Income investors had grown to love Main Street Capital’s (MAIN) big, safe, monthly dividend so much that its share price had risen to a dramatic premium relative to its net asset value (“NAV”). Then the coronavirus hit. The share price plunged, once loved supplemental dividends have been suspended, and even the “sacred” regular dividend is now at risk. In this report, we analyze the company’s background, impacts of the coronavirus on its business, earnings power, the dividend, valuation and risks to understand whether now is the right time to establish or add to existing positions.
Main Street Capital (MAIN) Overview (8.2% Yield):
Main Street Capital Corporation, formed in 2007, is an internally managed Business Development Company (BDC) that primarily makes debt and equity investments in the middle markets. It has over $4 billion in capital under management and is headquartered in Houston, Texas. The company’s current portfolio is invested in 181 companies across 40 industries. MAIN provides debt financing and equity capital to lower middle market (“LMM”) companies and debt to middle market companies for management buyouts, growth financing and acquisitions. The company also provides private loans to companies through collaboration with other investment funds.
Based on transaction type, leveraged buyouts and management buyouts are 40% of the mix, Recapitalization or refinancings are at 44%, 12% of the investment capital is provided for acquisitions and remaining 4% is provided as growth capital. Average investment size in portfolio companies stands at $12.6 million. The company is also in the business of providing sub-advisory services to external parties for a fee income that accounts for nearly 3-5% of total investment income.
More details on the company’s portfolio segments are provided below:
Lower middle market (LMM): The company invests $5 million to $50 million in companies with annual revenue between $10 million to $150 million—making long-term equity investments and debt investments with typical maturity between 5 to 7 years. It has investments of $1.2 billion in 70 LMM companies at fair value. 64% of investments (in cost terms) are debt—out of which 98% is first lien. LMM debt effective yield is 11.8%. The company has equity investments in nearly all of its LMM companies and the average ownership is 41%. The portfolio of LMM companies, on average, earn EBITDA of $5.5 million.
Middle market (MM): The company invests $3 million to $20 million in debt securities of companies with annual revenue between $150 million to $1.5 billion. Out of $541 million in investments in 48 companies, nearly 95% is debt out of which 91% is first lien. Investment periods for debt is 3 to 7 years, and the weighted average effective yield is 8.1%. Average EBITDA of middle market portfolio companies is $80.6 million.
Private Loan: These are debt investments made in privately held LMM and MM companies as part of ‘club deals’ along with other investment companies. Out of debt investments in 63 companies in this segment, nearly 95% is first lien debt. These companies have an average EBITDA of $52 million and the average yield on debt is 9%.
Other Portfolio Investments: These are investments that do not fall under the above categories and also include investments managed by third parties. These account for 4% of total investment value and have an investment term of 5 to 10 years.
External Investment Manager: This segment includes the wholly-owned subsidiary “MSC advisers”. Through this subsidiary the company provides investment management and advisory services to clients other than Main Street Capital and earns fee income. The segment accounts for 4.5% of total investment income.
What Is A Business Development Company (BDC)?
A business development company is a closed-end investment company that invests in privately owned, middle-market companies, providing them capital to grow or recapitalize.
What Are the Advantages of Investing via a BDC?
For perspective, a few advantages of investing in BDCs are listed below.
High dividend yield as BDCs are required to distribute 90% of their profits to shareholders as per the governing law.
Being a regulated investment company, a BDC is not required to pay corporate income tax on profits.
They offer diversification as the portfolio consists of companies belonging to varied industries.
Experienced Investment management teams.
Fair amount of liquidity and transparency as BDCs are traded on public exchanges, unlike venture capital funds which are privately placed.
As they are traded on stock exchanges, periods of volatility can lead to shares of BDCs trading at attractive discounts to NAV.
Seasoned investment team that has seen multiple business cycles
The senior investment team at Main Street has been investing together for a reasonably long time and the team has maneuvered middle market-oriented funds through multiple business cycles. The management team owns 3.3m shares (over $90M) of the company’s equity and has more skin in the game as compared to the management teams of many other BDCs. Additionally, being an internally managed BDC, the company also runs a lean cost structure and is able to be more prudent when making investment decisions as it is under less pressure to search for higher-yielding, riskier debt to justify a higher cost structure. In fact, the company’s operating expense to total assets ratio stands at 1.3% as compared to ~3% for many other popular BDCs.
A highly diversified book reduces the risk of permanent loss of capital
The company has investments spread across 40 industries and 183 companies which helps mitigate the risk of a large drawdown from a concentrated investment even as the overall portfolio fights macro weakness. The largest portfolio company accounts for just 3% of portfolio value while most companies are under 1% of the portfolio. The average investment per company across the portfolio is just $12.6 million.
Excellent track record across cycles
Since the company’s IPO in 2007, MAIN has grown its DNII (distributable net investment income) by 241% and portfolio investment value by 212% per share. Regular dividends have increased by nearly 86% since the IPO and have never been cut. Supplemental dividends were initiated in 2013 to account for capital gains impact. The company has delivered an average ROE from 2010 to 2019 of 12.3% annually. Also, NII as a percentage of average NAV per share has been stable between 10.2% to 11.8% since 2011. Further, during the last recession, when Main Street Capital primarily handled lower middle market portfolios, it came out stronger on the other side of the recession. Between 2007-2011, DNII per share increased at a CAGR of 23.5% while assets saw significant increases backed by capital raised in IPO and additional follow-on offerings.
COVID-19 a clear negative but the damage is less pronounced than the stock indicates
Coronavirus related shutdowns have led to carnage in most dividend-oriented names including MLPs and BDCs. MAIN dropped 64.5% in March and since then has recovered somewhat but is still down around 38% from its pre-COVID levels. As indicated earlier in this report, the company has a highly diversified portfolio with a conservative investment philosophy and a strong pedigree in the low middle market which should help MAIN limit the damages as long as the current crisis is a recession (mild or deep) and not a depression.
Having said that, the company will clearly see an impact and it has understandably suspended its supplemental dividend while continuing to convey confidence in its ability to pay regular dividends in the near term.
“I think again if the COVID-19 pandemic issues last longer, we'll obviously have to re-evaluate that over the next couple of quarters, but I think given everything that we're looking at today across all factors we feel pretty good about that monthly dividend and that's what we're trying to communicate in our previous comments.” - Brent Smith, CFO
Additionally, the company highlighted that most of its portfolio companies have been able to operate at “full operating capacity” remotely during last few months. On this front, there could be more progress in the coming months as we get deeper into the summer. The company’s portfolio companies by region are well diversified and increasingly states are starting to lift restrictions (partially) especially in the Midwest and in the South.
We stress tested MAIN’s portfolio to understand what a realistic worst case scenario might look like. The company derives around 77% of its income from interest on debt (primarily first lien). As per the latest quarterly update, MAIN’s LMM portfolio companies are likely to have an EBITDA to interest ratio of 3:1. Given the industry mix of the portfolio companies, we believe the portfolio companies are likely to see EBITDA declines of between 40-50% in our worst case scenario. Assuming the LM and private loan segments also experience similar portfolio interest coverage, even after EBITDA declines, the portfolio should have interest coverage of 1.6 times. While that still means most of the interest income is secured for now, some of the portfolio companies especially in the consumer facing industries and oil and gas may seek interest deferrals (and lower LIBOR will hurt interest income as well) and therefore we are modelling a 10% decline in interest income for the whole year. Dividend receipts from portfolio companies on equity capital are likely to be down significantly. We are modeling an 80% decline, conservatively. Per Main Street…
“We expect a decline in the dividend income from an equity investments as the cash flows of some of our portfolio of companies have been negatively impacted to varying degrees and in general, our portfolio of companies are appropriately taking a conservative approach in managing their overall liquidity during this period of uncertainty.” - Brent Smith, CFO
“I would say there has been some activity there and I would say most of the activity has been around deferrals on a temporary basis for either interest or some type of principle repayment. I would say our approach which is consistent with what I think you would have always been is fair to request there. We're looking for the company and its equity investors to do something in tandem with this or as part of that request they've got to do something whether that cost cutting internally at the company if they're owners of the business and also management or to the private equity group in our private loan or middle market portfolio is making some other confession to go along with that request.” - Dwayne Hyzak, CEO
Even in our worst-case scenario, the company is still likely to be able to pay $1.93 per share in dividends, an impressive 7.1% yield at the prevailing stock price.
Strong financial position
As of March 31, 2020, Main Street had $54.2 million in cash and equivalents, plus unused capacity of $463 million in revolver and $20 million in SBIC debenture capacity. This liquidity will ensure sufficient dry powder to put to work in current portfolio companies and tap new opportunities at favorable terms (even though the company’s current investment pipeline is a bit weak given the lockdowns and a conservative stance).
Additionally, there are no significant debt maturities for the next two years. The debt-to-equity ratio stands at 0.81. And as evident in the chart below, MAIN’s debt-to-equity is among the lowest in the industry.
Attractive dividend yield even assuming cuts to regular dividend
The company’s stock has typically yielded around 6%, and it is still trading at over a 7% yield even in our Bear Case scenario where we assume a cut to the regular dividend (and not just the elimination of supplemental dividends). Additionally, the company’s price to NAV premium has shrunk since the COVID-19 related meltdown in the space.
Risks:
Prolonged impact of COVID-19: If coronavirus lockdowns and restricted activity last longer than expected, MAIN’s portfolio and earnings power could see larger erosion than we are modeling currently.
Lower middle market exposure: Main derives a substantial portion of its earnings from lending activity to the lower middle market sector. Smaller companies typically see a more disproportionate impact on their business in economic slowdowns. Having said that, the investment team at MAIN has experience managing LMM portfolios during previous downturns and has positioned the portfolio conservatively going into this latest downturn.
Conclusion:
Main Street Capital is among the best performing BDCs with a diversified portfolio and a conservative balance sheet. While there is no doubt the current COVID-19 crisis will erode the company’s asset base and earnings power, the depressed stock price, coupled with the staying power of the company (even in stressed conditions) provides investors with an opportunity to re-engage with the BDC space. Even in our worst case scenario (where coronavirus lock downs drag on), Main Street is still able to offer an attractive dividend. And if Main Street gets through this crisis (as it has gotten through previous crises), the shares have significant price appreciation potential to go along with their big monthly dividend payments to investors.