant reductions in the value of MCG’s largest investments battered its balance sheet in the last quarter. Communications company Broadview Network Holdings and plastic manufacturer Jet Plastica together accounted for $40.2 million of the $56.4 million net investment loss reported for the fourth quarter.

All told in 2011, MCG’s net loss widened to $93.1 million, or $1.22 a share, from a net loss of $13.1 million, or 17 cents a share, in 2010.

“We began the [review] process with the fundamental goal of simplifying our operation,” said MCG chief executive Richard W. Neu, during a conference call with analysts. The aim is to “maximize our strengths as a strong middle-market debt lender, while ... reducing the risk profile of MCG from both a credit and leverage standpoint.”

At the core of its operations, MCG lends to companies with $20 million to $100 million in revenue, and $3 million to $15 million in earnings before taxes.

The firm currently owns a number of loans in excess of $25 million, but as those assets are repaid it will “originate a more granular book of business with no hold position greater than $15 million,” said Hagan Saville, the firm’s president and chief operating officer, during the call.

A cool reception

Analysts have given a cool reception to MCG’s turn around strategy. BB&T Capital Markets, for one, downgraded the company from buy to hold 16 months after an upgrade.

“While we feel the company is currently on the right path given its restructuring efforts, uncertainties surrounding the successful execution and timing of its plan, portfolio performance and balance sheet de-leveraging have sapped our conviction,” wrote BB&T analyst Vernon Plack in a research note.

Shareholders are equally uneasy about the MCG’s future.

“It’s going to be very hard for them to recover their lost reputation given the disastrous performance,” said Arthur Lipson, managing director of hedge fund Western Investment, which holds 54,000 shares of MCG, down from 1.6 million in 2010.

Western and MCG locked horns in April 2010 as the hedge fund sought unsuccessfully to elect a new slate to the MCG board. The objective was to replace the management, which Lipson said “enriched themselves unjustly through stock grants, despite the huge loss shareholders had taken.”

Officials from MCG declined to comment for this article.

In its heyday, MCG, founded in 1990, soared alongside a flock of area financiers such as American Capital and Allied Capital. These firms were renown “mezzanine” lenders to midsize companies — an arrangement that could yield enough interest to pay dividends in the high single digits.

But during the heady days of 2005 to 2007, they began taking large stakes in the companies for higher returns. In MCG’s case, more than 30 percent of its portfolio was comprised of equity investments at the height of the market, said analyst Greg Mason of Stifel Nicolaus.

When private equity values took a nose dive in 2009, MCG’s equity investments, much like that of Allied Capital, sunk its balance sheet. Allied Capital was sold in 2010.

“You have volatility that can occur in the business development company model because you have to mark to market assets. You don’t want to put equity, which is very volatile in nature, inside that vehicle,” Mason said.

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