MidCap Financial: Buy This 10% Yielder Before The Merger (NASDAQ:MFIC)

MidCap Financial Investment Corporation (NASDAQ:MFIC) is a business development company that invests in senior secured debt loans to middle market companies. The company also carries a high dividend yield of 10% and offers an 8% coupon baby bond (MFICL) that is currently trading over par. After covering the income opportunity of MidCap Financial back in February, a few readers suggested that I update my coverage to reflect the upcoming merger. After analyzing the proposed merger and what the proposed company would look like, I am still bullish on MidCap Financial’s shares.

Who is Involved in the MFIC Merger?

Back in November, MidCap Financial announced that it would be merging with two other externally managed corporations, Apollo Senior Floating Rate Fund (NYSE:AFT) and Apollo Tactical Income Fund (NYSE:AIF). Both funds, as well as MidCap Financial, are managed by affiliates of Apollo Global Management. It was also announced at that time that the combined company, while comprising of assets different from MidCap Financial’s core approach, would transform over time back to MidCap Financial’s model of originating first lien debt to middle market companies.

What Will the Combined MFIC/AFT/AIF Company Look Like?

The transaction will be completed using equity, where MidCap Financial will issue shares to compensate AFT and AIF shareholders. AFT shareholders will own 16% of the new company, with AIF shareholders owning 15% of the new company. Current shareholders of MFIC will own 69% of the combined company. Management also mentioned that the increase in net assets will require the financing of $600 million in new debt (discussed further under risks).

While MidCap Financial shareholders may be concerned about how much non-core investment assets they are taking on, it is rather modest compared to the proposed company size. Both Apollo funds combined have less than $700 million in portfolio assets compared to $2.37 billion already on the books for MidCap Financial. The assets coming into MidCap Financial will also improve the company’s asset coverage ratio, as the two Apollo funds have a higher minimum requirement.

Like most mergers, management believes that there will be operational benefits. Among those benefits are cost synergies that will lower the operating costs of the combined companies. These lower costs will help keep MidCap Financial’s high yield dividend more sustainable. Additionally, the larger balance sheet will improve scale and access to capital, which should reduce financing costs for the company.

What Will MFIC’s New Portfolio Look Like?

MidCap Financial’s investment portfolio is well diversified across many industries. MidCap invests the most capital into high tech, healthcare & pharmaceuticals, as well as business service industries. These three industries combine for slightly more than half of the company’s investment portfolio. Interestingly, the top three industries of MidCap Financial are also the top three industries of AFT and AIF. This is likely a reflection of Apollo’s investment management philosophy and will make the integration of the three companies easier.

Following the merger, MidCap Financial will begin to rotate AFT and AIF’s high yield bond holdings, which account for less than $500 million, into MidCap Financial’s investment portfolio. This process will involve liquidating some high yield investments and allowing others to ride until maturity. Once the capital from AFT and AIF’s high yield bonds is liquidated, MidCap Financial will repurpose those funds into its core business of direct origination of first lien loans.

Will MFIC’s Dividend Remain Sustainable?

The biggest question among MidCap Financial investors is how likely the merger will affect MidCap Financial’s dividend. While management did not touch on its opinion of dividend sustainability regarding the combined companies, a combination of the operating cash flows of all three entities, along with the dividend obligation of the proposed share volume, shows that the combined company should have sufficient funds to support its dividend. These estimates do not include any new financing costs or any estimated operational synergies, but I believe the two will be immaterial to the analysis.

What Are the Risks to the MFIC/AFT/AIF Merger?

Investors should be mindful of the risks at play when combining these entities together. First, I believe there is a short-term risk to the high yield bond portion of the new portfolio. Since it is outside of the core of the business, I am hopeful that MidCap Financial can rotate it into fresh capital as soon as possible. Default events in this area of the portfolio could be problematic as they do not carry the same characteristics (first lien) as the rest of the portfolio and may lead to financial losses.

The second risk for investors to note is liquidity. To complete the deal, Midcap Financial will need to raise $600 million. While I believe the company will explore many options to raise those funds, in the merger announcement, they stated they could pull from their revolving line of credit and use their existing liquidity to fund the merger. If MidCap Financial follows through with drawing on its revolving line of credit, the combined company will have much less liquidity than the current entity. Investors will need to keep a careful eye on liquidity over subsequent quarters after the merger to ensure that it does not threaten the dividend.

Conclusion

I believe the merger between MidCap Financial, Apollo Senior Floating Rate Fund, and Apollo Tactical Income Fund will create value for investors. The combined company will continue the core investment strategy of MidCap Financial and better scale to control its costs. The current cash flow of the three companies supports the dividend at today’s level, and the opportunities presented in this merger may increase the dividend in the future.