Harvest Capital Credit Corp. (HCAP) is small for its scale. The company’s market cap is less than $20 million as of Monday’s market close, yet, assets under management are $104 million. For the sake of comparison, take Rand Capital (RAND), which has a larger market cap, yet its investment portfolio is about a third that of HCAP.
HCAP’s NAV stands at $10.24 per share, while its share price (as of October 12 market close) is $3.25. This translates to a 70% discount to NAV. Equus Total Return (EQS), a defunct micro-cap BDC, trades at a higher valuation of 60% discount to NAV.
One would think that HCAP is undervalued, but the fact is the company’s portfolio is in a state of extreme disarray. This article concludes that HCAP is not suitable for risk-averse investors, for the following reasons:
- Increasing defaults (before and after COVID-19)
- Unfavorable refinancing terms for defaulting businesses
- Low quality of loan collaterals
- High industry concentration
- Disappointing performance record
- Uncertainty regarding the extension of revolving credit
Sloppy Investment Screening
Management has been picking investments from the bottom of the barrel of the U.S. middle market. For new readers, the middle market is a term used by business development companies (“BDCs”) to refer to small and medium-sized private companies with little or no access to the banking sector.
Many BDCs have been performing well for years. Many continue to do so even during the pandemic, demonstrating the quality of their portfolio. This is not the case for HCAP. As of June 30, 2020, the company had 4 non-performing loans constituting 20% of total investments (at cost value). This is quite high compared to its peers.
One reason for high defaulting loans is the sloppy investment screening process, demonstrated by the short period between loan origination and default.
HCAP extended a $3 million loan to CRS in November 2013. Less than a year later, CRS defaulted. Another example is the $4 million loan to General Nutrition Centers (“GNC”) in February 2019. By June 30, 2020, GNC was defaulting on this debt.
Before the company put GNC and CRS in the non-performing loans list, it injected additional capital in both companies in an attempt to put them back on track. Unfortunately, these efforts were futile and the company only added to its loss.
Refinancing is also loss-making. For example, the company refinanced CRS’s debt (both the original and additional cash injections), extending its maturity and lowering the interest from 15% (12% cash + 3% PIK) to 5% in Q2 2015. The refinancing terms do not cover HCAP’s cost of capital, not to mention costs, base management fees (2% of AUM), and other expenditures. The company pays 6.125% just for the 2022 debt notes (HCAPZ).
This is only one example. Many portfolio companies are on and off the default list, receiving cash injections, refinancing, and credit amendments.
All the eggs in one basket
Portfolio concentration also played a role. HCAP failed to diversify its risk exposure. This meant that one defaulting loan translated to big losses. In Q4 2019, the company had two non-performing loans amounting to 10% of the portfolio (at cost). The company is still not diversified. As of June 30, 2020, 43% of the assets are concentrated in two industries or 5 businesses.
- Business services: 23.7% – 3 businesses
- Construction: 19.4% – 2 businesses
Finally, write-offs of senior secured loans cast doubt on the quality of HCAP’s assets. For example, in Q1 2016, the company realized a $926,204 loss on its investment in Solex Fine Foods LLC. That is a 50% discount on the loan’s principal, which was ~$1.9 million at the time of the transaction.
As a result of these factors, annual revenues declined consequently since 2016.
Source: Graph created by the author. Data sourced from HCAP financial statements.
A Pattern is Forming
HCAP is run by Joseph Andrew Jolson, who is the Chairman/CEO/Co-Founder of both HCAP and JMP Group LLC (JMP). Both companies have disappointing performance, as shown in the graphs below.
Source: YCharts. Graph edited by author.
Bankers Are Saying “No”
HCAP has a balance of $45 million under its credit facility. This amount matures on October 30, 2021. The lender is refusing to extend the facility beyond the maturity date. Now the company is looking for another bank to replace the previous lender. If HCAP fails to find a banker that is willing to replace the previous lender, its operations will suffer. As of August 7, 2020, the company hasn’t found a replacement for the credit facility.
HCAP’s portfolio is such a mess that even its bankers are refusing to extend the revolving credit facility to the company. Many portfolio companies are alternating in and out of the default list, receiving cash injections, refinancing, and credit amendments. Revenue decreased significantly between 2016 and 2019 and will decrease further in 2020 as a result of COVID-19 disruptions.
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Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: This is not investment advice. All information herein is for informational purposes only.