Main Street Capital Corp

NYSE:MAIN

Earnings Call Transcript 2021-Q1

[Zach Vaughan, IR]

Thank you, operator, and good morning, everyone. Thank you for joining us for Main Street Capital Corporation's First Quarter 2021 Earnings Conference Call. Main Street issued a press release yesterday afternoon that details the company's first quarter financial and operating results. This document is available on the Investor Relations section of the company's website at mainstcapital.com.

A replay of today's call will be available beginning an hour after the completion of the call and will remain available until May 14. Information on how to access the replay was included in yesterday's release. We also advise you that this conference call is being broadcast live through the Internet and can be accessed on the company's home page.

Please note that information reported on this call speaks only as of today, May 7, 2021, and therefore, you are advised that the time-sensitive information may no longer be accurate at the time of any replay listening or transcript reading.

Today's call will contain forward-looking statements. Many of these forward-looking statements can be identified by the use of words such as anticipates, believes, expects, intends, will, should, may or similar expressions. These statements are based on management's estimates, assumptions and projections as of the date of this call, and there are no guarantees of future performance. Actual results may differ materially from the results expressed or implied in these statements as a result of risks, uncertainties and other factors, including, but not limited to, the factors set forth in the company's filings with the Securities and Exchange Commission, which can be found on the company's website or at sec.gov.

Main Street assumes no obligation to update any of these statements unless required by law. During today's call, management will discuss non-GAAP financial measures, including distributable net investment income. Please refer to yesterday's press release for a reconciliation of these measures to the most directly comparable GAAP financial measures. Certain information discussed on this call, including information related to portfolio companies, was derived from third-party sources and has not been independently verified.

And now I'll turn the call over to Main Street's CEO, Dwayne Hyzak. Dwayne?

[Dwayne Hyzak, CEO & Executive Director]

Thanks, Zach. Good morning, everyone, and thank you for joining us today. We appreciate you taking the time to join us. We hope that everyone is doing well and staying healthy and safe. Joining me today with prepared comments are David Magdol, our President and Chief Investment Officer; and Brent Smith, our CFO. Also joining us for the Q&A portion of our call are Vince Foster, our Executive Chairman; and Nick Meserve, our Managing Director and Head of our Middle Market Investment Group.

On today's call, I'll provide my normal updates regarding our performance in the quarter, while also providing updates on our overall capital structure and liquidity position, our asset management activities, our investment activities and current investment pipeline, our recent dividend announcement and several other updates. Following my comments, David and Brent will provide additional comments on our investment strategy, investment portfolio, financial results and future expectations, after which we will be happy to take your questions. We are pleased with our first quarter results, which we believe illustrate our portfolio companies continued recovery from the impacts of the COVID-19 pandemic.

These first quarter results include the continued improvement in our net asset value per share and the generation of distributable net investment income, or DNII, per share in excess of our monthly dividends paid during the quarter.

We also continued our success with investments in both our lower middle market and private loan investment strategies with the 2 portfolios combining for almost $100 million in investment originations in the quarter, and we are excited about our current investment pipeline in both strategies. We believe that our conservative capital structure and significant liquidity position, which we further enhanced by our $300 million investment-grade notes issuance in January and the significant expansion of our credit facility in April will allow us to continue to execute on our pipeline of attractive investment opportunities.

We are also pleased to see the operating performance across the vast majority of our portfolio companies continued to improve during the quarter, resulting in net appreciation in each of our primary investment strategies and an increase in our net asset value per share of 1.3% in the quarter.

We feel good about the overall quality of our investment portfolio. We are excited about the organic and acquisition growth activities as several of our high-performing companies, which I will discuss in more detail shortly. As a result, we are optimistic about our ability to continue generating incremental fair value improvement in NAV per share increases for the next few quarters.

We also made additional progress in our asset management business during the first quarter. This includes progress at MSC Income Fund, the non-traded BDC we advised through our external investment manager, with a significant progress, including the resumption of normal investment activities in the first quarter and dividend payments to the fund shareholders at the beginning of April. We remain excited about our plans for the fund as we execute on our investment strategies and other strategic initiatives.

Our new privately held fund that we discussed last quarter, MS Private Loan Fund I, executed its first investments as a co-investor with Main Street and MSC Income Fund in our private loan strategy, and we are pleased with our progress on this initiative. We remain excited about this new opportunity and believe it is an integral part of our overall strategy to grow our asset management business within our internally managed structure and continue to provide this unique benefit to our Main street stakeholders.

We also continued our progress in the last few quarters in relation to our nonaccrual and underperforming investments, resulting in sequential improvement in our nonaccrual stats during the quarter, as Brent will cover in his comments later. Our team is focused on working through these underperforming investments to realize the best possible outcome for our stakeholders.

Based upon our results for the first quarter and the positive developments we have seen in our existing portfolio companies, coupled with the future benefits of our growing asset management business, the attractive new investment opportunities we are seeing in our lower middle market and private loan strategies, our efficient operating structure and strong liquidity position, we remain confident with our expectations for continued improvement in our DNII per share in 2021 and our expectation to resume consistently generating DNII in excess of our monthly dividends later this year, followed by the eventual growth of our monthly dividends, consistent with our long-term historical practices prior to the onset of the pandemic. To that end, earlier this week, our Board declared our third quarter 2021 monthly dividends of $0.205 per share payable in each of July, August and September, an amount that is unchanged from our monthly dividends for the second quarter.

Now turning to some additional details on our investment activities in the first quarter and our current investment pipeline. We completed lower middle market investments of $59 million in the quarter, including investments in 2 new companies.

As of today, I'd characterize our lower middle market investment pipeline as above average.

We remain very active in our lower middle market strategy, and we are excited about the investment opportunities in the current pipeline.

Consistent with our activities since the beginning of the pandemic, the current pipeline includes several follow-on investments in existing portfolio companies as we and our companies actively look to execute on various growth opportunities. We view these follow-on investment opportunities as very attractive as they allow us to make follow-on investments in some of our top-performing companies and management teams and provide the opportunity for meaningful equity value creation through these accretive acquisitions and continued fair value appreciation on these investments going forward.

In the first quarter, we began to realize some of the benefits from the acquisitions completed by several of our portfolio companies over the last few quarters, and we are excited about the prospects for continued increases in the fair values of these portfolio companies over the next few quarters as these companies continue to execute their growth strategies and realize these benefits.

As we look forward, we believe that the difficult environment experienced broadly across the economy since early 2020 has caused many entrepreneur owners to refocus on their financial and estate planning priorities. We believe that these factors, coupled with the significant uncertainty and concern regarding increasing future tax rates, particularly taxes on capital gains, should be positive catalyst for the transaction activities in the lower middle market.

Consistent with our historical experiences over the last 2 decades as the industry-leading partner for lower middle market companies and their management teams, we believe that our combined debt and equity investment offering and our ability to be a long-term to permanent partner for the companies we invest in, positions us as a favorite investment partner for these business owners.

During the first quarter, we also continued the successful focus on our investments in our private loan strategy, resulting in total investments of approximately $40 million. Due to repayments in the quarter, the private loan portfolio decreased by approximately $5 million on a net basis, while our middle market portfolio decreased by $35 million. As of today, I'd characterize our private loan investment pipeline as above average.

With that, I will turn the call over to David.

[David Magdol, President, CIO & Senior MD]

Thanks, Dwayne, and good morning, everyone. As Dwayne highlighted in his remarks, during the first quarter, we experienced continued general improvement in the operating performance and results of our portfolio companies with many returning to or exceeding their historical levels of revenue and profitability. However, some industries, particularly those industries that experienced most significant negative impact for the pandemic, are just now beginning to show signs of recovery.

The continued improvement in the operating performance for the majority of our portfolio companies resulted in another increase in our NAV per share in the quarter. This increase is a direct benefit of our long-term strategy of maintaining an investment portfolio that is well diversified by end market, industry vintage and security type. This diversification has been the cornerstone of our philosophy over our 20 years plus of investment history and will continue to be key to our investment strategy in the future.

Over the last year, the COVID-19 pandemic provided a significant stress test for our portfolio and our investment strategies. While this was a strenuous time for us and our portfolio company operating partners, we're pleased to have seen our investment strategy serve us well during this period of time.

Each quarter, we try to highlight key aspects of our differentiated investment strategy. This quarter, we'd like to revisit several reasons why we believe that our structure as a publicly traded BDC with the significant benefits of permanent capital is a great match with our focus of investing in both debt and equity capital in the lower middle market.

First, on the new lower middle market origination side, we believe that our permanent capital structure allows us to be an ideal long-term to permanent partner for the owners of privately held businesses. One of the challenges of a typical term-specific private equity fund is that they cannot represent a permanent partnership solution for a retiring business owner or their management teams. Our long-term investment structure allows us the flexibility to compete for transactions based on beneficial structural considerations as opposed to solely on price.

Ultimately, we believe that this can generate highly attractive investment profiles that other more traditional PE funds cannot provide. In addition, our ability to be a long-term to permanent partner of the companies we invest in allows the long-term owners of these businesses and their management teams the ability to maintain the identity and the dependence of their companies while also achieving the best long-term outcomes for their company's stakeholders.

Second, our long-term holding periods generate a diversified portfolio of mature companies that typically have lower relative leverage. This provides these companies the ability to work through negative economic cycles and take advantage of internal and external growth opportunities as they arise. In 2020, many of our lower middle market portfolio companies reduced their dividends to equity owners, including Main Street, in an effort to conserve cash during a stressful and unknown operating environment.

As visibility improved in the first quarter of 2021, Main Street benefited from several of our portfolio companies resuming and/or increasing dividends. The contributions from these companies were significant to our total dividend income for the first quarter, an amount which represents our largest amount of dividend income for a quarter in our company's history.

Over the last year, we also saw several of our lower middle market portfolio companies complete opportunistic acquisitions. Because of our ability to provide both the debt and equity capital to our portfolio companies, we are well situated to move quickly to support our portfolio of companies when they identify add-on acquisitions.

Today, the pipeline for add-on acquisitions by our portfolio companies is greater than any time in recent past. We welcome the opportunity to make incremental investments in our successful lower middle market portfolio companies as we strive to create long-term value for both our shareholders and the shareholders at the portfolio company level.

Our lower middle market portfolio is comprised of 35 companies, which have been in our portfolio for greater than 5 years and 16 of which have been in our portfolio for greater than a decade. We are seeing increasing opportunities across the seasoned portfolio to generate increased dividend income to Main Street and an ability to put incremental capital to work supporting internal and external growth initiatives with companies that have proven long-term track records with Main Street.

This seasoned portfolio continues to grow new originations each year, and we are excited with the long-term results they are achieving. Finally, while we can hold investments for extended periods of time, we also periodically achieve monetization events within our portfolio. We expect to be in a position to share some very positive news about some unrealized gains that we believe will be realized over the next few quarters.

Consistent with prior quarters, the contributions from our lower middle market portfolio continue to be well diversified, with 44 of our 71 lower middle market companies with equity investments having appreciation at quarter end. And with 30 of these companies that are flow-through entities for tax purposes contributing to our dividend income over the last 12 months. In addition, we also have several equity investments in nonflow-through entities, which have contributed to our dividend income over the last 12 months.

Our lower middle market investment activity in the first quarter included investments of approximately $59 million, including an investment of $54 million in 2 new lower middle market investments, which after aggregate repayments on debt investments and return of invested equity capital resulted in a net increase in our lower middle market portfolio of approximately $24 million. We had a net decrease in our private loan portfolio of approximately $5 million and a net decrease in our middle market portfolio of approximately $35 million.

As of March 31, we had investments in 174 portfolio companies spanning across 50 different industries. Our largest portfolio company represented approximately 2.7% of our total investment portfolio fair value at quarter end and 2.9% of our total investment income for the last 12 months. The vast majority of our portfolio investments represented less than 1% of our assets and our income. At quarter end, our lower middle market portfolio included investments in 71 companies, representing approximately $1.3 billion of fair value, which is approximately 20% above our cost basis. Our private loan investment activity in the first quarter included new and add-on investments totaling approximately $40 million.

As of March 31, Main Street's private loan portfolio included total investments of approximately $741 million of fair value across 63 unique companies. In our middle market portfolio, we had investments in 40 companies, representing approximately $418 million of fair value. The total investment portfolio at fair value at quarter end was approximately 108% of the related cost basis. In summary, Main Street's investment portfolio continues to perform at a high level and continues to deliver on our long-term goals.

With that, I'll turn the call over to Brent to cover our financial results, capital structure and liquidity position.

[Brent Smith, CFO & Treasurer]

Thanks, David. Our total investment income in the first quarter increased by 12% over the same period in 2020 to a total of $62.8 million, primarily driven by an increase in dividend income, partially offset by decreases in interest and fee income. The change in total investment income includes a net increase of $0.7 million, primarily related to higher levels of dividend income that is generally considered nonrecurring, partially offset by lower levels of accelerated income for certain debt investments considered nonrecurring.

Our operating expenses, excluding noncash share-based compensation expense, increased by $3.9 million over the same period of the prior year to a total of $20.7 million, primarily related to an increase in compensation expense in the quarter. $1.3 million of the increase in compensation expense related to the change in the fair value of our deferred compensation plan assets, as there was a significant benefit or reduction to compensation expense in the first quarter of last year.

The ratio of our total operating expenses, excluding interest expense as a percentage of our average total assets, was 1.3% for the first quarter on an annualized basis. The activities of our external investment manager benefited our net investment income by approximately $3.6 million during the first quarter to the allocation of $2.4 million of operating expenses for services we provided to it and $1.2 million of dividend income.

This increase from the first quarter of last year is a result of Main Street taking over as a sole adviser in October 2020 to the HMS Income Fund since we named the MSC Income Fund.

We recorded a net realized loss of $15.7 million during the first quarter, primarily relating to the realized loss from the restructure of a lower middle market debt investment that was previously on nonaccrual, which resulted in a further improvement in our nonaccrual stats, and we ended the first quarter with 6 investments on nonaccrual status, down from 7 at year-end, comprising approximately 0.8% of the total investment portfolio at fair value at approximately 2.9% at cost.

In addition, we recorded realized losses related to the exit of a middle market debt investment and the exit of an equity investment in the other portfolio. We recorded net unrealized appreciation on the investment portfolio of $19.5 million during the first quarter, primarily related to $9.4 million of net appreciation on the lower middle market portfolio, $2.5 million of net appreciation on our private loan portfolio, $5.6 million of net appreciation on our middle market portfolio, $0.million of appreciation relating to our external investment manager and $1.6 million of net appreciation on our other portfolio.

Our operating results for the first quarter resulted in a net increase in net assets of $57.3 million or $0.84 per share. Our overall capitalization and liquidity remained very strong as our total liquidity is currently in excess of $800 million. In January, we issued $300 million of investment-grade notes with a cash coupon of 3% and a maturity in July 2026. Due to our excess liquidity position, during the first quarter, we only raised approximately $3.5 million in net proceeds under our ATM equity issuance program.

We were also very pleased to have further enhanced our liquidity position by recently extending our revolving credit facility in April, with an increase in total commitments to $855 million, including increases from several of the long-term participants in the facility.

We continue to believe that our conservative leverage, strong liquidity and continued access to capital are significant strengths that have us well positioned for the future. As we look forward to the second quarter, we expect that we will generate distributable net investment income of $0.59 to $0.62 per share.

With that, I will now turn the call back over to the operator so we can take any questions.

[Operator]

[Operator Instructions] Our first question is from Robert Dodd with Raymond James.

[Robert Dodd, Raymond James]

Congratulations on the quarter. A couple of questions. I mean first, on David's comments to anybody. Dividends picked up, obviously, in 2020. Is it identifiable how much of that was maybe, for lack of better terms, spillover from 2020 because businesses maybe did better than they expected earlier in the year versus kind of ongoing dividend kind of sustainable run rate?

[Dwayne Hyzak, CEO & Executive Director]

Yes, Robert, what I would say on the question about the dividends is as we identified in our comments and in our press release, there was one large dividend from a company that was related to an exit of our investment there that we would clearly say is nonrecurring since we exited that investment.

But I think the other investments, while there may be some quarter-to-quarter volatility and some increases from time to time in the dividend income that comes from those companies, the other large dividend pairs we had in the quarter represented -- all represented long-term contributors to our dividend income. So while you do have some quarter-to-quarter volatility, we don't think it's nonrecurring or unusual. You do see it get elevated, but it's really hard to say how much of that would be spillover or carryover from the prior year.

[Robert Dodd, Raymond James]

Got it. Got it. I appreciate it. And then on the comment -- the low middle market pipeline about average, is it another identifiable question? I mean there's the potential for tax changes, which you also mentioned in the prepared remarks. And historically, that does tend to drive greater activity. Is that all already showing up in the above-average pipeline? And if the potential tax changes firm up, what's the time scale that the potential sellers, entrepreneurs, et cetera, come to you one versus getting it closed before, so the end of the year if the tax has changed next year?

[Dwayne Hyzak, CEO & Executive Director]

Yes, Robert, what I would say on that question is when you look at the current pipeline, I would say that we don't think there's a lot of tax-related planning that's included in that pipeline. The current pipeline, as we said in our comments, includes a number of follow-on investment opportunities in existing companies, which, as you've heard us say in the past, we find very attractive. So we're excited about that activity, and that would be an elevated portion of our current pipeline when you look at the lower middle market activity.

But I wouldn't say the other activity to date includes a lot of tax planning or tax strategies in relation to potential increases in tax rates going forward. Historically, when we look at other time periods where you've seen this type of a change in the administration and the tax changes that may come with that, it's typically going to be the second half of the year.

So I think we're starting to see new investment activity that's coming at the front end or the top of our funnel that likely includes the beginnings of that tax planning, but I wouldn't say that it's in the existing pipeline that we expect to execute on over the next couple of months.

[Robert Dodd, Raymond James]

Got it. Great. One more, if I can. On DNII, I mean, I appreciate the guidance you gave. Dwayne, you gave comments about eventual growth of the monthly dividend. I mean is there a rule of thumb on -- does DNII have to not only consistently exceed the dividend? But is there a margin you'd like to see before dividend increase would be, obviously, it's a Board question, but you're on the Board before the dividend increases would be potential? Or is it just -- if it can be sustainably covered, it's on the table?

[Dwayne Hyzak, CEO & Executive Director]

Yes, Robert, I would say it's the latter. It's more -- it's having a really high level of confidence about the sustainability of the DNII levels. I think we feel really good about the DNII that we've produced in Q4 and Q1. But as we said earlier, it does include some volatility, specifically on the dividend income side. So I think we really want to see that dividend income become more predictable and more consistent as its contribution to the DNII as well as you hope to have continued improvements or contributions on the interest income side from continued growth in our investment originations.

And when we see those 2 items come into play, I think that's when you'll see us look at increasing the monthly dividend. Historically, we've always said that our goal was to have DNII cover the monthly dividend by 5%. That's kind of been a long-term goal we've had, but I think it's really, as we sit here today, it's really getting into a more consistent visibility or practice on the receipt of dividend income from our portfolio companies. It's going to be the biggest driver going forward.

[Operator]

Our next question is from Kenneth Lee with RBC Capital Markets.

[Dwayne Hyzak, CEO & Executive Director]

I'm not sure if you can hear us. But we can't hear you if you're trying to ask us a question.

[Operator]

[Operator Instructions] We have reached the end of our question-and-answer session. I would like to turn the conference back over to management for closing comments.

[Dwayne Hyzak, CEO & Executive Director]

We just want to say thank you again to everyone for joining us this morning for the conference call, and we look forward to talking to you again here in a few months.

[Operator]

Thank you. This does conclude today's conference. You may disconnect your lines at this time, and thank you for your participation.