Monroe Capital BDC: Avoid This 10.7% Yielding Value Trap (NASDAQ:MRCC)

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Despite the fact that business development firm Monroe Capital Corporation (NASDAQ:MRCC) is trading at a discount to net asset value, the BDC’s stock is not a buy, partly because the company pays out 100% of its adjusted net investment income and the dividend is subject to reduction.

Monroe Capital’s net investment income is subject to an increase in non-accruals (which are currently significant) as the economy enters a recession, and the company’s net investment income may fall.

Not Every BDC Is A Buy Because Of Its Yield

Monroe Capital is comparable to other business development organizations in many ways: the company invests a substantial portion of its investment funds in first lien senior secured debt as well as junior debt and a small portion of its portfolio in equity securities to achieve valuation upside.

However, as I shall show in this post, I do not believe Monroe Capital, despite its substantial book value discount and first lien-centric investment portfolio, needs to be purchased.

As of March 31, 2022, Monroe Capital had invested $546 million in 97 portfolio firms.

At the end of March, the majority of Monroe Capital’s portfolio was invested in first lien senior secured loans, accounting for 76.7% of the BDC’s investments. Other investments included junior debt, equity securities, and investments in a senior loan fund managed in collaboration with a life insurance firm.

Monroe Capital Portfolio By Security Type

Portfolio By Security Type (Monroe Capital Corp)

As of March 31, 2022, six investments were non-accrual, placing a total investment (fair) value of $12.2 million at risk. The non-accrual percentage improved somewhat from 2.6% on December 31, 2021.

The six non-accrual investments were BLST Operating Company, LLC, Curion Holdings, LLC, Education Corporation of America, NECB Collections, LLC, Toojay’s Management, LLC, and Vinci Brands LLC, all of which had loans or preferred securities outstanding.

Monroe Capital has a 14.0% exposure to the real estate business, which is an industry that can be severely impacted by the economy’s poor growth forecast. Because real estate is typically cyclical, it exposes the BDC to greater risk than other businesses.

While the BDC also had significant exposure to business services (12.3% of the portfolio) and healthcare & pharmaceuticals (10.3% of the portfolio), Monroe Capital’s real estate exposure distinguishes it from other business development companies in the sector such as this one that have a larger focus on software, healthcare, and business service companies.

BDCs often have a greater exposure to such industries since they are considered recession-proof, meaning they create consistent cash flows even when the economy is in a slump.

Monroe Capital Industry Diversification

Industry Diversification (Monroe Capital Corp)

Monroe Capital’s weighted average portfolio yield was 8.0% as of March 31, 2022, outperforming numerous other yield investments. However, in the business development sector, an effective portfolio yield of 8% is not exceptional, and there are several BDCs such as this one that perform significantly better than Monroe Capital.

Monroe Capital Weighted Average Yield On Debt Portfolio

Weighted Average Yield On Debt Portfolio (Monroe Capital Corp)

Pay-Out Ratio Leaves Much To Be Desired

The biggest issue with Monroe Capital is that the BDC paid out 100% of its adjusted net investment income in the last two quarters, implying that an increase in non-accruals or a fall in portfolio income owing to increased interest costs might drive the BDC back above the 100% mark.

A pay-out ratio more than 100% does not automatically suggest that a BDC must cut its dividend, but a high pay-out ratio that sustains over a longer period of time makes it more likely.

Monroe Capital has paid out a total of $1.00 per share in the last year (based on a quarterly payout of $0.25 per share), which is equal to 95% of its adjusted net investment income. Having said that, the pay-out ratio was 100% in 2Q-21, 4Q-21, and 1Q-22, leaving investors with no margin of safety.

Monroe Capital Financial Highlights

Financial Highlights (Monroe Capital Corp)

Book Value Growth

Monroe Capital had a book value of $11.30 per share as of March 31, 2022, and the BDC’s book value increased following 1Q-20. However, the BDC’s long-term record of book value increase is not particularly impressive, given that it began with a book value of $14.72 per share at the time of its IPO a decade ago.

Monroe Capital Book Value Per Share

Book Value Per Share (Monroe Capital Corp)

Book value discounts can point to valuation bargains, but not always. Sometimes the market is simply attempting to communicate with you.

In the case of Monroe Capital, the market sees very distinct dividend risks, which I believe are fair, because the BDC may be unable to cover its dividend with net investment income if interest expenses or non-accruals rise.

Monroe Capital’s book value discount is currently 20%, but as I previously stated, the discount alone is not a cause to purchase the business development company.

Monroe Capital price to book value
Data by YCharts

Why Monroe Capital Could See A Higher Valuation

Monroe Capital may have some successful exits from its equity assets, generating enough additional income to keep the BDC paying out. The labor market report released on Friday showed strong non-farm payroll growth of 372K, indicating that the labor market is not yet flashing recession signals. If a recession is avoided, which is a possibility, Monroe Capital may be able to continue paying dividends.

My Conclusion

Monroe Capital has a first lien-centric investment portfolio, but there are other factors that call the BDC’s value to dividend investors into question.

Exposure to the unpredictable real estate business is a disadvantage, and the lack of coverage in terms of adjusted net investment income leaves much to be desired.

As a result of the above-average dividend risks, Monroe Capital’s 10.7% yield, despite a sizable book value discount, appears to be too risky.

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