By The Sick Economist
Regarding financial crises, investing legend Warren Buffett once quipped, “You never know who is swimming naked until the tide goes out.” In 2020 and 2021, the financial tide went out, swiftly and unexpectedly in the form of Covid-19. Many business models were challenged, and some collapsed. One that held steady was New Mountain Financial (Ticker: NMFC), a business development company that frequently yields 9% or more. Conventional wisdom holds that a stock offering that much income must be risky. But Covid-19 bounced right off New Mountain. What is the secret to New Mountain’s success, and should an investor anticipate more financial strength in the future?
Let’s take a look.
What is NMFC and What do they Do?
New Mountain Financial is a prime example of a business development company (BDC). They borrow money at long term, fixed rates, and loan that money out at shorter term, variable rates, and profit from the difference in what they pay for credit, and what they charge their own clients for credit. A BDC has a special legal designation, like a REIT, whereby they must pay out at least 90% of net income to shareholders. Much like a REIT, the entity does not pay taxes on earnings; only shareholders are taxed on the cash distributions they receive.
New Mountain operates in the world of Mid-Market businesses owned by private equity companies. They should know this space, since the company started out in life as a division of a New Mountain, which is, itself, a private equity company. Private equity companies use loans to take over existing businesses with strong, reliable cash flows. New Mountain Financial makes loans to those kinds of companies.
But NMFC doesn’t just loan to anyone. In fact, NMFC’s many years of experience in this specific niche (Mid Market, private equity), means they have very specific lending criteria. As the company explained in it’s Q3, 2021 investor presentation:
We believe our portfolio continues to be well positioned as a result of our defensive growth investment strategy, which focuses on acyclical, recurring, and predictable business models with long term viability, even in a recessionary environment
Many companies make such bold, confident sounding statements. Typically, investors just have to trust in the statements and hope for the best. But in the case of New Mountain, investors got to see a real world example of how the loan portfolio performed under pressure.
Managing Through Crisis
For many debt oriented companies, 2020 was a disaster of epic proportions. Simply put, when the world’s economic activity grinds to a halt, essentially going from a healthy economy to total shutdown within three months, it should be terrible for debt service. Companies should be defaulting on their loans left and right. Some lenders did suffer mightily, but not New Mountain.
When it became clear that the world was entering into crisis, New Mountain’s experienced management lept into action. They immediately created “Covid exposure grids” by which they ranked all portfolio companies by exposure to covid damage. The most vulnerable companies received coaching and extra attention, almost from day one. The “exposure” grid was provided to shareholders, along with granular information about the risk level of each portfolio company.
Ultimately, very few portfolio companies defaulted on their loans. As of Q2, 2021, 85% of portfolio companies were rated “business as usual.” In Q3 of 2021, only $18 million worth of loans were considered to be in default….$18 million out of a portfolio of $3 billion in outstanding loans. That’s less than 1% of the portfolio.
Through it all, not only did New Mountain manage to maintain a dividend, but they didn’t even cut the dividend. In fact, between 2019 and 2020, New Mountain actually still managed to grow the dividend by about 10%!
The company’s share price did crash. In that year of great uncertainty, the jittery investment community just assumed that any lender would suffer a wave of defaults. New Mountain’s share price crashed from $14 to a low of $4. All that meant was a once in a lifetime buying opportunity for the bold investor. Today, shares have rebounded, roughly back to the $12 level.
Secrets To Success
How could NMFC have built such a strong portfolio while lending to small, unknown companies? There are a few specific tricks that have kept the company’s portfolio healthy.
First, NMFC is a diversified lender. Although they tend to work with private equity backed companies, their loan portfolio covers a broad array of industries. This is why, during the worst of Covid, some loans were considered more endangered than others. Some types of businesses got hit harder than others by the nature of the Covid crises. In the next crisis, the companies that feel the heat could be totally different. NMFC’s broad portfolio is, “ready for anything.”
Another secret to success is that NMFC is relatively conservative about how much it lends businesses. Private Equity owners are notorious for larding too much debt onto companies they acquire. If they want to lever to the hilt, they will have to borrow from someone else. NMFC rarely loans more than 50% of the value of a client company’s assets
Reliance on assets is another secret to success. NMFC doesn’t just make random loans on a wing and a prayer. These loans are based on collateral….or assets that NMFC can seize if a client company cannot repay loans. Most of the loans that New Mountain makes are “senior secured,” meaning that they are loans against collateral, and New Mountain is legally entitled to be paid back before anyone else.
Lastly, the experience of the team leads them to choose only very specific client companies. The underwriting team at New Mountain has a cumulative reserve of dozens of years of experience dealing with private equity Middle Market, and they stick to certain kinds of companies. The strategy has paid off richly for investors.
A common knock on these kinds of high dividend paying companies is the accusation that they won’t be able to grow their dividends over time. In the case of New Mountain, this accusation is false for a few specific reasons.
First, the company has a sterling track record of dividend growth. In 2012, they paid out $78 million in dividends….in 2020, one of the worst years on record, they managed to pay out $816 million in dividends. How is that for growth!
Second, the entire business of private equity just keeps growing and growing. Deloitte, a consultancy, expects private equity to keep attracting more and more investments through the next decade. In that case, New Mountain can just keep growing along with their private equity clients. Private Equity cannot keep growing without specialized lenders, and no one is better positioned than New Mountain.
Lastly, some market commentators feel that Business Development Corporations, in general, could suffer if interest rates go up. Afterall, New Mountain has handed in its world-beating performance in a historical time period while interest rates have only fallen. Remember, the entire BDC business revolves around lending entities that can borrow cheaply, then disperse loans at higher rates. Some fear that, if BDCs like New Mountain must pay more for capital, then their profit margins could get squeezed. Indeed, shares have suffered lately due to this fear, dropping from a post pandemic high of $14 to just $12 and change.
One quick look at NMFC’s loan portfolio should dispel these fears. The vast majority of NMFC’s client loans are floating rate, meaning that, as interest rates rise, client companies’ repayments to NMFC also rise. NMFC, in turn, has borrowed almost 60% of its capital at fixed rates. Many of these loans aren’t even due until 2025 or later. This could mean that, if interest rates rise substantially over the next two years, as many believe they will, NMFC could actually make more money, because client’s payments will be growing, while 60% of NMFC’s funding costs will remain the same.
In a world where bonds still offer negative real yields, and S&P 500 companies might pay 2% in quarterly dividends, New Mountain Financial’s 9% dividend, paid out monthly, is a breath of fresh air. The business model has been tested under intense pressure and come out fully intact. If you climb to the top of this mountain, you should see some beautiful cash flow laid out before you.
DISCLOSURE: The Sick Economist owns shares in $NMFC