Monroe Capital: Risks Still Too Excessive to Sustain (NASDAQ:MRCC)

In December of last year, I wrote an article about Monroe Capital (Nasdaq: MRCC) I outline three specific reasons why, in my opinion, investors should avoid investing in a BDC.

These reasons were the following:

1. Low margin of safety in covering profits.
2. One of the highest leverage profiles in the BDC industry.
3. Clear signs of deteriorating portfolio quality.

At the time, in light of expectations of lower interest rates and increasing distress in the corporate sector, investing in BDC, which embodied an abnormal risk profile, did not seem reasonable.

However, since publishing my bearish article, MRCC has actually outperformed the BDC market.

The main driver behind this dynamic has been the positive systemic or empirical movement in the overall BDC space, where aspects such as consolidation of the long-term top scenario and lower levels of institutional distress have been strengthened. It provided a tailwind for almost all BDCs. In these “risky” market conditions, riskier, highly leveraged companies tend to outperform more defensive companies.

Another factor to take into account when evaluating MRCC’s performance and current appeal is its 2024 Q1 earnings results, which reveal some interesting data points.

Let’s now review the Q1 report in detail to determine if there are any significant changes in MRCC fundamentals that would now justify a more bullish stance on BDC.

Dissertation review

Overall, the first quarter of 2024 delivered suboptimal results, leaving open the question of the sustainability of MRCC’s dividend.

In the first quarter, MRCC reported a decrease in underlying net asset value of $0.10 per share, or approximately 1%, compared to the prior quarter. The 1.1% decline was mostly driven by the fact that MRCC distributed all of its adjusted net investment income as dividends and was forced to record an unrealized loss on some portfolio companies due to distressed credit performance.

The key metric, which measures MRCC’s ability to absorb dividends and leave some cash in BDC to cover incremental growth (or maintain a cash flow buffer) — adjusted net investment income — came in $0.01 lower per share than it was in Q4 2023. This decrease is due to a decrease in the average investment and the average size of assets invested during the period, along with the accumulation of non-accrual positions.

As we can see in the table below, MRCC’s dividend coverage has fallen to the 100% level, which means that there is no longer a margin of safety left.

Interestingly, despite the decline in cash flows, MRCC’s leverage has continued to rise. During the quarter, MRCC’s debt-to-equity ratio rose from 1.49x (which was already excessively high) to 1.6x. This now makes MRCC the fourth most leveraged BDC (with the sector average being 1.15x).

Speaking of leverage, it is also important to highlight that of the approximately $322 million in loans currently outstanding, $130 million is based on a fixed interest rate, where the funding level cost is much lower than the market level rate (i.e. The fixed rate is 4.75%). The maturity date for this fixed-rate financing is 2026, which, at the time of refinancing, will likely expand the interest cost component of MRCC (unless interest rates/SOFR fall below 2%).

On top of the deteriorating cash flow profile and increased leverage, MRCC was forced to place additional positions within non-accruals, representing approximately 1.1% of the total portfolio value. With this, MRCC’s total non-accrual position reached 2.1% of portfolio value, which is fairly in line with what is typically observed across the BDC landscape.

With that said, in our most recent earnings call, Mick Solmin — CFO, Chief Investment Officer and Company Secretary — still painted a positive picture about MRCC’s ability to cover dividends on a forward-looking basis:

When considering our current leverage levels, and our favorable percentage interest rate environment at a fixed rate, we believe that on a run rate basis, our adjusted net investment income will continue to cover our current quarterly dividend of $0.25 per share, all other things being equal.

Bottom line

In summary, after analyzing the Q1 2024 earnings report, it is clear that the recent rise in MRCC’s stock price was not driven by fundamentals as much as it was driven by a general beta factor that lifted the overall BDC market higher (i.e., reinforcing a higher-to-longer scenario and lower levels of distress for companies).

There are four factors identified at the core end, which together fully justify the decision to avoid investing in MRCC:

1. Adjusted net investment income is declining.
2. The leverage profile has gone from bad to worse.
3. The dynamics on the non-entitlement front are not encouraging.
4. There is no margin of safety for MRCC’s ability to cover dividends in a sustainable manner.

Finally, in the context of the built-in margin of safety (or rather the lack of it), we also have to keep in mind that the presence of unnatural leverage imposes an additional layer of risk in terms of amplifying any simple struggle (or cash flow). decrease) in core business operations.

So, the combination of excessive leverage, lack of a safety buffer, and negative portfolio dynamics, in my opinion, makes Monroe Capital a suboptimal investment choice.