Description
MCG Capital Corporation. CEO RICHARD W NEU bought 72,577 shares on 8-28-2012 at $ 4.54
BUSINESS OVERVIEW
General
We are a solutions-focused commercial finance company that provides capital and advisory services to middle-market companies throughout the United States. Our investment objective is to achieve current income and capital gains.
We are an internally managed, non-diversified, closed-end investment company that has elected to be regulated as a business development company, or BDC, under the Investment Company Act of 1940, as amended , or the 1940 Act. As a BDC, we are required to meet various regulatory tests, which include investing at least 70% of our total assets in private or thinly traded public U.S.-based companies and meeting a 200% asset coverage ratio of total net assets to total senior securities.
For federal income tax purposes, we have elected to be treated as a regulated investment company, or RIC, under Subchapter M of the Internal Revenue Code. In order to continue to qualify as a RIC for federal income tax purposes and obtain favorable RIC tax treatment, we must meet certain requirements, including certain minimum distribution requirements.
Corporate Structure
We conduct some of our activities through wholly owned, special-purpose financing subsidiaries. These subsidiaries are bankruptcy remote, special-purpose entities to which we transfer certain loans. Each financing subsidiary, in turn, transfers the loans to a Delaware statutory trust. For accounting purposes, the transfers of the loans to the Delaware statutory trusts are structured as on-balance sheet securitizations. We also use wholly owned subsidiaries, all of which are structured as Delaware corporations and limited liability companies, to hold the assets of one or more of our portfolio companies. Some of these subsidiaries have wholly owned subsidiaries, all of which are Delaware corporations that hold the assets of certain of our portfolio companies.
We also make investments in qualifying small businesses through Solutions Capital I, L.P., or Solutions Capital, our wholly owned subsidiary licensed by the United States Small Business Administration, or the SBA, to operate as a small business investment company, or SBIC, under the Small Business Investment Act of 1958 , as amended, or the SBIC Act. As a SBIC, Solutions Capital is subject to a variety of regulations concerning, among other things, the size and nature of the companies in which it may invest and the structure of those investments.
Company Background
We were incorporated in Delaware in 1998. On March 18, 1998, we changed our name from MCG, Inc. to MCG Credit Corporation and, on June 14, 2001, we changed our name from MCG Credit Corporation to MCG Capital Corporation. Our principal executive offices are located at 1100 Wilson Boulevard, Suite 3000, Arlington, VA 22209 and our telephone number is (703) 247-7500 .
In this Annual Report on Form 10-K, the terms “Company,” “MCG,” “we,” “us” and “our” refer to MCG Capital Corporation and its wholly owned subsidiaries (including its affiliated securitization trusts) unless the context otherwise requires.
We are subject to the informational requirements of the Securities Exchange Act of 1934 , as amended, or the Exchange Act, and, accordingly, file reports, proxy statements and other information with the Securities Exchange Commission, or the SEC. Such reports, proxy statements and other information can be read and copied at the public reference facilities maintained by the SEC at the Public Reference Room, 100 F Street, N.E., Washington, D.C. 20549. Information regarding the operation of the Public Reference Room may be obtained by calling the SEC at 1-800-SEC-0330 . The SEC maintains a web site ( www.sec.gov ) that contains reports, proxy and information statements and other information regarding issuers that file electronically with the SEC.
Our Internet address is www.mcgcapital.com . We are not including the information contained on our website as a part of, or incorporating it by reference into, this Annual Report on Form 10-K. We make available free of charge on our website our Annual Reports on Form 10-K, Quarterly Reports on Form 10-Q, Current Reports on Form 8-K and amendments to those reports filed or furnished pursuant to Section 13(a) or 15(d) of the Exchange Act, as soon as reasonably practicable after we electronically file such material with, or furnish it to, the SEC.
Our logo, trademarks and service marks are the property of MCG. Other trademarks or service marks appearing in this Annual Report on Form 10-K are the property of their respective holders.
Significant Developments in 2011
In 2011, we continued to execute on our previously stated strategic plan to, among other initiatives, convert lower-yielding equity investments and unencumbered cash into yield-oriented new investment opportunities. We successfully monetized equity investments in 15 control and other equity positions generating cash proceeds of $64.3 million. Our liquidity position, together with the generation of distributable net operating income, or DNOI, of $0.53 per share, enabled our board or directors to declare dividend distributions of $0.66 per share in 2011.
Notwithstanding the success of our 2011 monetization efforts and the solid performance of the majority of our investment portfolio, continued valuation adjustments to our largest control investment, Broadview Networks Holdings, Inc., or Broadview, and valuation adjustments to certain other legacy investments resulted in a reported loss of $93.1 million for 2011. These losses, together with our limited access to debt and equity markets, have currently restricted our origination liquidity sources to our existing SBIC facility and unencumbered cash.
On October 31, 2011, Richard W. Neu, Chairman of our board of directors, was elected as chief executive officer, succeeding Steven F. Tunney, Sr. who resigned in order to pursue other interests. Additionally, B. Hagen Saville, previously our Executive Vice President of Business Development and a member of our board of directors, was appointed President and Chief Operating Officer.
Outlook
Under the direction of Messrs. Neu and Saville, MCG took a fresh look at how to prudently and expeditiously return the Company to its roots as a strong middle market debt lender. As part of that undertaking, every aspect of the Company was examined under the assumption that our legacy equity positions wind down over the course of 2012 and with the fundamental goal of simplifying operations.
This transition is consistent with the desire to create a company with less credit and leverage risk yet one that has a sustainable and predictable level of NOI and dividend generation. The transition also addresses the potential impact of an expected reduction, over the next several years, of the size of our investment portfolio as our existing secondary market funding facilities contractually wind down.
We are substantially complete with our process review. Relative to our fourth quarter annualized general and administrative costs, excluding costs related to the resignation of Mr. Tunney, we have identified non-compensation cost reduction opportunities of approximately $4.5 million to $5.5 million per annum which, when fully implemented, we believe will target a non-compensation cost structure of approximately $5.5 million to $6.5 million. We expect these cost reductions to be embedded in our non-compensation general and administrative costs by no later than the end of the first quarter of 2013, which is when the lease on our current headquarters facility expires.
In addition to our process review, and taking into consideration the anticipated wind down of our legacy equity positions and current secondary market funding facilities, we undertook a comprehensive review of our current work force and structure. This review encompassed a benchmark review against internally managed peers together with a skill assessment of our current personnel. It was undertaken with the intended fundamental principle of allowing no degradation to the Company’s existing risk management profile.
As a result of this review, we would anticipate our current work force of 37 employees will transition to a level of 20 to 25 by year end 2012. This reduction in force is intended to generate a targeted future base compensation and benefits level of approximately $4.0 million to $5.0 million beginning in 2013.
As we enter 2013 and begin to realize the expected benefits of the initiatives discussed above, we are forecasting NOI of approximately $0.50 per share to $0.60 per share. In effect, the anticipated cost savings of approximately $8.5 million to $10.5 million, together with the earnings benefits from projected monetizations and proposed conversions of legacy equity investments to debt instruments, are intended to provide a substantial offset to the earnings reduction attributable to the significant deleveraging of our balance sheet.
In arriving at this forecast, a number of assumptions are required which, if incorrect, could materially change the results of our forecast, including potential monetizations and proposed conversions. However, we have assumed no incremental debt or equity issuances as we clearly recognize that the primary path to future debt and equity support from investors, at economic levels, is through the stabilization of our investment portfolio.
With respect to 2012, we are anticipating to incur non-recurring costs of approximately $0.10 per share to $0.15 per share, primarily associated with expected severance costs, the previously announced amendment of our SunTrust Warehouse facility, the early retirement of our private placement notes and other transitional costs. Excluding these costs, we are forecasting NOI of approximately $0.40 per share to $0.50 per share.
Recognizing the one time nature of the 2012 transitory costs, our strong liquidity position, and the importance of dividends to our investor base, we have committed to a dividend declaration level of $0.14 per share for the next two quarters. Accordingly, we will pay a $0.17 per share dividend in May 2012 followed by a $0.14 per share dividend in both July and October 2012. Such payments are expected to include a return of capital.
Lastly, as previously announced on January 17, 2012, we are authorized to repurchase shares of our common stock, up to $35 million, in open market transactions, including through block purchases, depending on prevailing market conditions and other factors. As of March 1, 2012, no shares have been repurchased.
MCG’s Investment Portfolio
Our investment portfolio is composed primarily of middle-market companies in which we have made up to $75 million of debt and equity investments. Typically, these middle-market companies have $20 million to $200 million in annual revenue and $3 million to $25 million in earnings before interest, taxes, depreciation and amortization, or EBITDA. Generally, our portfolio companies use our capital investments to finance acquisitions, recapitalizations and buyouts, as well as for organic growth and working capital. We identify and source new portfolio companies through multiple channels, including private equity sponsors, investment bankers, brokers, fund-less sponsors, institutional syndication partners, owner operators, and other club lenders (“club lenders” are organizations that facilitate peer-to-peer loans). We generally invest in some combination of senior debt, second lien debt, secured and unsecured subordinated debt and equity.
Competition
Our primary competitors in providing financing to middle-market companies include public and private funds, commercial and investment banks, commercial financing companies, and, to the extent they provide an alternative form of financing, private equity funds. Additionally, because competition for investment opportunities generally has increased among alternative investment vehicles, such as hedge funds, those entities have begun to invest in areas they have not traditionally invested, including investments in middle-market companies. Some of our existing and potential competitors are substantially larger and have considerably greater financial, technical and marketing resources than we do. For example, some competitors may have a lower cost of funds and access to funding sources that are not available to us. In addition, some of our competitors may have higher risk tolerances or different risk assessments, which could allow them to consider a wider variety of investments and establish more relationships and build their market shares.
We do not seek to compete primarily based on the interest rates we offer, and we believe that some of our competitors make loans with interest rates that are comparable to, or lower than, the rates we offer. We generally compete by using our knowledge of our portfolio companies’ business needs, derived from the research, analyses, and interaction by our professional staff with our portfolio companies, to offer the appropriate product-mix coupled with a range of corporate finance services and information that enhances our portfolio companies’ business prospects.
Life Cycle of Debt and Equity Originations
The key aspects of our portfolio origination, servicing and monitoring process are set forth below.
I NVESTMENT O BJECTIVE AND S TRATEGIES
Our investment objective is to achieve current income and capital gains. The primary goal of our investment process is to increase our earnings and net asset value, or NAV, by investing in debt and equity securities of middle-market companies. We earn interest, dividends and fees on our investments, and we may report unrealized appreciation and depreciation as the fair value of our investments increases or decreases. We realize capital gains or losses when the investment is eventually monetized.
I NVESTMENT F UNDING
We fund our investments using cash that we receive in exchange for a combination of debt and equity instruments that we issue from time to time. Throughout 2011, our debt obligations included secured obligations that included provisions that restricted the types of investments that could be used as collateral in the facility. In 2011, our debt obligations also included unsecured obligations that we subsequently repaid in full in January 2012. See the Liquidity and Capital Resources—Borrowings section of our Management’s Discussion and Analysis of Financial Condition and Results of Operations for additional information about these secured and unsecured debt obligations . As a BDC, we are not permitted to incur indebtedness unless immediately after such borrowing we meet a coverage ratio of total assets to total senior securities, which include all of our borrowings (excluding borrowings made by our SBIC) and any preferred stock we may issue in the future, of at least 200%.
I NVESTMENT M ONITORING AND R ESTRUCTURING
We monitor the status and financial performance of each company in our portfolio in order to evaluate overall portfolio quality. We are proactive with companies that are underperforming and, in many instances, have added better covenant protection and rights over time.
When our attempts to collect past due principal and/or interest on a loan are unsuccessful, we will perform an analysis to determine the appropriate course of action. In some cases, we may consider restructuring the investment to better reflect the current financial performance of the portfolio company. Such a restructuring may, among other things, involve deferring principal and interest payments, adjusting interest rates or warrant positions, imposing additional fees, amending financial or operating covenants or converting debt to equity. In connection with a restructuring, we generally receive compensation from the portfolio company for any increased risk. During the process of monitoring a loan in default, we will send a notice of non-compliance outlining the specific defaults that have occurred and preserving our contractual remedies, and initiate a review of the collateral, if any. When a restructuring is not the most appropriate course of action, we generally pursue remedies available to us that minimize potential losses, including initiating foreclosure and/or liquidation proceedings.
When one of our loans becomes more than 90 days past due, or if we otherwise do not expect the portfolio company to be able to service its debt and other obligations, we will, as a general matter, place the loan on non-accrual status and generally will cease recognizing interest income on that loan until all principal and interest has been brought current through payment or due to a restructuring such that the interest income is deemed to be collectible. However, we may make exceptions to this policy if the loan has sufficient collateral value and is in the process of collection. If the fair value of a loan is below cost, we may cease recognizing paid-in-kind interest and/or the accretion of a discount on the debt investment until such time that the fair value equals or exceeds cost.
Investment Adviser
We have no investment adviser and are internally managed by our executive officers under the supervision of the board of directors. Our investment decisions are made by our officers, directors and senior investment professionals who serve on our credit and investment and valuation committees. None of our executive officers or other employees has the unilateral authority to approve any investment.
Regulation
I NVESTMENT C OMPANY A CT OF 1940
As a BDC, we are regulated under the 1940 Act. The BDC structure provides stockholders the ability to retain the liquidity of a publicly traded stock, while sharing in the possible benefits, if any, of investing in primarily privately owned companies.
In part, the 1940 Act requires us to be organized in the United States for the purpose of investing in, or lending to, primarily private companies and making managerial assistance available to them. As a BDC we may use capital provided by public stockholders and from other sources to invest in long-term, private investments in businesses.
Significant Managerial Assistance
In order to count portfolio securities as qualifying assets for the purpose of the 70% test discussed above, we must either control the issuer of the securities or must offer to make available significant managerial assistance; except that, where we purchase such securities in conjunction with one or more other persons acting together, one of the other persons in the group may make available such managerial assistance. Making available significant managerial assistance means, among other things, any arrangement in which we offer to provide and, if accepted, provide significant guidance and counsel concerning the management, operations or business objectives and policies of a portfolio company through monitoring of portfolio company operations, selective participation in board and management meetings, consulting with and advising a portfolio company’s officers or other organizational or financial guidance.
Warrants and Options
Under the 1940 Act, we are subject to restrictions on the amount of warrants, options, restricted stock or rights to purchase shares of capital stock that we may have outstanding at any time. In particular, the amount of capital stock that would result from the conversion or exercise of all outstanding warrants, options or rights to purchase capital stock cannot exceed 25% of our total outstanding shares of capital stock. This amount is reduced to 20% of our total outstanding shares of capital stock if the amount of warrants, options or rights issued pursuant to an executive compensation plan would exceed 15% of our total outstanding shares of capital stock. We have received exemptive relief from the SEC permitting us to issue restricted stock to our employees and directors subject to the above conditions, among others.
Indebtedness and Senior Securities
We will be permitted, under specified conditions, to issue multiple classes of indebtedness and one class of stock senior to our common stock if our asset coverage, as defined in the 1940 Act, is at least equal to 200% immediately after each such issuance. In addition, we may not be permitted to declare any cash dividend or other distribution on our outstanding common shares, or purchase any such shares, unless, at the time of such declaration or purchase, we have asset coverage of at least 200% after deducting the amount of such dividend, distribution, or purchase price. We may also borrow amounts up to 5% of the value of our total assets for temporary or emergency purposes.
Capital Structure
As a BDC, we generally cannot issue and sell our common stock at a price below the current NAV per share. We may, however, sell our common stock, or warrants, options or rights to acquire our common stock, at a price below the current NAV of our common stock in a rights offering to our stockholders if: 1) our board of directors determines that such sale is in the best interests of the Company and our stockholders; 2) our stockholders approve the sale of our common stock at a price that is less than the current NAV; and 3) the price at which our common stock is to be issued and sold may not be less than a price which, in the determination of our board of directors, closely approximates the market value of such securities (less any sales load).
We may also be prohibited under the 1940 Act from participating in certain transactions with our affiliates without the prior approval of our directors who are not interested persons and, in some cases, prior approval by the SEC.
We do not intend to acquire securities issued by any investment company that exceed the limits imposed by the 1940 Act. Under these limits, we generally cannot acquire more than 3% of the voting stock of any registered investment company (as defined in the 1940 Act), invest more than 5% of the value of our total assets in the securities of one such investment company or invest more than 10% of the value of our total assets in the securities of such investment companies in the aggregate.
CEO BACKGROUND
A. Hugh Ewing, III(1)(2)(3)(4)
68 2007
From January 1992 to May 2009, Mr. Ewing served as President and Managing Director, and continues to serve as a Managing Director, of Ewing Bemiss & Co., an independent investment bank providing investment banking services to middle market companies across the United States based in Richmond, Virginia. Prior to founding Ewing Bemiss & Co. in 1992, he was a partner in Galleher & Company where he was active in private placements, leveraged buyouts, and mergers and acquisitions, and as a principal in leveraged buyouts and venture capital. Prior to that, he was vice president, corporate finance of Wheat, First Securities, Inc., where he headed the mergers and acquisitions group. Mr. Ewing was also a general partner of Hillcrest Group, which managed venture capital funds, and is a past chairman of the National Association of Small Business Investment Companies. Mr. Ewing received his M.B.A. from the University of Virginia, Darden School of Business and his B.S. in civil engineering from the Virginia Military Institute.
Mr. Ewing possesses a vast amount of knowledge regarding the financial services industry acquired through his 40 years of experience with several banking organizations. He has gained valuable insight by overseeing many aspects of the banking field, including his work in mergers and acquisitions, leveraged buyouts, financial modeling and valuations. He also brings significant middle market company experience to his position, having worked extensively in venture capital financing and private placements and through his involvement with the Small Business Investment Company (SBIC) industry.
Kenneth J. O’Keefe(2)(3)
57 2001
Mr. O’Keefe served as the Chairman of our board from February 2005 to March 2007. He is currently a Managing Director and the Chief Operating Officer of Vestar Capital Partners, a private equity firm. From July 2003 until June 2006, he was Chief Executive Officer of NewVen Partners, LLC, a private investment firm, which he founded. Prior to July 2003, Mr. O’Keefe held executive positions with several large media companies over an 18-year career, including Pyramid Communications, Inc., where he served as Executive Vice President, Chief Financial Officer and a board member, Evergreen Media Corporation as Executive Vice President of Operations and a board member, Chancellor Media Corporation as Executive Vice President of Operations, AMFM, Inc. as Chief Executive Officer, President and Chief Operating Officer, and Clear Channel Communications, Inc. as President and Chief Operating Officer of its radio division. Mr. O’Keefe is a graduate of Brown University and currently serves as a Trustee Emeriti of the Corporation of Brown University.
Mr. O’Keefe brings to the board his finance and investment experience as well as business development skills acquired through his work managing private equity investments. Mr. O’Keefe’s extensive background as an executive officer and board member of several large media issuers demonstrates his leadership capability and business acumen. This expertise enables Mr. O’Keefe to provide useful insights to management in connection with all of our portfolio companies, and especially with regard to our media and communications investments. With his knowledge of the complex issues facing companies today and his understanding of what makes businesses work effectively and efficiently, Mr. O’Keefe provides a unique perspective to our board. Mr. O’Keefe’s background has enabled him to cultivate an enhanced understanding of operations and strategy with an added layer of risk management experience that is an important aspect of the composition of our board of directors.
Gavin Saitowitz(1)(2)(3)(4)
39 2009
Mr. Saitowitz is a Managing Member of Springbok Capital Management, LLC, a New York-based investment management firm. Prior to co-founding Springbok Capital, from 2002 through 2004 Mr. Saitowitz served as an Investment Analyst at Highfields Capital Management LP, a Boston-based investment firm specializing in long-term capital appreciation. From 1998 to 2000, Mr. Saitowitz was an Analyst at Kohlberg Kravis Roberts & Co., a private equity firm. From 1996 to 1998, Mr. Saitowitz was an Analyst in the Investment Banking Division of Goldman, Sachs & Co. From 1994 to 1996, Mr. Saitowitz was a valuation consultant for Arthur Andersen LLP. Mr. Saitowitz received a B.S. from the University of Colorado, Boulder and an M.B.A. from Harvard Business School.
Mr. Saitowitz has substantial experience analyzing and evaluating companies through his work as a valuation consultant, investment banker, private equity investor and hedge fund manager. Through his research knowledge and experience supervising the investment management process, including asset management, improving operations, the rollout of new products and the advancement of technology, Mr. Saitowitz brings valuable financial, operational and strategic expertise to our board. The breadth of his background and experience enables Mr. Saitowitz to provide unique insight into our strategic process and into the management of our investment portfolio.
Richard W. Neu(4) 56 2007
Mr. Neu became our Chief Executive Officer in October 2011 and has served as the Chairman of our board since April 2009. Mr. Neu currently serves on the board of directors and audit committee of Huntington Bancshares Incorporated and is the lead director and serves on the audit committee and governance committee of Dollar Thrifty Automotive Group, Inc., having served as the chairman of the Dollar Thrifty board of directors from 2010 through 2011. Mr. Neu was the Chief Financial Officer and Treasurer of Charter One Financial, Inc. from December 1985 to August 2004, and was a director of Charter One Financial, Inc. from 1992 to August 2004. Mr. Neu previously worked for KPMG as a Senior Audit Manager. Mr. Neu received a B.B.A. from Eastern Michigan University with a major in accounting. Mr. Neu’s term as a Class III director will expire in 2013.
Mr. Neu’s public company board experience along with his proven success as an executive officer of a large public company demonstrates his leadership capability and extensive knowledge of complex financial and operational issues that public companies face. Mr. Neu brings years of experience in public accounting with KPMG and as a chief financial officer of two publicly held financial institutions that is critical to our board of directors. Mr. Neu’s knowledge of accounting principles, financial reporting rules and regulations, the evaluation of financial results and the oversight of the financial reporting process of large public companies from the perspective of an independent auditor, a board member and an audit committee member of other public companies makes him an ideal chairman and asset to our board of directors.
B. Hagen Saville(4) 50 2006
Mr. Saville has served as our President and Chief Operating Officer since October 2011. From March 1998 until October 2011, he served as Executive Vice President of Business Development. From 1997 to March 1998, Mr. Saville was employed at First Union National Bank, which acquired Signet Bank in 1997. From 1994 to 1997, Mr. Saville was employed at Signet Bank where he served as vice president. Mr. Saville received a B.A. from Washington College, an M.B.A. from The College of William and Mary and an M.S. from New York University. Mr. Saville’s term as a Class I director will expire in 2014.
Through his 17-plus years of experience at our Company and its predecessor, as a member of Signet Bank and First Union National Bank and through his background in commercial and investment banking, Mr. Saville has developed a deep knowledge and understanding of the financial services industry, the restructuring of troubled investments, public and private capital raising, asset management activities for debt and equity investments, the valuation of private debt and equity investments, various industry sectors, MCG, our business and the companies in which we invest. Through this time, Mr. Saville has demonstrated his leadership abilities and his commitment to our Company. The board also believes that Mr. Saville’s integrity, values and good judgment make him well suited to serve on our board.
Kim D. Kelly(1)(2)(3)(4) 55 2004
Since June 2005, Ms. Kelly has served as a consultant, primarily to private equity firms, in the media and restructuring fields. Most recently, beginning in August 2011, Ms. Kelly has served as Chief Restructuring Officer for Allegiance Communications LLC and, from December 2008 to July 2010, Ms. Kelly served as Chief Restructuring Officer for Equity Media Holdings Corporation, a former NASDAQ issuer. Previously, Ms. Kelly held executive positions with a number of large media companies. From May 2004 until April 2005, Ms. Kelly served as the President and Chief Executive Officer, and from April 2004 until April 2006 as a director, of Arroyo Video Solutions, Inc., a software company serving video service providers. From 1990 to August 2003, Ms. Kelly was employed by Insight Communications Company, Inc., where she was President from January 2002 to August 2003, Chief Operating Officer from January 1998 to August 2003 and Executive Vice President and Chief Financial Officer from 1990 to January 2002. Ms. Kelly also served as a director at Insight Communications from July 1999 to August 2003. From July 1999 to 2003, she also served as Chief Executive Officer of Insight Midwest, L.P. Ms. Kelly currently serves as a trustee of BNY Mellon Funds Trust. Ms. Kelly is a graduate of George Washington University. Ms. Kelly’s term as a Class III director will expire in 2013.
Ms. Kelly, the chair of our audit and nominating and corporate governance committees, has vast experience in the financial and operational restructuring of complex businesses, and her skills gained through service as a chief executive officer, chief financial officer, chief operating officer and chief restructuring officer of various public and private companies is essential to our board of directors. Her experience on the board of directors of other public companies and her insight on financial and operational issues are particularly valuable to our board of directors during this period of challenging economic conditions.
Wallace B. Millner, III(3)(4) 72 1998
Mr. Millner served as the Chairman of our board from November 2002 to February 2005 and from 1998 through May 2001. From 1973 until his retirement in 1997, Mr. Millner served in various executive positions at Signet Banking Corporation, a bank holding company, including Vice Chairman and Chief Financial Officer, where he was responsible for the capital markets function. Mr. Millner received an M.B.A. from the University of North Carolina and a B.A. from Davidson College. Mr. Millner’s term as a Class I director will expire in 2014.
Mr. Millner is an experienced financial leader with the skills necessary to lead our investment and valuation committee. His service as Vice Chairman and Chief Financial Officer of Signet Banking Corporation and as a former director of another business development company make him a valuable asset on our board of directors. Mr. Millner’s positions have provided him with a wealth of knowledge in dealing with financial and accounting matters. The depth and breadth of his exposure to complex financial issues makes him a skilled advisor to MCG.
MANAGEMENT DISCUSSION FROM LATEST 10K
Description of Business
We are a solutions-focused commercial finance company providing capital and advisory services to middle-market companies throughout the United States. For our core portfolio, we make debt and equity investments primarily in companies with annual revenue of $20 million to $200 million and earnings before interest, taxes, depreciation and amortization, or EBITDA, of $3 million to $25 million, which we refer to as “middle-market” companies. Generally, our portfolio companies use our capital investment to finance acquisitions, recapitalizations, buyouts, organic growth and working capital. We identify and source new portfolio companies through multiple channels, including private equity sponsors, investment bankers, brokers, fund-less sponsors, institutional syndication partners, other club lenders and owner operators.
Currently, we use borrowings under Solutions Capital, our wholly owned subsidiary, licensed as a small business investment company, or SBIC, under the Small Business Investment Act of 1958 , as amended, or SBIC Act, to fund unitranche, second-lien and subordinated debt investments. Historically, we have funded senior and subordinated debt to middle-market companies and purchased rated syndicated private debt in larger companies through our on-balance sheet securitization trust—Commercial Loan Trust 2006-1. This securitized trust included a five-year reinvestment period, during which the trust was permitted to use principal collections received from repayments of the underlying collateral to purchase new collateral from us. The reinvestment period ended on July 20, 2011 and all future principal collections received will be used to repay the securitized debt.
We are an internally managed, non-diversified, closed-end investment company that has elected to be regulated as a business development company, or BDC, under the Investment Company Act of 1940, as amended , or the 1940 Act. As a BDC we must meet various regulatory tests, which include investing at least 70% of our total assets in private or thinly traded public U.S.-based companies and meeting a 200% asset coverage ratio of total net assets to total senior securities excluding SBIC debt. In addition, we have elected to be treated for federal income tax purposes as a regulated investment company, or RIC, under Subchapter M of the Internal Revenue Code. In order to continue to qualify as a RIC for federal income tax purposes and obtain favorable RIC tax treatment, we must meet certain requirements, including certain minimum distribution requirements. If we satisfy these requirements, we generally will not have to pay corporate-level taxes on any income we distribute to our stockholders as distributions, allowing us to substantially reduce or eliminate our corporate-level tax liability. From time to time, our wholly owned subsidiaries may execute transactions that trigger corporate-level tax liabilities. In such cases, we recognize a tax provision in the period when it becomes more likely than not that the taxable event will occur.
Recent Developments
S IGNIFICANT D EVELOPMENTS IN 2011
In 2011, we continued to execute on our previously stated strategic plan to, among other initiatives, convert lower-yielding equity investments and unencumbered cash into yield-oriented new investment opportunities. We successfully monetized equity investments in 15 control and other equity positions generating cash proceeds of $64.3 million. Our liquidity position, together with the generation of DNOI of $0.53 per share, enabled the board to declare dividend distributions of $0.66 per share in 2011.
Notwithstanding the success of our 2011 monetization efforts and the solid performance of the majority of our investment portfolio, continued valuation adjustments to our largest control investment, Broadview, and valuation adjustments to certain other legacy investments resulted in a reported loss of $93.1 million for 2011. These losses, together with our limited access to debt and equity markets, have currently restricted our origination liquidity sources to our existing SBIC facility and unencumbered cash.
On October 31, 2011, Richard W. Neu, Chairman of our board of directors was elected as chief executive officer, succeeding Steven F. Tunney, Sr. who resigned in order to pursue other interests. Additionally, B. Hagen Saville, previously the Company’s Executive Vice President of Business Development and a member of our board of directors, was appointed President and Chief Operating Officer.
O UTLOOK
Under the direction of Messrs. Neu and Saville, MCG took a fresh look at how to prudently and expeditiously return the Company to its roots as a strong middle market debt lender. As part of that undertaking, every aspect of the Company was examined under the assumption that our legacy equity positions wind down over the course of 2012 and with the fundamental goal of simplifying operations.
This transition is consistent with the desire to create a company with less credit and leverage risk yet one that has a sustainable and predictable level of NOI and dividend generation. The transition also addresses the potential impact of an expected reduction, over the next several years, of the size of our investment portfolio as our existing secondary market funding facilities contractually wind down.
We are substantially complete with our process review. Relative to our fourth quarter annualized general and administrative costs, excluding costs related to the resignation of Mr. Tunney, we have identified non- compensation cost reduction opportunities of approximately $4.5 million to $5.5 million per annum which, when fully implemented, we believe will target a non-compensation cost structure of approximately $5.5 million to $6.5 million. We expect these cost reductions to be embedded in our non-compensation general and administrative costs by no later than the end of the first quarter of 2013, which is when the lease on our current headquarters facility expires.
In addition to our process review, and taking into consideration the anticipated wind down of our legacy equity positions and current secondary market funding facilities, we undertook a comprehensive review of our current work force and structure. This review encompassed a benchmark review against internally managed peers together with a skill assessment of our current personnel. It was undertaken with the intended fundamental principle of allowing no degradation to the Company’s existing risk management profile.
As a result of this review, we would anticipate our current work force of 37 employees will transition to a level of 20 to 25 by year end 2012. This reduction in force is intended to generate a targeted future base compensation and benefits level of approximately $4.0 million to $5.0 million beginning in 2013.
As we enter 2013 and begin to realize the expected benefits of the initiatives discussed above, we are forecasting NOI of approximately $0.50 per share to $0.60 per share. In effect, the anticipated cost savings of approximately $8.5 million to $10.5 million, together with the earnings benefits from projected monetizations and proposed conversions of legacy equity investments to debt instruments, are intended to provide a substantial offset to the earnings reduction attributable to the significant deleveraging of our balance sheet.
In arriving at this forecast, a number of assumptions are required which, if incorrect, could materially change the results of our forecast, including potential monetizations and proposed conversions. However, we have assumed no incremental debt or equity issuances as we clearly recognize that the primary path to future debt and equity support from investors, at economic levels, is through the stabilization of our investment portfolio.
With respect to 2012, we are anticipating to incur non-recurring costs of approximately $0.10 per share to $0.15 per share, primarily associated with expected severance costs, the previously announced amendment of our SunTrust Warehouse facility, the early retirement of our private placement notes and other transitional costs. Excluding these costs, we are forecasting NOI of approximately $0.40 per share to $0.50 per share.
Recognizing the one time nature of the 2012 transitory costs, our strong liquidity position, and the importance of dividends to our investor base, we have committed to a dividend declaration level of $0.14 per share for the next two quarters. Accordingly, we will pay a $0.17 per share dividend in May 2012 followed by a $0.14 per share dividend in both July and October 2012. Such payments are expected to include a return of capital.
Lastly, as previously announced on January 17, 2012, we are authorized to repurchase shares of our common stock, up to $35 million, in open market transactions, including through block purchases, depending on prevailing market conditions and other factors. As of March 1, 2012, no shares have been repurchased.
O VERVIEW OF R ESULTS OF O PERATIONS
There were a number of indicators of modest growth in the United States’ economy during 2011. However, certain leading and lagging indicators suggest continuing volatility and economic instability. Our financial and operating results, including those of a number of our portfolio companies, continue to be affected by the weakness and volatility of certain segments of the economy.
During the year ended December 31, 2011, we reported a net loss of $93.1 million, or $1.22 per diluted share, compared to a net loss of $13.1 million, or $0.17 per diluted share, during the year ended December 31, 2010. This increase in net loss resulted primarily from a $75.1 million increase in net investment loss.
Our net operating income during the year ended December 31, 2011 was $37.7 million, or $0.49 per diluted share, compared to $40.6 million, or $0.54 per diluted share, during the year ended December 31, 2010. This $2.9 million, or 7.2%, decrease in our operating income from the comparable period in 2010 reflects a $3.9 million, or 4.3%, decrease in total revenue offset by a decrease in total operating expense by $1.0 million, or 2.0%. The decrease in total revenue primarily resulted from a $5.5 million, or 7.2%, decrease in interest income reflecting a 133 basis-point decrease in our spread to LIBOR partially offset by increases in our loan fee income and advisory fee income.
The decrease in total operating expense resulted primarily from a decrease in compensation expense by $6.5 million, or 31.7%, primarily due to a decrease in employee compensation and the timing of the recognition of certain stock-based compensation. In addition, interest expense decreased by $1.3 million, or 7.4%, due to a narrowing of the interest rate spread and a decrease in the average borrowing balance from 2010 compared to 2011. The decreases in compensation and interest expense were partially offset by $4.3 million in restructuring expense and a $2.5 million, or 22.1%, increase in general and administrative expense primarily due to severance costs related to the resignation of our former CEO and higher professional fees related to portfolio litigation and other corporate initiatives. In the fourth quarter of 2011, we recognized $2.7 million of expenses related to the resignation of our former chief executive officer consisting of $2.3 million recognized in general and administrative expense and $0.4 million recognized in amortization of employee restricted stock.
During the year ended December 31, 2011, we recorded net investment losses of $129.9 million, which primarily resulted from a $92.1 million decrease in the fair value of our investment in Broadview. Broadview, a public registrant, is a competitive local exchange carrier, or CLEC. We recorded $92.1 million of unrealized depreciation on our Broadview investment primarily to reflect, among other factors, continuing challenges in the bond market, a downgrade of Broadview’s corporate credit rating, delays by Broadview in refinancing its debt, as well as the near-term maturities of Broadview’s debt facilities. As of September 30, 2011, Broadview had $17.1 million of borrowings outstanding under its revolving credit facility, which becomes payable on June 1, 2012. In addition, as of September 30, 2011, Broadview had $301.4 million of outstanding senior secured notes, which will mature on September 1, 2012. If Broadview is unable to refinance these debt facilities by their respective maturity dates, the value of our portfolio investment in Broadview could decline by up to the remaining fair value at December 31, 2011, and we may be required to recognize additional unrealized depreciation on this investment. During the year ended December 31, 2011, we also recorded $28.8 million of unrealized depreciation on our investment in Jet Plastica Investors, LLC, or Jet Plastica, to reflect a decrease in that company’s operating performance.
A more detailed discussion of our results of operations for the year ended December 31, 2011 begins on page 44.
A CCESS TO C APITAL AND L IQUIDITY
The availability of debt and equity capital continues to be constrained. We believe that we will continue to be constrained by the limited access we have to debt and equity capital. Because our stock continues to trade below net asset value, or NAV, and we do not have stockholder approval to sell equity below our NAV, we effectively lack access to the equity markets. Lenders, in general, may be reluctant to extend credit to us without such equity capital markets access.
As of December 31, 2011, we had $58.6 million of cash and cash equivalents available for general corporate purposes as well as $28.2 million of cash in restricted accounts related to our SBIC that we could use to fund new investments and $6.8 million of restricted cash held in escrow. In addition, we had $40.3 million of cash in securitization accounts, including $25.2 million in our Commercial Loan Trust 2006-1 that may only be used to make interest and principal payments on our securitized borrowings or distributions to MCG in accordance with the indenture agreement. In January 2012, we used $19.5 million of securitized cash to repay borrowings of our Commercial Loan Trust 2006-1. In addition, cash in securitization accounts included $15.1 million in our Commercial Loan Funding Trust that may only be used to make interest and principal payments on our securitized borrowings under the SunTrust Warehouse facility. In January 2012, we used $4.8 million to repay outstanding borrowings of our Commercial Loan Funding Trust, and this facility entered a 24-month amortization period with a final legal maturity in January 2014. All future principal collections by the Commercial Loan Funding Trust will be used to reduce the balance of the outstanding advances under this facility. The reinvestment period for Commercial Loan Trust 2006-1 ended on July 20, 2011 and all subsequent principal collections received will be used to repay the securitized debt.
In January 2011, the United States Small Business Administration, or SBA, increased its total commitment for potential borrowings from $130.0 million to $150.0 million. As of December 31, 2011, $128.6 million of SBA borrowings were outstanding, and in January 2012, we borrowed the remaining $21.4 million available under this facility in our wholly owned subsidiary, Solutions Capital.
In March 2011, we formed Solutions Capital II, L.P., and in May 2011, we submitted a license application to the SBA for a second SBIC license under Solutions Capital II, L.P. After discussions with the SBA, we elected to withdraw our application for a second license until the SBA has an opportunity to evaluate, among other things, the organizational impact of our recent restructuring and changes in management. We may seek to re-file our application for a second license in the future. There is no assurance that, if filed, the SBA will grant the additional license.
Portfolio Composition and Investment Activity
As of December 31, 2011, the fair value of our investment portfolio was $741.2 million, which represents a $268.5 million, or 26.6%, decrease from the $1,009.7 million fair value as of December 31, 2010. The following sections describe the composition of our investment portfolio as of December 31, 2011 and 2010 and describe key changes in our portfolio during 2011 and 2010.
A DVISORY F EES AND O THER I NCOME
Advisory fees and other income primarily include fees related to advisory and management services, equity structuring fees, syndication fees, prepayment fees, bank interest and other income. Generally, advisory fees and other income relate to specific transactions or services and, therefore, may vary from period to period depending on the level and types of services provided. During 2011, we earned $3.5 million of advisory fees and other income, which represented a $0.4 million, or 14.7%, increase from 2010. This increase primarily represents increases in advisory fees and prepayment penalties.
T OTAL O PERATING E XPENSES
Total operating expenses include interest, employee compensation and general and administrative expense. During 2011, we incurred $48.0 million of operating expenses, representing a $1.0 million, or 2.0%, decrease from the same period in the prior year. This decrease was composed of a $6.5 million decrease in employee compensation expense and a $1.3 million decrease in interest expense partially offset by a $4.3 million increase in restructure expense and a $2.5 million increase in general and administrative expense. The reasons for these variances are discussed in more detail below.
I NTEREST E XPENSE
During 2011, we incurred $15.6 million of interest expense, which represented a $1.3 million, or 7.4%, decrease from 2010. A narrowing of the interest rate spread from 2.33% during 2010 to 2.15% during 2011 caused interest expense to decrease by $1.0 million. Interest expense also decreased $0.6 million as a result of a reduction in the average borrowing balance during 2011 compared to 2010. These decreases in interest expense were offset by a $0.3 million increase in interest expense related to amortization of deferred debt issuance costs.
E MPLOYEE C OMPENSATION
Employee compensation expense includes base salaries and benefits, variable annual incentive compensation and amortization of employee stock awards. During 2011, our employee compensation expense was $14.1 million, which represented a $6.5 million, or 31.7%, decrease from 2010. Our salaries and benefits decreased by $4.3 million, or 26.3%, primarily due to a $3.2 million decrease in incentive compensation and a $1.0 million decrease in salaries, which primarily resulted from a 42% reduction in our workforce that occurred as part of the corporate restructuring that we implemented during 2011.
During 2011, we recognized $2.1 million of compensation expense related to restricted stock awards, compared to $4.3 million for 2010, which represented a $2.3 million, or 52.1%, decrease. Included in the 2011 amortization of employee restricted stock was $0.4 million of amortization expenses associated with Mr. Tunney’s resignation. The lapsing of forfeiture provisions for previously awarded restricted stock accounted for the reduction in amortization of employee restricted stock. Issuance of restricted stock under the 2009 Long-Term Incentive Plan , or LTIP, was contingent upon the closing price of MCG’s stock meeting certain price thresholds and the approval of the compensation committee of our board of directors. We achieved the final price threshold for which restricted stock could be issued during 2011, resulting in the issuance of 86,500 shares of restricted common stock and the award of $1.0 million to LTIP participants.
On August 1, 2011, our board of directors approved the MCG Capital Corporation 2011 Retention Program , or the Retention Program, for the benefit of our employees. We designed the Retention Program to provide eligible employees with certain incentives related to their past service and continuing employment with MCG. The Retention Program consisted of an aggregate of $1.3 million in cash and up to 121,250 shares of restricted common stock.
Under the Retention Program, we awarded a cash bonus to eligible employees, representing a specified percentage of each eligible employee’s respective annual cash bonus target for the fiscal year ending December 31, 2011. We will pay the incentive bonus to eligible employees in two equal installments on each of March 31, 2012 and September 30, 2012, subject to continued employment with MCG. Certain employees also received shares of restricted common stock under the MCG Capital Corporation 2006 Employee Restricted Stock Plan , as amended, or the 2006 Plan. The forfeiture provisions with respect to 50% of the shares of restricted common stock subject to each retention stock award will lapse on each of March 31, 2012 and September 30, 2012.
G ENERAL AND A DMINISTRATIVE
During 2011, general and administrative expense was $14.0 million, which represented a $2.5 million, or 22.1%, increase from 2010. During the three months ending December 31, 2011, we recognized $2.3 million of severance and other expenses associated with Mr. Tunney’s resignation. In addition, professional fees increased $1.3 million from 2010 resulting from portfolio-related litigation and other corporate initiatives in 2011. These increases were partially offset by $0.9 million of fees paid in the second quarter of 2010 related to the contested election of directors to our board of directors at our 2010 Annual Meeting.
R ESTRUCTURING
We are restructuring our business to simplify our organizational structure, refine operations and reduce annual operating expenses. On August 1, 2011, our board of directors approved a plan to reduce our workforce by 42%, including 22 current employees and 5 resignations. As of December 31, 2011, we had 37 employees. Affected employees were eligible to receive severance pay, continuation of benefits and, for employees who previously had been awarded restricted stock, additional lapsing of restrictions associated with restricted stock awards.
We estimate that the aggregate charges associated with the plan will total $4.3 million to $4.4 million. These estimated costs primarily reflect severance pay and related obligations. During 2011, we incurred $4.3 million of restructuring expenses. During 2012 and 2013, we expect to record restructuring charges of $80,000 associated with the August 2011 workforce reduction, which represent the accretion costs of severance benefits.
MANAGEMENT DISCUSSION FOR LATEST QUARTER
DESCRIPTION OF BUSINESS
We are a solutions-focused commercial finance company providing capital and advisory services to middle-market companies throughout the United States. For our core portfolio, we make debt and equity investments primarily in companies with annual revenue of $20 million to $200 million and earnings before interest, taxes, depreciation and amortization, or EBITDA, of $3 million to $25 million, which we refer to as “middle-market” companies. Generally, our portfolio companies use our capital investment to finance acquisitions, recapitalizations, buyouts, organic growth and working capital.
We are an internally managed, non-diversified, closed-end investment company that has elected to be regulated as a business development company, or BDC, under the Investment Company Act of 1940, as amended , or the 1940 Act. As a BDC we must meet various regulatory tests, which include investing at least 70% of our total assets in private or thinly traded public U.S.-based companies and meeting a 200% asset coverage ratio of total net assets to total senior securities, excluding SBIC debt.
In addition, we have elected to be treated for federal income tax purposes as a regulated investment company, or RIC, under Subchapter M of the Internal Revenue Code. In order to continue to qualify as a RIC for federal income tax purposes and obtain favorable RIC tax treatment, we must meet certain requirements, including certain minimum distribution requirements. If we satisfy these requirements, we generally will not have to pay corporate-level taxes on any income we distribute to our stockholders as distributions, allowing us to substantially reduce or eliminate our corporate-level tax liability. From time to time, our wholly owned subsidiaries may execute transactions that trigger corporate-level tax liabilities. In such cases, we recognize a tax provision in the period when it becomes more likely than not that the taxable event will occur.
OUTLOOK
As previously discussed, based on the successful execution of our strategic plan, we continue to target future annual base compensation and benefits levels of approximately $4.0 million to $5.0 million beginning in 2013. In addition, we are lowering our projected embedded annual non-compensation cost structure to approximately $5.0 million to $6.0 million from our previous projection of approximately $5.5 million to $6.5 million.
Consistent with our previous 2012 guidance, we expect to incur costs associated with our transition plan of approximately $0.10 per share to $0.15 per share, primarily attributable to severance costs and the related acceleration of restricted stock for terminated employees, the amendment and pay-off of our SunTrust Warehouse financing facility and employee compensation, primarily in the form of retention and inducement payments.
During the three months ended June 30, 2012, we incurred costs associated with our transition plan of $3.1 million or $0.04 per share, consisting of $0.8 million in accelerated deferred financing fees and other costs associated with the payoff of our SunTrust Warehouse financing facility that we recorded as interest expense, $0.3 million in retention and inducement payments that we recorded as salaries and benefits, $0.2 million in amortization expenses associated with the elimination of positions that we recorded as amortization of employee restricted stock awards, and $1.8 million in severance related expenses that we recorded as general and administrative expense. For the six months ended June 30, 2012, we incurred $6.8 million, or $0.09 per share, of costs associated with our transition plan.
Given the accelerated level of monetizations and payoffs experienced through the first six months of 2012, together with the slower than anticipated pace of new originations, we are presently carrying liquidity levels substantially higher than previously forecasted. We remain committed to making disciplined investments at appropriate risk-adjusted yields. Absent a significant pickup in liquidity redeployment opportunities or an increase in leverage from a second SBIC license or other sources, we would anticipate 2013 NOI levels of $0.45 to $0.55 per share, a reduction from the previous forecast of $0.50 to $0.60 per share.
ACCESS TO CAPITAL AND LIQUIDITY
At June 30, 2012 , we had $79.9 million of cash and cash equivalents available for general corporate purposes, as well as $124.5 million of cash in restricted accounts related to our SBIC that we could use to fund new investments in the SBIC and $6.5 million of restricted cash held in escrow. In addition, we had $78.0 million of cash in securitization accounts, that may only be used to make interest and principal payments on our securitized borrowings or distributions to MCG in accordance with the indenture agreement.
At June 30, 2012 , cash in securitization accounts included $71.3 million in the principal collections account of our Commercial Loan Trust 2006-1. In July 2012, we used $90.7 million of securitized cash, including $19.4 million collected in July 2012, to repay borrowings of our Commercial Loan Trust 2006-1. The reinvestment period for this facility ended on July 20, 2011 and all subsequent principal collections received have been, and will be, used to repay the securitized debt.
At June 30, 2012 , $150.0 million of SBA borrowings were outstanding, the maximum available under our current SBIC license.
PORTFOLIO COMPOSITION AND INVESTMENT ACTIVITY
As of June 30, 2012 , the fair value of our investment portfolio was $453.5 million , which represents a $287.7 million , or 38.8% , decrease from the $741.2 million fair value as of December 31, 2011. The following sections describe the composition of our investment portfolio as of June 30, 2012 and describe key changes in our portfolio during the six months ended June 30, 2012 .
DIVIDEND INCOME
We accrete dividends on equity investments with stated dividend rates as they are earned, to the extent that we believe the dividends will be paid ultimately and the associated portfolio company has sufficient value to support the accretion. We recognize dividends on our other equity investments when we receive the dividend payment. Our dividend income varies from period to period because of changes in the size and composition of our equity investments, the yield from the investments in our equity portfolio and the ability of the portfolio companies to declare and pay dividends. During the three months ended June 30, 2012 and 2011, we recognized dividend income of $0.9 million and $2.1 million , respectively. In addition, during the three months ended June 30, 2012 and 2011, we received payments on accrued dividends of $4.4 million and $7.9 million, respectively.
ADVISORY FEES AND OTHER INCOME
Advisory fees and other income primarily include fees related to prepayment fees, advisory and management services, equity structuring fees, syndication fees, bank interest and other income. Generally, advisory fees and other income relate to specific transactions or services and, therefore, may vary from period to period depending on the level and types of services provided. During the three months ended June 30, 2012 , we earned $2.1 million of advisory fees and other income, which represented a $1.1 million , or 108.0% , increase from the three months ended June 30, 2011 . This increase was attributable primarily to an increase in prepayment penalties of $1.9 million related to four investment repayments in the second quarter of 2012 offset by a decrease of $0.8 million in advisory fees due to our lower investment activity in the second quarter of 2012 compared to the second quarter of 2011.
TOTAL OPERATING EXPENSES
Total operating expenses include interest, employee compensation and general and administrative expenses. The reasons for these variances are discussed in more detail below.
INTEREST EXPENSE
During the three months ended June 30, 2012 , we incurred $4.6 million of interest expense, which represented a $0.6 million , or 15.4% , increase from the same period in 2011. Interest expense for the three months ended June 30, 2012 increased $1.4 million related to increased amortization of debt issuance costs, including $0.8 million of accelerated deferred financing fees related to the repayment in full of our SunTrust Warehouse financing facility and $0.3 million of accelerated deferred financing fees related to prepayments of collateral in our Commercial Loan Trust 2006-1 facility. Interest expense also increased $0.3 million due to an increase in the average LIBOR rate by 0.20% during the second quarter of 2012. These increases were partially offset by a $1.1 million decrease in interest expense due to a lower average borrowing balance in the first quarter of 2012.
EMPLOYEE COMPENSATION
Employee compensation expense includes base salaries and benefits, variable annual incentive compensation and amortization of employee stock awards. During the three months ended June 30, 2012 , our employee compensation expense was $3.5 million , which represented a $0.2 million , or 5.7% , increase from the same period in 2011. Our salaries and benefits decreased by $0.1 million , or 4.0% , due to a $1.2 million decrease in salaries and benefits primarily resulting from a 42% reduction in our workforce that occurred as part of the corporate restructuring that we implemented during 2011 offset by an increase in incentive compensation of $1.1 million primarily resulting from incentive and inducement bonuses paid in the second quarter of 2012.
During the three months ended June 30, 2012 , we recognized $0.7 million of compensation expense related to restricted stock awards, compared to $0.4 million for the three months ended June 30, 2011 , which represented a $0.3 million , or 75.1% , increase . The amortization of restricted stock awards during the three months ended June 30, 2012 included accelerated amortization of $0.2 million related to employees who were terminated during 2012.
GENERAL AND ADMINISTRATIVE
During the three months ended June 30, 2012 , general and administrative expense was $4.3 million , which represented a $1.6 million , or 61.5% , increase compared to the same period in 2011. General and administrative expense for second quarter of 2012 included $1.8 million in severance-related expenses.
TOTAL OPERATING EXPENSES
Total operating expenses include interest, employee compensation and general and administrative expenses. The reasons for these variances are discussed in more detail below.
INTEREST EXPENSE
During the six months ended June 30, 2012 , we incurred $9.8 million of interest expense, which represented a $1.9 million , or 24.8% , increase from the same period in 2011. Interest expense for the six months ended June 30, 2012 increased $3.3 million related to increased amortization of debt issuance costs, including $2.3 million of accelerated deferred financing fees related to the termination of our SunTrust Warehouse financing facility and $0.3 million of accelerated deferred financing fees related to prepayments of collateral in our Commercial Loan Trust 2006-1 facility. Interest expense also increased $0.6 million due to an increase in the average LIBOR rate by 0.21% during the second quarter of 2012. These increases were partially offset by a $1.9 million decrease in interest expense due to a lower average borrowing balance in the first quarter of 2012.
EMPLOYEE COMPENSATION
Employee compensation expense includes base salaries and benefits, variable annual incentive compensation and amortization of employee stock awards. During the six months ended June 30, 2012 , our employee compensation expense was $7.9 million , which represented a $0.1 million , or 0.7% , decrease from the same period in 2011. Our salaries and benefits decreased by $0.2 million , or 3.2% , due to a $2.1 million decrease in salaries and benefits primarily resulting from a 42% reduction in our workforce that occurred as part of the corporate restructuring that we implemented during 2011 offset by an increase in incentive compensation of $1.9 million primarily resulting from incentive and inducement bonuses paid in the first half of 2012.
During the six months ended June 30, 2012 , we recognized $1.2 million of compensation expense related to restricted stock awards, compared to $1.0 million for the six months ended June 30, 2011 , which represented a $0.2 million , or 15.4% , increase . The amortization of restricted stock awards during the six months ended June 30, 2012 included accelerated amortization of $0.3 million related to employees who terminated in during 2012.
GENERAL AND ADMINISTRATIVE
During the six months ended June 30, 2012 , general and administrative expense was $8.2 million , which represented a $2.7 million , or 50.0% , increase compared to the same period in 2011. General and administrative expense for 2012 included $2.9 million in severance related expenses.
CONF CALL
Richard Neu - Chief Executive Officer
Thank you, operator, and welcome to the call. I am here with Hagen Saville, MCG’s President and Chief Operating Officer, and Keith Kennedy, MCG’s Chief Financial Officer. Before we get started I will ask Tod Reichert, MCG’s General Counsel, to highlight our forward-looking disclosures. Tod?
Tod Reichert - General Counsel, Chief Compliance Officer, Corporate Secretary and Senior Vice President
Thanks, Rich. Good morning everyone and thanks for joining the call. Before we begin we would like to remind you that various statements that we may make during this morning’s call will include forward-looking statements as defined under applicable securities laws. Management’s assumptions, expectations and opinions reflected in those statements are subject to risks and uncertainties that may cause actual results and our performance to differ materially from any future results, performance or achievements discussed in or implied by such forward-looking statements and the company can give no assurance that they will prove to be correct. Those risks and uncertainties are described in the company's earnings release and in its filings with the Securities and Exchange Commission.
With that I will turn the call back over to our CEO, Rich Neu.
Richard Neu - Chief Executive Officer
Thanks, Tod. In the context of executing our strategic plan, the second quarter was an excellent quarter for MCG, and puts us well on our path to our previously stated objective of returning to our roots as a strong middle market lender. Absence the previously announced charge relative to Broadview Networks Holdings, portfolio performance from a valuation standpoint was generally in line with our expectations. Net operating income adjusted for cost associated with our transition plan was $0.11, which was consistent with our internal forecast.
Our liquidity position enabled us to return capital to our stockholders in the form of a $0.14 dividend on July 13, 2012, to shareholders of record on June 13, 2012. Additionally, we used approximately $12 million of our excess capital position, to repurchase approximately $2.7 million shares of our common stock. Similar to last quarter, the two areas that were outside of our internal forecast were originations, which came in below our target for the quarter, and debt payoffs, which exceeded our internal forecast.
As a result, we are carrying a total cash position at June 30 of just under $300 million, which is well above our previous second quarter target. This level of un-invested cash together with the current pace of originations will create some earnings pressure as we enter 2013. Subject to the pace and yields of new investments as we redeploy our excess liquidity, we now anticipate a 2013 earnings level of $0.45 to $0.55, down from our previous 2013 target range of $0.50 to $0.60 per share.
As Hagen and I communicated last November, the primary goal of our strategic plan was to create a company with less credit and leverage risk, yet one as of sustainable and predictable level of NOI and dividend generation. I am pleased to say that in our view, our transformation is substantially complete. Our equity investment position has been substantially reduced and our overall credit profile has been substantially improved. Our leverage risk profile has been substantially reduced and our infrastructure has been right sized to a smaller and simpler operating profile.
The final phase of our transformation, which I will ask Hagen to comment on, is validation of our internal managed BDC business model and the underlying portfolio of management and leverage assumptions that we have previously set out for you. I will turn it over to Hagen now, thank you.
Hagen Saville - President and Chief Operating Officer
Thank you, Rich, and good morning everyone. I would like to give some additional context to Rich’s remarks and provide some thoughts about the state of our business. As Rich mentioned, we have demonstrable progress in the execution of our business plan. Our equity portfolio is steadily being reduced and our loan book is becoming more granular, as a results our risk profile has been reduced. Furthermore, our cost reduction initiatives combined with our internally managed [status], will enable us to operate very efficiently with incremental asset growth being accretive.
Generally, I am very pleased with where we sit, halfway through 2012, as a transition year for MCG. During the quarter, our investment portfolio declined from $666 million to $453 million including the sale of three meaningful equity investments where we also own loans. Orbitel Holdings, $34.8 million, Garden State, $32.4 million, and Stratford School, $27.6 million, as well as repayment of several standalone loan assets. We made one new loan during the quarter, an $8 million subordinated debt investment in a healthcare company.
The remaining portfolio continues to meet our expectations with a majority of our names experiencing favorable sequential operating trends and improved credit metrics. Given the significant repayments on the quarter, we have experienced an imbalance between ordinary course origination and payoff activity. As a result, today our balance sheet is roughly only two-third employed. This imbalance is attributable to, one, the robust loan repayment and asset sale activity during the quarter. Two, weak market conditions; and three, the MCG reorganization, which is now essentially complete.
It’s important to note that our asset managers have been intimately involved in the time consuming sales process for certain investments. This no doubt has impacted the pace of new originations during the first half. As you can see from our press release, we currently have over $200 million of unencumbered and restricted cash available for new investments. The slower pace of origination compared to payoffs is the principal reason for our reduced guidance.
This slower origination pacing is not a long-term concern of mine. We currently have two new deals under signed LOIs along with several other actionable opportunities for Q3. The two LOIs are sponsors new to MCG, a positive statement about the status of our business. I would say the deal flow we are experiencing is a result of our calling efforts and our industry expertise in certain sectors, not a material improvement in market conditions.
While the pace of new originations is behind plan and subject to future market conditions, I remain confident that we can manage the business to optimize balance sheet utilization and restore the proper balance of ordinary course capital recycling. On a previous call, I described an economic model comprised of a pool of senior unsubordinated loan assets providing an all in IRR of 12% to 13%, a debt to equity ratio of 0.4 to 0.7 times, cash operating costs of approximately equal to 2% of assets, and long run credit charges of 2% to 3%, all delivering a return on equity of 10% plus.
I continue to believe we can achieve these results as we fully deploy our resources. The BDC space appears to be one of the few segments within financial services experiencing a favorable regulatory environment. House Bill 5929 would increase permissible leverage to one, and we classify preferred stock as equity not debt. Senate Bill 2136 would authorize the SBA to expand the SBIC debenture program from a current aggregate limit of $225 million to $350 million per issuer. These bills enjoy bipartisan support and if they come to pass we would have positive implications for MCG.
In summary, our portfolio performance is in line with expectations. Our economic model is intact, origination activity is picking up, and our industry appears to be on the verge of several positive regulatory developments. Keith, will now provide an overview of the quarter.
Keith Kennedy - Chief Financial Officer, Executive Vice President and Managing Director
Thank you, Hagen. For the three months ended June 30, 2012, our net operating income or NOI was $5.6 million or $0.07 per share. As previously noted during the second quarter, we incurred $3.1 million or $0.04 per share in transition cost, consisting of $1.8 million in severance related expenses. $800,000 in accelerated, deferred financing fees associated with the payoff of our SunTrust Warehouse financing facility, $300,000 in retention and inducement payments, and $200,000 in restricted stock amortization expense associated with a realignment of our workforce.
We anticipate incurring no more than $3 million of onetime costs in the second half of the year to substantially complete our transition. We are confirming our guidance for projected 2012 core NOI of $0.35 to $0.40 per share excluding transition expenses. We recognized a net loss of $7 million or $0.09 per share. Our net loss for the second quarter was driven by a $12.3 million net loss on our investment portfolio. Our net loss included an $8.9 million write-down of our equity position Broadview Networks. $5 million in other marks on our investment portfolio, and $1.6 million realized gain on the monetization of our debt and equity investments which includes a reversal of previous marks on such investments.
We have made significant strides to reposition our investment portfolio away from principal equity investments to middle market leveraged loan. In the second quarter we made the following significant strides in repositioning our balance sheet. First, we monetized approximately $213 of investments consisting of $40 million of equity investments and $173 million of loans. The results being that debt investments now made up 92% of our investments of fair value. Second, we reduced total borrowings by $63 million. As a note, in July, we used approximately $91 million of cash and securitized accounts to reduce our borrowings and to improve our total debt to equity ratio form 1:1 at December 31, 2011 to 0.7:1 as of July 28, 2012.
Third, we increased our investable cash to approximately $204 million, which converts to available liquidity to make ten or more new loans at our average target size of approximately $15 million. Four, our average total yield on our loan portfolio remained above 10% for the quarter, even after adjusting for the acceleration of unearned fees on monetization of loans. Finally, and as Rich preciously mentioned, during the quarter we repurchased approximately 2.7 million shares at an average price per share of $4.36, which equated to approximately a 20% discount from our quarterly net asset value per share.
As we monetize investments and accrued various loans, the balance of loans on non-accrual at fair value declined from $23.2 million to $12.4 million, from March 31, 2012 to June 30, 2012. Non-accruals as a percentage of fair value are approximately 3%. And with that I will turn it back to Rich.
Richard Neu - Chief Executive Officer
Thank you, Keith. Let me close by updating on our current dividend and stock repurchase thoughts. From a dividend standpoint, we will pay the $0.14 per dividend declared on July 27, 2012, on August 31 of 2012. Additionally, it is anticipated that the dividend to be declared at our October board meeting will be paid at the end of November. We have shortened the time between declaration and payment of our dividend at the request of several shareholders. Based on our current forecast, the shortening of our dividend payment cycle this year, means that the five dividends to by paid by MCG in 2012 should represent a return of capital in the range of 85% to 90%.
Although we are not providing guidance on future dividend levels, we would anticipate that beginning in the fourth quarter and continuing into 2013, future dividends will began to more closely approximate NOI excluding any remaining transition costs. Based on our evaluation of our current liquidity and medium term earnings profile, this would imply a fourth quarter dividend of 12.5 cents per share. Our ultimate goal is to pay a dividend that is well covered by our NOI results.
From a stock repurchase standpoint, we continue to anticipate being active under our stock repurchase program depending on prevailing market conditions and other factors. We are approximately $18 million in repurchasing authorization remaining under our $35 million program. With that I would say thank you for your support, and we are now available to answer any questions you may have. Operator?
|
|
Fund Letters
