THEDEALNEWSROOM

9:15 AM Jun 02, 2015

Philip Falcone’s fight with MCG Capital is getting dirty

by Paul Springer

Business development company MCG Capital Corp. (MCGC) rejected a second, higher buyout offer from Philip Falcone’s HC2 Holdings Inc. (HCHC), expressing continuing support of an earlier offer from PennantPark Floating Rate Capital Ltd. (PFLT).

MCG’s response, announced Monday, June 1, prompted an immediate threat of legal action from Falcone, whose attorneys said that MCG made materially false and misleading statements in a document arguing against HC2’s bid and for PennantPark’s.

Meanwhile, activist investor Richard Fearon’s Accretive Capital Partners LLC continues to support the HC2 bid.

PennantPark Floating Rate Capital has had a $4.75-per-share stock and cash offer outstanding since April. That bid would value MCG at about $176 million. But HC2 came in with a $5 cash and stock bid last month that it sweetened to $5.25 on May 19, valuing the company around $194.5 million.

If HC2’s campaign is successful, it would be the third major acquisition for HC2 since former Harbinger Capital Partners head Falcone took over last year.

HC2’s bid is based on a higher valuation of MCG, but the business development company argued that PennantPark’s bid is superior, in a presentation filed with the Securities and Exchange Commission on June 1. The presentation raises issues including timing and Falcone’s history with market regulators.

In a 2013 settlement with the SEC, he was banned for five years from working with hedge funds and related financial institutions. Under the settlement, Falcone acknowledged taking a $113 million loan from one of his funds, creating a short squeeze in a company’s bonds as a retaliation against the company, and giving preferential treatment to some hedge fund clients.

The settlement does not prevent him from running publicly traded companies like HC2.

In a letter to MCG, Falcone asked the company to change its presentation to remove statements that he admitted to engaging in securities fraud and to remove an implication that criminal charges had been filed against him.

Falcone also noted, in an e-mail to The Deal, that HC2 did not intend to hold MCG as a business development company, so the SEC bar is irrelevant and no SEC approval would be needed for HC2 to acquire MCG.

The competing bidders for MCG are structurally different types of businesses.

The PennantPark Floating Rate fund is one of three managed by New York-based PennantPark, which has about $4.3 billion invested in middle market companies. PennantPark’s other vehicles are BDC PennantPark Investment Corp. (PNNT) and private fund PennantPark Credit Opportunities Fund II.

PennantPark has said in regulatory filings that it and MCG would be good merger partners because their greater market capitalization as one entity would make them more competitive, more attractive to sponsors and lenders, and more liquid in capital markets.

HC2 is a New York-based holding company that Falcone is using to acquire businesses that generate substantial free cash flow.

Since Falcone joined HC2 as a director in January of last year and assumed the CEO, president and chairman roles in May 2014, the company has used private placements, bond issues, credit agreements and cash to accomplish various goals, and the company’s persistence in the current bidding contest suggests its future efforts will be aggressive in raising capital and investing it in additional companies.

HC2’s largest holdings are Phoenix-based steel fabricator Schuff Steel Co. and U.K.- and Singapore-based underwater cable specialist Global Marine Systems Ltd. On a May 22 conference call with investors and analysts, Falcone said he is actively looking at further acquisitions in a variety of sectors.

Now, HC2 is working to use its equity as a currency to acquire MCG Capital and the $115 million in cash it had on its books as of March.

“It’s the cash,” Falcone said of both bidders’ interest. He also noted that an acquisition would amount to a synthetic equity raise for MCG, which might have difficulty selling equity on the open market. MCG also said in regulatory filings that there would be benefits from such a synthetic raise, but not with HC2.

Before MCG took its latest stand against his HC2’s bid, Falcone told The Deal that while he was confident that the bid was superior, but he was concerned that MCG’s board would not make the best decision.

MCG’s response to shareholders about the first HC2 bid addressed concerns including adviser Morgan Stanley’s observation that HC2 has not been operating long in its current form, with Falcone in charge and Schuff and Global as the main money makers. MCG has also noted that HC2’s stock is more volatile than PennantPark’s, and that part of the equity in HC2’s bid would derive from a new class of preferred securities that would likely have an illiquid market.

MCG further said that termination fees could alter the value of the deal, but HC2 responded in a May 22 letter that payment of a termination fee would not affect the equity or cash payments behind the offer.

On May 19, HC2 raised its bid from $5 to $5.25 per share and eliminated the preferred shares from the deal.

MCG’s June 1 response included a detailed account of Falcone’s regulatory history and civil sanctions from regulators.

This is the document that elicited the threat of litigation.

The presentation raised the possibility that Falcone’s regulatory history could make him ineligible to manage a financial company like MCG and that HC2 is what the SEC terms an “ineligible person” based on its control by Falcone.

The SEC, according to the presentation, might have to provide a “no-action” letter to allow Falcone and HC2 to complete the merger. HC2’s takeover bid does not propose management changes to MCG, however.

“The SEC could view this [merger] as a fiction designed to circumvent the prohibition on Mr. Falcone’s association with an investment company and to deprive MCG’s investors of the protections of the [Investment Company Act of 1940],” the presentation says.

“We don’t need an SEC ‘no action’ approval because we are not keeping the BDC status,” Falcone said in an e-mail.

Falcone also said MCG is making a desperate attempt to turn down his deal and that MCG’s board can’t justify the company’s drop in stock price from $20 in 2006 to the current $4-to-$5 level.

The presentation expanded further on MCG’s previous concerns with the volatility of HC2 stock, which would provide most of the consideration for HC2’s bid.

However, Falcone has stressed the financial strengths of HC2 and the liquidity of its stock compared to that of MCG’s.

HC2’s first-quarter revenue jumped to $201 million from $43 million the previous year, while the company has more than $128 million in cash and nearly $200 million in receivables.

MCG continues to take issue with HC2’s liabilities, which include around $376 million in long-term debt.

Accretive’s Fearon has taken a stand for HC2’s liquidity and financial condition in a letter to shareholders and communications with The Deal. He told The Deal that he believes the MCG board is erring in refusing even to meet with Falcone.

“They seem to have dismissed both Phil and HC2 as not credible, and I think this is a disservice to shareholders,” Fearon said in an e-mail.

Last month, Fearon advocated for HC2’s financial strengths in a letter to MCG shareholders.

“Net debt stands at approximately $280 million or a manageable 4.1x multiple of EBITDA,” he wrote. “HC2 trades at a fully-diluted enterprise value of approximately 0.8 times sales and 10.1 times EBITDA, based on the 2014 pro forma financial statements, and the company is not subject to management fees made to an external manager, as required under the PennantPark transaction.”

The letter also noted that HC2s stock trades around 133,000 shares daily, or about 2.5 times PennantPark’s volume.

Fearon told The Deal that his fund had been investing in Arlington, Va.-based MCG for years and was pleased by its performance, except that transactions in Jet Plastica and Broadview Networks had curtailed returns. However, Fearon said MCG had responded to most requests he had made as an activist, including arranging a stock buyback.

Fearon has said in regulatory filings that a transaction with PennantPark would benefit PennantPark more than it would MCG. In his analysis, MCG’s last capital raise, in 2013, entailed issuing equity at a 6% discount inclusive of fees and costs.

“With the MCG merger, PennantPark accomplishes a 'synthetic equity’ raise of almost three times this amount, without any NAV dilution to PennantPark shareholders never mind the fact that PennantPark cannot raise equity while its stock trades below NAV,” Fearon said in his letter to shareholders.

Fearon told The Deal that he has faith in MCG board chair Richard Neu to make the best choice between the two offers.

Numerous securities class action law firms are asking shareholders to question MCG’s support of the PennantPark bid. The law firms say in press releases and on websites that MCG’s management could breach its fiduciary duty by accepting a deal that undervalues the company.

Representatives of MCG and PennantPark did not respond to requests for comment.