Smart Management, Horrible Stock

Among investors, Michael Tokarz isn't a household name.

He was one of the general partners presiding over Kohlberg Kravis Roberts' (NYSE: KKR  ) ascent to the private-equity and leveraged buyout elite -- now the stuff of Wall Street legend. After a long and illustrious career there, he left KKR and Wall Street to take the reins at MVC Capital (NYSE: MVC  ) .

In some ways, though, he didn't go far. Like the banks of his bygone Wall Street, MVC is a total black box. And if recent years have taught us anything, it's that black boxes -- including but certainly not limited to MVC -- that deal in hard-to-value investments can be incredible wealth accruers for investors, fabulous at losing investors' funds, or, for the enterprising investor, wonderful shorts.

A recipe for riches?
MVC Capital is a regulated investment company (RIC) -- a company that invests in other companies. Under Tokarz's direction, MVC buys debt and equity securities from tiny private businesses.

Its business model is much like those of its business development company (BDC) brethren, American Capital (Nasdaq: ACAS  ) and Apollo Investment (Nasdaq: AINV  ) . When capably managed, these businesses are wealth-compounding machines, and Michael Tokarz is one very competent manager.

Sounds promising, right?

Not so fast
The trouble with MVC, Apollo, and American Capital is this: How does an investor determine whether the investments they purchase are actually creating value?

Their holdings are typically private companies with little to no publicly available financial information. Markets for them are illiquid at best, and more often nonexistent. Investors can't even ballpark the market value of their holdings.

In other words, they're asking investors to trust them.

MVC management's answer -- as it is in the rest of its industry -- is to provide its portfolio's net asset value (NAV).

That may sound like an imperfect but acceptable solution to a thorny issue. But MVC gets its NAV calculations from a valuation committee employed by -- wait for it -- MVC itself. (Apollo, by comparison, seeks independent, third-party confirmation of its valuation committee's estimates.)

At best, that's an enormous conflict of interest. At worst, it's a disaster in the making.

A cautionary tale
As the financial crisis roiled markets in 2008 and 2009, MVC's portfolio held 40 companies. About half of those investments were particularly sensitive to economic woes, linked to business spending, industrial activity, and the whims of highly leveraged consumers.

At the same time, public-market proxies for the sort of investments MVC held painted a seriously bleak picture:

  • The Russell Microcap Index was roughly halved from March 2008 to March 2009, and closed 2009 almost 17% below March 2008's levels. And these were the firms that were good (or lucky) enough to make it to the public markets.
  • The 12-month default rate for speculative-grade bonds peaked at 12.9%, in November 2009 -- more than 10 times its 2007 level of 0.9%. 

During the time of all this trouble and turmoil (March 2008 through December 2009), MVC's NAV increased 9.5%.

Let me get this straight: The world economy belly flopped, defaults soared skyward, equity markets nosedived, and MVC's NAV actually increased?

Tokarz and MVC might be that good. I just don't see how MVC's investments appreciated against such a rotten backdrop.

The moral of the story?
This could be a great investment -- or an incredible short.

Consider Allied Capital, a onetime Wall Street darling and BDC that has since been acquired by Ares Capital (Nasdaq: ARCC  ) , which is also in the same business as Allied and MVC. Like MVC, Allied made investments in small companies. David Einhorn profited wildly by shorting Allied , but his gumption took a painstaking six years to bear fruit.  

The problem is, MVC and Tokarz may just be as smart as their numbers suggest. And even if impropriety, or some sleight of hand, exists at MVC, the company might never blow up as spectacularly as Wall Street did.

Because the company's books are so opaque, the investing public probably won't ever know which scenario is more likely. That's why I can't recommend shorting MVC.

The Citigroups (NYSE: C  ) , Lehmans, Bear Stearnses, and Ambacs (NYSE: ABK  ) of the world taught would-be investors a critical lesson about smart guys and impossible-to-decipher financial statements: They can blow up, and on account of their financial statements' opacity, investors can remain oblivious to their troubles until it's too late. And while some things have changed since the credit crisis's beginning, that has not.

MVC is no different. That's why I'd advise you to steer clear, Fools. If you're interested in learning about short opportunities more likely to go down in spectacular and highly profitable flames, check my friend and Foolish colleague John Del Vecchio's special report "5 Red Flags – How to Find the Next Big Short." He's got the goods on Wall Street's not-so-goods.

Michael Olsen doesn't own shares of any company mentioned. True to its name, The Motley Fool is made up of a motley assortment of writers and analysts, each with a unique perspective; sometimes we agree, sometimes we disagree, but we all believe in the power of learning from each other through our Foolish community. The Motley Fool has a disclosure policy.

 


Read/Post Comments (5) | Recommend This Article (26)

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Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On September 12, 2010, at 6:39 PM, 1caflash wrote:

    I invest Long-Term Not to short. I read about Options but I don't invest that way. Here is my Glossary: Put: I add more shares to my favorite company and spend Money, sometimes what I consider Lots of It. Call: I phone my Financial Advisor and We work as One Team. Options: I can Buy, Sell, Hold, Do Research, Watch Financial Channels, or Take a Vacation because my Investments help pay for it. Shorts: Something at my age [almost 62] in which I don't look well. Limit Order: Years left in my Life. You get the Idea. Room for Improvement: A Place where Each Day We Thank the Highest Power for the Opportunities to become good Investors and Better [not bitter] Persons! Thanks to Motley Fool for allowing me to share Opinions.

  • Report this Comment On September 13, 2010, at 11:14 AM, RegLeCrisp wrote:

    Can we please change the word 'horrible' to 'interesting'?

    thanks,

    Michael Tokarz

  • Report this Comment On September 13, 2010, at 11:14 AM, TMFAgewone wrote:

    1caflash,

    Your point is taken, and fair. But for many long-only investors, there's a reasonable fundamental case for shorting, if we're to consider the index/market returns over the past 10 years. For an investor nearing retirement age invested predominantly in equities (something I wouldn't recommend, but it happens), the impact of a dramatic downdraft to equities can be paralyzing to a seemingly bullet-proofed financial plan. Shorting is certainly not the only tool for mitigating this risk, but one in a toolbox.

    Thanks for your comments, and Fool on!

    -Mike

  • Report this Comment On September 13, 2010, at 12:22 PM, TMFAgewone wrote:

    @RegLeCrisp,

    I can see how some might think that, and per the article's contents, that could be true. But for my dollar, 'fraid not. Fool on, and thanks for your comments!

    -Mike

  • Report this Comment On September 21, 2010, at 5:53 PM, easyavenue wrote:

    I got burned by ACAS devauling their portfolio. They were forced to by... some agency? Hugely. And so the stock plummeted. Also hugely. Using an outside, arm's length appraiser sounds like the right thing to do under the circumstances.

    If your work can't stand scrutiny then either you or your work has a problem.

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