If you screen the market for insider buys, Medley Capital Corporation (PFX -2.18%) will show up with regularity. In six out of seven full months of 2017, insiders have filed at least one SEC Form 4 to disclose insider purchases of the company's stock.
Investors may want to dig deeper. Insider buying at Medley Capital appears to be driven by a desire to keep control, rather than a bet on the business development company's future performance.
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How Medley's insiders are buying
The majority of insider buys are linked to Brook and Seth Taube, brothers who founded Medley Management (MDLY) in 2006. Through a complicated structure, they're using other people's money to maintain control of Medley Capital Corporation and preserve its relationship with Medley Management.
It's important to recognize that these "insider buys" are funded with capital supplied by Medley Management and a joint-venture partner, not the Taubes' personal piggy banks. The joint venture created in 2016 calls for a third-party investor to contribute as much as $40 million in cash. Medley Management will chip in as much as $10 million in cash, plus its ownership stake of an investment manager by the name of STRF Advisors LLC.
The outside investors receive an 8% preferred return on their capital, plus 15% of the joint venture's earnings, and 100% of the earnings generated by the interest in STRF Advisors LLC. Medley Management collects the scraps, or what's left after the outside investors get their required 8% return and 15% of the joint venture's earnings.
So far, amounts contributed to this joint venture have been used to purchase shares of Medley Capital Corporation. Because the Taube brothers are majority owners of Medley Management, the Form 4 filings are filed under the Taube brothers' names when the Medley Management-owned joint venture purchases shares of Medley Capital.
Insiders of high-yield BDCs have many reasons to buy their shares. Image source: Getty Images.
What's in it for the Taube brothers?
One can think of this joint venture as roughly equivalent to a seven-year margin loan. In effect, Medley Management gets 4:1 leverage on its contributed capital to snap up shares of Medley Capital Corporation stock, leveraging the potential gains and losses over the life of the joint venture.
In a perfect world, Medley Capital would merely trade flat for seven years while paying a juicy double-digit dividend yield that more than covers the 8% return requirement of the joint-venture partner. Medley Management, and the brothers who own the majority of the business, would generate a tremendous return on capital employed in the joint venture.
Its easy to see this as a very bullish sign for Medley Capital Corporation. After all, insiders should have a good view of a company's future prospects. Using other people's money to magnify the returns suggests that Medley insiders really like the opportunity to buy Medley Capital shares at the current market price.
But business development companies come with complex conflicts of interest. Often, insiders of poorly performing BDCs buy stock to cement their control, rather than profit from a continuous stream of dividends.
We saw this most recently at Fifth Street Finance and Fifth Street Floating Rate. The manager of these two BDCs, Fifth Street Asset Management, bought shares of the BDCs with borrowed money to thwart off activist campaigns that threatened the millions of dollars in fees they paid to the asset manager each year. Fifth Street Asset Management was rewarded for this defensive maneuver when, rather than lose its contracts to manage the BDCs to activists, it later sold the contracts to Oaktree Capital in a deal valued as high as $320 million.
Medley borrows from Fifth Street's playbook
I suspect that the Medley complex is using Fifth Street's playbook for defensive stock purchases.
In the most recent quarter, Medley Capital Corporation paid roughly $4.5 million in fees to Medley Management, equating to 32% of Medley Management's total revenue during the period. Medley Capital is the company's largest and most profitable fund and constitutes the majority of its "permanent capital" under management.
In effect, the $10 million maximum commitment to the joint venture can be viewed as an insurance policy on its $18 million annual fee stream. Whether or not the JV is profitable because of Medley Capital's stock performance is a secondary concern. What really matters is keeping Medley Capital under Medley Management's... well, management.
Investors who have been trained to understand that insider buying is bullish will probably see this as conspiratorial -- something like Ancient Aliens meets business development companies. But before writing off the Taube brothers' interest in Medley Management as purely coincidental, consider this: Medley Capital's independent board members don't share the same enthusiasm about Medley Capital stock. Its independent board members rank among the worst in the industry for their stock ownership.
It's a curious thing when insiders who profit from Medley Capital's operating expenses have a very different view from board members who are tasked with the important role of setting dividend policy and valuing the company's assets each quarter, isn't it?
