Main Street Capital Corp

NYSE:MAIN

Earnings Call Transcript 2022-Q2

[Operator]

Greetings, and welcome to the Main Street Capital Corporation’s Second Quarter Earnings Conference Call. [Operator Instructions] As a reminder, this conference is being recorded. It is now my pleasure to introduce your host, Zach Vaughan with Dennard Lascar, Investor Relations. Please go ahead.

[Zach Vaughan, Investor Relations]

Thank you, operator and good morning everyone. Thank you for joining us for Main Street Capital Corporation’s second quarter 2022 earnings conference call. Joining me today with prepared comments are Dwayne Hyzak, Chief Executive Officer; David Magdol, President and Chief Investment Officer; and Jesse Morris, Chief Financial Officer and Chief Operating Officer. Also participating for the Q&A portion of the call is Nick Meserve, Managing Director and Head of the Private Credit Investment Group.

Main Street issued a press release yesterday afternoon that details the company’s second 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 August 12. 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 homepage.

Please note that information reported on this call speaks only as of today, August 5, 2022 and therefore, you are advised that 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 of companies, was derived from third-party sources and has not been independently verified.

And now I will turn the call over to Main Street’s CEO, Dwayne Hyzak.

[Dwayne Hyzak, Chief Executive Officer]

Thanks, Zach. Good morning, everyone and thank you for joining us today. We appreciate everyone’s participation on this morning’s call. We hope that everyone is doing well. On today’s call, I will provide my usual updates regarding our performance in the quarter, while also providing updates on our asset management activities, our recent declarations of our supplemental dividend in September and the increase to our monthly dividends for the fourth quarter, our expectations for dividends going forward, our recent investment activities and current investment pipeline and several other noteworthy updates. Following my comments, David and Jesse will provide additional comments regarding our investment strategy, investment portfolio, financial results, capital structure and leverage, the impact of rising interest rates on our future net investment income and our expectations for the third quarter, after which we will be happy to take your questions.

Before we begin with our normal quarterly commentary, I want to highlight a change we are making this quarter to our definition of distributable net investment income, or DNII, which Jesse will cover in more detail in his comments. Our goal in using DNII as a key operating metric has always been to increase the quality of our reporting by providing this metric of the amount of cash flow from our investment activities that is available to fund our recurring monthly dividends paid to shareholders and thereby increase the visibility our shareholders have regarding the quality and recurring nature of our monthly dividends. Given both the growth and increased variability of our deferred compensation expense or benefit a non-cash item, over the last few quarters, we have concluded that it is appropriate to modify our definition of DNII to adjust for this item. All of our comments this morning are provided using this new definition of DNII.

We are pleased with Main Street’s strong second quarter results, which included a new quarterly record for net investment income per share and matched our prior quarterly record for DNII per share. These positive results included contributions from each of our primary investment strategies, and as a result of our strong performance, DNII per share exceeded our regular monthly dividends by 21%. This strong performance resulted in our recommendations to our Board of Directors for our most recent dividend announcements, which I will detail later.

While our net asset value per share declined in the quarter, the decline was primarily the result of the impact of market spread increases as opposed to company-specific performance on our private loan and middle-market debt investments. We are very pleased with the continued strong performance of our lower middle-market portfolio companies which resulted in another quarter of significant fair value appreciation in this portfolio and partially offset the overall decline in the valuations of our debt investments.

We are also very pleased with our recent investment grade rating assigned to us by Fitch in July in the support of our existing lender group that allowed us to complete the expansion and extension of our credit facility that we announced yesterday. We view these developments as significant enhancements to our current and future capital structure. We remain very confident that our highly unique lower middle-market strategy, combined with the strength of our private loan platform and our asset management business, will allow us to continue to deliver superior results for our shareholders. Despite the increased market volatility and uncertainty over the last few months, we are very pleased that our lower middle-market and private loan strategies have continued to deliver attractive investment originations.

While our lower middle-market investments of $32 million in the quarter were offset by several repayments, resulting in a net decrease in our lower middle-market investments on a cost basis of $5 million for the quarter, we are very pleased that since quarter end, we have already executed over $85 million of follow-on investments in existing lower middle-market portfolio companies.

We are also very pleased that we have maintained our significant momentum in our private loan strategy resulting in a net increase in our private loan investments of $72 million for the quarter. We believe that our second quarter results illustrate the benefits of the significant growth of our investment portfolio over the last year and we expect these benefits to continue in the second half of the year. Despite the negative impact of the increase in market spreads to the fair values of our debt investments at quarter end, the underlying operating performance across most of our portfolio of companies has continued to be strong. This strong performance provides us optimism about the overall value creation we expect from these companies in the third quarter.

We continue to believe that the strength of our differentiated investment strategies, including our highly unique lower middle-market strategy, combined with our diversified group of portfolio companies and our asset management business, will allow us to consistently deliver superior results for our shareholders and we are very excited about our outlook for the remainder of the year.

We have also continued to make progress in our asset management business. MSC Income Fund, the non-traded BDC we advised through our External Investment Manager, continued to maintain a fully invested portfolio at the end of the second quarter. We remain excited about our plans for the fund as we execute on our investment strategies and other strategic initiatives and we are optimistic about the future performance of the fund.

We continue to grow the investment portfolio at MS Private Loan Fund I through its co-investment activities with Main Street and MSC Income Fund and our private loan investment strategy and we are excited about the growing benefits we expect to receive from this relationship in the future. We remain excited about our strategy for growing our asset management business within our internally managed structure and increasing the contributions from this unique benefit to our Main Street stakeholders.

Based upon our results for the second quarter and the positive performance of our existing portfolio of companies, combined with our favorable outlook in each of our primary investment strategies and for our asset management business and the benefits of our efficient operating structure, earlier this week, our Board declared a supplemental dividend of $0.10 per share payable in September and an increase in monthly dividends for the fourth quarter of 2022 to $0.22 per share payable in each of October, November and December. These monthly dividends represent a 4.8% increase from the fourth quarter of 2021 and a 2.3% increase from the third quarter of 2022.

The supplemental dividend for September is due to our strong performance in the second quarter, which resulted in DNII per share, it was over $0.13 or 21% greater than the monthly dividends paid during the quarter. This represents our fourth consecutive quarter of paying a supplemental dividend and result in total supplemental dividends paid over the last year of $0.35 per share, representing an additional 13% paid above our monthly dividends and an increase in total dividends paid for the trailing 12-month period of 18.5% over the prior year. We are pleased to have been able to deliver this significant additional value to our shareholders.

As a reminder, we currently expect to recommend that our board declared future supplemental dividends to the extent DNII significantly exceeds monthly dividends paid in future quarters, which is consistent with our practice for the last four quarters. Based upon our expectations for continued favorable performance in the third quarter, we currently anticipate proposing an additional supplemental dividend for the fourth quarter.

Now turning to our current investment pipeline, we are pleased to maintain a number of attractive opportunities in our lower middle-market and private loan strategies. As of today and after closing over $85 million of investments to-date in the third quarter, I would characterize our lower middle-market investment pipeline as average. We remain excited about the quality of the investment opportunities in our current pipeline and about the prospects for follow-on investments in existing portfolio of companies as we and our companies actively look to execute on various growth opportunities. We also continue to be very pleased with the performance of our private credit team and the significant growth they have provided for our private loan portfolio and our asset management business. And as of today, I would characterize our private loan investment pipeline as average.

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

[David Magdol, President and Chief Investment Officer]

Thanks, Dwayne and good morning everyone. As Dwayne highlighted in his remarks, we believe our strong second quarter financial results demonstrate the strength of Main Street’s platform, our differentiated investment approach and our unique operating model. We are pleased to report that the overall operating performance for most of our portfolio companies was strong during the quarter and contributed to our strong financial results at Main Street.

Another major contributor to our results was our robust lower middle-market and private loan originations in the second half of 2021 and our private loan origination activities in the first half of 2022. As we have discussed in the past, the primary driver of our long-term success has been and continues to be our focus on the underserved lower middle-market and specifically, our strategy of investing in both the debt and the equity of our lower middle-market companies.

When we evaluate new lower middle-market investments, we target our combined first lien debt and equity investments to achieve a blended internal rate of return in the mid to high-teens range and we are pleased that our total asset level returns in the second quarter were at the high-end of this expected range. From an underwriting standpoint, we achieved these targets by maintaining a disciplined mix of debt and equity investments with a typical investment comprised of approximately 75% to 80% debt and 20% to 25% equity.

We are confident that our long-term proven success of investing in the lower middle-market combined with our prudent use of low to modest leverage at Main Street will continue to allow us to deliver very attractive financial results for our investors in the future. It is also important to note that as our lower middle-market investments mature in our portfolio, they generally deleverage, which increases their ability to pay dividends and results in unrealized appreciation and the opportunity for realized gains. This quarter, due to the strong continued operating performance of our lower middle-market portfolio of companies, our lower middle-market equity investments experienced significant pretax net unrealized appreciation of over $25 million to partially offset an overall net decline in our debt investment valuations primarily in our private loan and middle-market portfolios, which were predominantly driven by increases in market spreads.

Additionally, in the quarter, certain of our lower middle-market portfolio companies have received interest from third parties, which we believe could result in those companies achieving attractive realized gains prior to year-end. Despite the periodic and current market conditions that can negatively impact our overall debt investment valuations, the positive long-term impact of our lower middle-market equity investments has been a primary driver in the growth of our NAV per share from approximately $13 per share at our IPO date in October of 2007 to over $25 per share today. And we believe our lower middle-market equity investments will continue to be the primary driver of our NAV per share growth in the future.

Now turning to the overall composition of our investment portfolio as of June 30, we continue to maintain a highly diversified portfolio with investments in 191 portfolio of companies spanning across more than 50 different industries. Our largest portfolio company represented 2.8% of our total investment income for the quarter and 2.5% of our total investment portfolio fair value at quarter end. The majority of our portfolio investments represent less than 1% of our income and our assets.

Our investment activity in the second quarter included total investments in our lower middle-market portfolio of $32 million, which after aggregate repayments on debt investments and return of invested equity capital resulted in a net decrease in our lower middle-market portfolio of approximately $5 million on a cost basis. During the quarter, we also continued to execute on our strategy to dedicate significant resources towards growing the private loan segment of our business, while deemphasizing our middle-market portfolio which, as a reminder, are typically investments in larger syndicated loans.

Our purposeful and intentional strategic shift to grow our private loan portfolio is primarily driven by our belief that an attractive and growing direct lending environment exists and that private loan investments provide an attractive risk-adjusted return profile. Driven by the capabilities and relationships of our private credit team, we made approximately $182 million in total private loan portfolio investments during the quarter, which after aggregate repayments of debt resulted in a net increase in our private loan portfolio of approximately $72 million.

Finally, during the quarter, we had a net decrease in our middle-market portfolio of approximately $26 million as we continue to strategically deemphasize this portfolio. To put this into perspective, as of quarter end, our middle-market portfolio represented approximately $363 million at fair value or 10% of our total investment portfolio at fair value as compared to $624 million or 30% of our investment portfolio for the corresponding period 5 years ago. Our total investment portfolio grew 1% to $3.7 billion at fair value as of June 30.

At quarter end, our lower middle-market portfolio included investments in 75 companies representing $1.8 billion at fair value which is over 20% above our cost basis. We had investments in 82 companies in our private loan portfolio, representing $1.3 billion at fair value. And in our middle-market portfolio, we had investments in 34 companies representing $363 million at fair value. The total investment portfolio at fair value at quarter end was approximately 109% of the related cost basis.

In summary, Main Street’s investment portfolio continues to perform at a high level and deliver on our long-term goals. Additional details on our investment portfolio at quarter end are included in the press release that we issued yesterday.

With that, I will turn the call over to Jesse to cover our financial results, capital structure and liquidity position.

[Jesse Morris]

Thank you, David. As Dwayne and David mentioned, we are very pleased with our operating results for the second quarter. Our total investment income in the second quarter increased by $17.9 million or 27% over the same period in 2021 to a total of $85.2 million. The strong top line growth was largely driven by an increase in interest income of $18 million as a direct result of the continued growth in our portfolio of debt investments, which David spoke to earlier. Fee income also increased by $0.6 million. These increases were partially offset by a $0.7 million decrease in dividend income from our portfolio equity investments.

Of note, in further supporting the overall strength of our results, the combined impact of certain income lines, including dividends, accelerated OID, prepayment fees or other activity that are considered less consistent or non-recurring in the quarter decreased by $1.5 million or about $0.025 per share when compared to the second quarter of 2021 and was $1.4 million or $0.02 per share below the average of the prior four quarters.

Total expenses for the quarter increased by $5.6 million or 22% over the same period of the prior year, largely driven by increases of $3.6 million in cash compensation expense, $2.9 million in interest expense, $0.8 million in G&A expense, with these increases partially offset by an increase of $0.9 million and expenses allocated to the External Investment Manager and a reduction of $0.9 million in non-cash compensation expenses.

The increase in interest expense was driven by higher borrowing levels to support our investment activity. The increase in compensation expense was also driven by our increased investment activity and favorable operating results which have resulted in increased headcount, higher base compensation and increased incentive accruals. Our operating expenses to assets ratio was 1.4% for the quarter on an annualized basis which continues to be among the lowest in our industry.

Our External Investment Manager contributed $5.2 million to our net investment income during the quarter, an increase of $1.3 million through the allocation of $3.5 million of operating expenses and $1.7 million of dividend income and ended the quarter with total assets under management of $1.4 billion.

As Dwayne noted in his comments, we wanted to highlight the change we’re making to our definition of distributable net investment income, or DNII. Our definition of DNII has historically only included one adjustment to net investment income, which was to exclude our non-cash share-based compensation expense. Our goal in using DNII as a key operating income metric has been to provide the amount of cash flow from our investment activities that is available to fund our recurring monthly dividends paid to shareholders.

Over time, the amount and variability of another non-cash expense item, deferred compensation expense or benefit which is the result and changes in the fair value of deferred compensation plan assets has increased significantly and represented $0.02 per share of non-cash benefit or additional NII in the second quarter.

Given the increased size of this amount to a given quarter’s results and our desire to provide the best visibility possible to this key operating income metric, we have modified our definition of DNII to also exclude the impact of this non-cash expense item. Additional details describing this change and the related reconciliations between our historical and new DNII metrics and net investment income determined in accordance with U.S. GAAP are included in our earnings release.

As a result of the strong growth in investment income, NII increased by $12.3 million or 29% in the second quarter of 2022 over the same period last year. The DNII grew to $57.1 million, an increase of $11.5 million or 25%. During the quarter, we reported net unrealized depreciation on the investment portfolio of $27.9 million. The depreciation of $23.4 million in our private loan portfolio and $15.1 million in our middle-market portfolio were primarily the result of increases to market spreads. The decrease in the valuation of our External Investment Manager of $14.6 million was due to a reduction in market multiples for our publicly traded peer set, partially offset by the growth in the External Investment Manager’s revenues.

As Dwayne and David both mentioned, our lower middle-market equity portfolio offset a large part of the depreciation recorded in the quarter, recognizing unrealized appreciation of $25.2 million as a result of the continued strong performance of these portfolio of companies. We also reported a net realized loss of $5.1 million, which was largely driven by the exit of a long-term underperforming middle-market investment that was previously on non-accrual. As a result of the net unrealized depreciation and net realized loss recorded in the quarter, partially offset by the increased net investment income, net asset value or NAV decreased by $8.5 million or $0.52 per share during the quarter to end the second quarter with NAV at $25.37 per share.

As I mentioned, we exited an investment which was on non-accrual and added a lower middle-market investment to non-accrual status, resulting in a total non-investments on non-accrual status at quarter end, representing 0.7% of the total investment portfolio at fair value and 3.2% on a cost basis. We continue to believe that our conservative leverage, strong liquidity and continued access to capital are important components of our capital allocation strategy. Our regulatory debt-to-equity leverage calculated its total debt, excluding our SBIC debentures, divided by net asset value was 0.81 within our target range of 0.7 to 0.9, and our regulatory asset coverage ratio was 2.23x, also well within our target range of 2.4x to 2.1x.

As Dwayne mentioned, we recently received an investment grade and corporate rating of BBB- with a stable outlook from Fitch Ratings, which is in addition to the rating of BBB- with a stable outlook that we maintain from S&P Global Ratings. We are very pleased with the confidence that Fitch has expressed in our investment strategies, management team and long-term performance, and are confident that the second investment-grade rating will be a significant positive for us in the future.

We continue to be active in raising capital through our aftermarket or ATM program with second quarter equity issuances of $26 million, bringing the total for the first half of the year to over $89 million. As Dwayne also mentioned, in order to enhance our liquidity this week, we amended our credit facility to expand the total commitments to $920 million, expanding the accordion feature to $1.4 billion and extend the maturity date to August 2027, and we are very much appreciative of the support and confidence from our lender group that this amendment represents. Given effect to the expanded commitments as of August 4, 2022, our cash on hand and available borrowings under our credit facility was approximately $389 million.

Coming back to our operating results, DNII per share increased to $0.78 per share, an increase of $0.11 or 16% from the same period last year and exceeded the regular monthly dividends per share paid to our shareholders by 21%. Including the June supplemental dividend of $0.075, dividends paid during the quarter were $0.72 per share, an increase of 17% over dividends paid during the second quarter of 2021. As Dwayne mentioned, these strong results and our positive outlook gave us the conviction to recommend to our Board that it approved a supplemental dividend for the fourth consecutive quarter, with this supplemental dividend at $0.10 per share payable September 2022, and an increase to our regular monthly dividends to $0.22 per share or $0.66 per share in the fourth quarter of 2022.

One additional item that I wanted to touch on is the impact of rising interest rates. During the quarter, LIBOR rates increased by approximately 130 basis points from those in effect as of March 31st to June 30th. At the end of the second quarter, 80% of our outstanding debt obligations maintain fixed interest rates. On the other hand, approximately 75% of Main’s debt investments for interest rates at floating rates with weighted average contractual interest rate floor of low current market index rates. As a result, in a rising interest rate environment, our exposure to higher interest expense is largely mitigated and over time, increases to our interest income will exceed the increases to our interest expense. It is important to note that the majority of our variable interest rate investments are based on contracts which reset quarterly, whereas our credit facility resets monthly. As a result, we generally will have a quarterly lag in the realization of benefits from rate increases in our interest income and net investment income.

During the second quarter, increased market index rates resulted in increases in interest income, which offset the impact of increased interest expenses with limited impact to our net investment income. In the third quarter, we expect to have a positive impact to our results, depending on the extent and timing of additional changes to market index rate changes and the timing of contractual rate resets on our debt investments. Finally, as we look forward, given the strength of our underlying portfolio and the investment environment thus far in the first half of 2022 that Dwayne and David mentioned in their remarks, we expect another strong top line and earnings quarter in the third quarter of 2022 with expected DNII per share of at least $0.78 per share.

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

[Operator]

[Operator Instructions] First question comes from Kenneth Lee with RBC Capital Markets.

[Kenneth Lee, RBC Capital Markets]

Hi. Good morning and thanks for taking my question. Just one on the LMM portfolio, in terms of the equity gains that you mentioned in the prepared remarks, wondering if you could just further flesh out what’s driving that strong performance? Are you seeing any kind of trends? Just wanted a little bit more detail around that? Thanks.

[Dwayne Hyzak, Chief Executive Officer]

Sure, Ken. Good morning and thanks for the question. When you look at the lower middle-market appreciation we had in the quarter, I would say the things that we are pleased with is that it wasn’t you concentrated in only one company. There was fairly broad-based contribution to that appreciation across a number of companies. And when you look at the drivers, I would say it’s just the fundamental performance of those companies. It’s increased trailing our historical EBITDA and cash flows and then it’s just a positive outlook they have for the – at least the near-term future that drove the vast majority of the change quarter-over-quarter. So, outside of that, I wouldn’t say there was anything that was really a big driver, a big part of that increase.

[Kenneth Lee, RBC Capital Markets]

Got it. Very helpful. And just one follow-up if I may, you also mentioned seeing potentially some increased third-party interest within the LMM portfolio. I am wondering if you could just talk a little bit more about what’s – any commonalities in terms of what’s driving interest, whether it’s just ongoing industry consolidation or anything else? Thanks.

[Dwayne Hyzak, Chief Executive Officer]

Yes. Ken, we are limited on what we can say, obviously, because the portfolio of companies wouldn’t want us to disclose too much. But with a large portfolio of lower middle-market companies and with those companies performing at a high level and growing, it’s not unusual for us to have inbound interest, either from third-parties or from management teams and other equity owners of those businesses. They decided it makes sense to take a look at the marketplace and see what could be available to them if they were to look to sell the business. So, we have had a couple of those companies that are involved in situations that fit that profile. And at least one of those, I would say is further down the process there, would not be something that happens in the next month. But if it was to happen, we would expect it to happen between now and year-end. And we think that would be a transaction that would be a really positive outcome for us. But I wouldn’t say there is anything unusual there. It’s just with a large portfolio of high-performing companies, we do get that type of activity from time-to-time.

[Kenneth Lee, RBC Capital Markets]

Great. Very helpful. Thanks again.

[Dwayne Hyzak, Chief Executive Officer]

Thank you, Ken.

[Operator]

Thank you. I would like to turn the floor over to management for closing comments.

[Dwayne Hyzak, Chief Executive Officer]

Okay. Thank you, operator, and thank you again to everyone for joining us this morning. We look forward to talking to you again in early November with our third quarter results.

[Operator]

This concludes today’s teleconference. You may disconnect your lines at this time and thank you for your participation.