Description

Medley Capital Corporation (MCC) is an externally managed BDC currently in the midst of a three-way merger with it’s manager (MDLY) and an affiliated private non-traded BDC (Sierra).  MCC is not a good BDC. The Taube brothers who oversee the Medley complex have a well-deserved reputation for self-interest and incompetence which I won’t try to defend. Nevertheless, the setup here provides for an asymmetric risk-return profile around the prospective transaction with 25%+ upside if the deal closes and limited downside if the deal breaks.  

A Very Brief Background

On August 8, 2018 Medley announced that Sierra would acquire both MCC and MDLY with the surviving entity Sierra listing on the NYSE.  The transaction was challenged by FrontFour partners in Delaware Chancery Court on grounds that the Medley Capital board breached its fiduciary duties to shareholders by endorsing a transaction for the benefit of the Taube brothers.  The Chancery Court judge found that the transaction was rife with self-dealing by the Taubes (https://courts.delaware.gov/Opinions/Download.aspx?id=287070) and in effect a backdoor bailout of troubled Medley Management (MDLY).  The decision is worth reading if only for the sad picture it paints of the realities of corporate governance  in many companies versus theoretical legal fictions such as independent directors.

On April 16, 2019, MCC and Frontfour announced a settlement whereby MCC would conduct a go-shop period, and, if no superior deal emerged, MCC shareholders would receive an additional $17MM in cash and $30MM of stock in Sierra (priced off the most recent Sierra NAV).  In October 2019 the go-shop expired with no superior offer and in November the Chancery Court approved the settlement along with an award of contingent attorneys fees. There is another class action in New York State Court challenging the deal from the Sierra shareholder side which was delayed while the Delaware litigation was pending.  While we see a low probability that this litigation prevents the transactions, the legal system is difficult to predict and the risk is not immaterial. We also expect that MCC and Sierra shareholders will vote to approve the transactions.  

Two Scenarios

If the proposed transaction closes, each share of MCC will be exchanged for 0.66 shares of Sierra.  We estimate that the current pro-forma NAV of Sierra is 5.80. We assume that the new Sierra will continue to trade at a sizable discount to NAV of 55%.  This provides $2.11 of value per MCC share. But there is an additional $0.61 if the deal closes as the result of the Frontfour litigation settlement. MCC shareholders will receive $17MM in cash ($0.31/shr) and $30MM of Sierra shares ($0.30 at 55% of NAV).  Thus the total deal consideration has a value of $2.72 which is 25% above the last closing price for MCC. If when the dust finally settles, Sierra trades at a still pathetic but not priced for death NAV discount of 65%, then the return rises to 45%.

And what if the deal fails to close?  MCC already trades at 48% of NAV. We do expect some pressure on NAV as credit costs are ticking up for lower quality BDCs.  But this is not a hyper-leveraged entity. MCC has just 265MM debt against an investment portfolio of $475MM. 48% of NAV is already a distressed valuation which incorporates (and probably overshoots to the downside) both the quality of MCC’s assets and the Taube brothers.  While there might be technical selling if the deal breaks due to unwinding merger arbitrage, we see fundamental valuation support at these levels. There are even scenarios in which a deal break could be positive for MCC. If something were to occur whereby MDLY loses the MCC management contract to a more respected party then MCC would likely erase some amount of its punitive NAV discount.

We like the setup with limited fundamental downside in a break scenario and meaningful upside upon merger consummation.  While we do think it is significantly more probable than not that the deal closes, we recognize that there is sufficient hair here to raise doubts and thus appreciate the downside valuation support.  Meanwhile the upside scenario would be realized with a hard catalyst at some point in 2020.

Catalyst

Deal closes in 2020