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Main Street Capital Corporation (MAIN)

Main Street Capital is a business development company, or BDC. All BDCs are basically middle market lenders, which means they lend or take equity stakes in the 200,000 or so subprime businesses that generate about a third of the U.S. economy.

Essentially, BDCs serve a market of small companies that regular banks don’t want to touch, helping those companies fund acquisitions, leveraged buyout (LBO) transactions, recapitalizations, and growth projects.
Source: Main Street Capital Investor Presentation
Main Street is a medium-sized BDC with approximately $3.7 billion of investment capital under management. The firm deals mostly with lower middle market companies that have annual revenue between $10 million and $150 million and EBITDA ranging from $3 million to $20 million.

Main Street’s portfolio consists of loans and equity stakes in 195 companies, diversified by industry and geography. With its average loan only $10 million in size, Main Street's cash flow is relatively well protected against a failure of any one of its clients. In fact, its single largest loan represents just 3.3% of its portfolio value and generates 3.2% of its total interest income.
Source: Main Street Capital Fact Sheet

Business Analysis

Main Street has enjoyed excellent growth in its portfolio, investment income, and distributable net investment income (what funds the dividend) in recent years. However, the last decade has been unique in that the Federal Reserve has kept interest rates at their lowest levels in history, greatly expanding the money supply (by $3.5 trillion), while limiting the amount of risky loans that major banks are allowed to make.

In other words, the BDC industry as a whole has been living in a golden age of relatively little competition from big banks, very cheap borrowing rates, and a world awash with cash and investors desperate for anything with a generous and growing dividend (which made it very easy to raise equity capital).

That being said, Main Street is different from its increasing number of rivals (there are more than 100 BDCs in the U.S.) because its management is far more disciplined and skilled at which investments it makes on behalf of shareholders.

That’s largely due to the fact that Main Street is one of the few internally managed BDCs, providing a meaningful cost advantage compared to its rivals. Unlike BDCs that are managed by a third party, who collects fees based on the size of the overall portfolio, Main Street’s management team actually works for and owns a large percentage of Main Street itself (over 5% of the company).

As a result of its efficient operating structure, Main Street has much lower operating costs and higher profitability compared to its BDC and bank peers.
Source: Main Street Capital Investor Presentation
Better yet, those operating cost advantages result in substantially higher distributable net investment income (DNII) per share, which makes for more secure and faster-growing dividends in the short-term.

Over the long-term, Main Street’s higher profitability compounds into far better returns on shareholder capital, which ultimately results in strong growth in net asset value (NAV), or book value per share.

That’s an important point because the BDC industry is essentially a subprime banking industry, meaning that share prices track changes in book value per share over time.

As you can see, while Main Street’s NAV per share has seen periodic volatility, especially during recessions and more recently the oil crash (which decreased the value of its energy related investments), in general the book value of the company (dark green line) has been rising steadily.
Source: Main Street Capital Investor Presentation
This is in contrast to most other BDCs, which have external management structures that provide incentives for management teams to grow their portfolios’ size at almost any cost, even if it requires funding this growth by excessively diluting their shareholders with equity offerings.

Since BDCs have to pay out 90% of taxable income as dividends by law to avoid paying taxes at the corporate level, they can’t retain much cash flow to fund growth. Therefore, they rely on external debt and equity markets to supply growth capital.

However, by law the maximum amount of leverage BDCs can have is 1:1, meaning that they can only borrow $1 in debt for each $1 in assets. As a result, BDCs are frequently selling new shares to raise growth capital and make new loans.

The danger with this model is that each new share is like a perpetual bond, raising the cost of the company's dividend and making it harder to secure and grow the existing payout over time. When combined with the industry's meaningful use of leverage, lower quality borrowers, and sensitivity to the economy, it's no wonder why the BDC industry can be such a challenging one to do well in over time.

Investors need to be very selective, trusting their hard-earned money only to management teams that don’t have incentives to grow the BDC (and their management fees) at the expense of shareholders.

One way investors can identify such firms is to carefully watch the long-term trend in NAV per share (i.e. a rough estimate of the intrinsic value of the BDC’s shares), which should rise over time if the company is being disciplined in the loans it chooses to make.

Not only does Main Street’s track record show that management has its interests aligned with those of regular investors (as does the steadily growing dividend over time), but Main Street is famous for taking a long-term approach to running its business in several other ways.

First, Main Street has always had a conservative approach to debt. For example, the company's net debt / equity ratio routinely sits below 0.7, far below the legal limit of 1.0.

While many other BDCs would want to leverage as much as possible to increase their portfolio size (and management fees), Main Street’s safer debt levels help to lower its borrowing costs. That’s because Main Street is one of the few BDCs with an investment grade credit rating (BBB).

As a result, the company can sell bonds and gain access to low-cost credit facilities at much lower interest rates. Main Street can more easily gain approval for SBIC (Small Business Investment Companies) loans as well, which further provide it with low interest capital.

Main Street’s combination of lower borrowing costs and lower operating costs (from its internally managed business structure) means that management can be far more selective with its underwriting and investments.

For example, the company’s average coupon (loan interest rate) sits between 8.5% and 12.5%, which is much lower compared to many BDCs that are making loans at 13% to 15% interest rates.

While lower interest rates may mean less investment income in the short-term, it also means that Main Street is likely making less risky loans to higher quality companies. Such conservatism will likely prove to be an advantage the next time the economy turns south and small businesses start defaulting on loans.

In addition, Main Street uses its expertise in small business management to not just lend to carefully selected clients, but also to take equity stakes and guide them towards their financial goals.

This benefits shareholders in three ways. First, it increases the value of Main Street’s brand because businesses know that Main Street isn’t just a lender, but a true business partner that can help better manage their companies.

Second, by becoming a part-owner in some of its clients, Main Street benefits from the growth and success of its clients.

When this happens, Main Street gets a larger-than-normal portion of its income from capital gains (anywhere from 10% to 40% any given year). That means more of its dividends are taxed at lower rates (0-20%) rather than ordinary income rates, which can exceed 40%.

Finally, while rising interest rates seem likely to pose a major growth challenge to most BDCs due to higher borrowing and equity costs, Main Street has made sure that it is well positioned. The company’s large amount of floating interest rate loans (70% of its debt investments) will allow it to realize an increase in net investment income as rates rise.
Source: Main Street Capital Investor Presentation
Even better, because of the lower risk profile of its portfolio book, Main Street doesn’t have to worry as much about the rising yields on its loans creating undue financial stress on its clients.

The same isn’t true for many of its externally managed rivals, which have been reaching for yield in recent years and have lower quality portfolios that are at higher risk of large defaults during the next economic downturn.

Key Risks

While Main Street Capital’s relatively conservative and disciplined management team means that it likely represents one of the best BDCs, it still comes with a high amount of risk compared to many other dividend stocks.

That’s because, while Main Street’s portfolio of loans and investments is less risky than that of most BDCs, we can’t forget that the majority of its clients are still B or BB rated companies.

In other words, the BDC industry is essentially a subprime junk bond market, resulting in higher risks of loan defaults and even bankruptcies during an economic downturn.

Now the good thing about Main Street is that as one of the oldest BDCs (the company went public in 2007), we know that management is able to guide the company through a major recession (e.g. 2008-2009).

However, while the Great Recession was very severe, it was also fairly short-lived. A more protracted downturn could result in more severe declines in DNII, as well as capital gains and dividends from its equity holdings in its clients.

This ties into the next risk, which is that Main Street’s special dividends, which are funded by capital gains and equity dividends (not DNII from loans), are a big factor in what makes Main Street’s stock so popular with many investors.

For example, while the BDC has a great track record of gradually raising the regular, monthly dividend, the steady annual special dividends have lifted the total yield to more than 7%.
Source: Main Street Capital Investor Presentation
During the next recession, those capital gains and dividends from clients will likely dry up, meaning that Main Street will likely have to cut or even eliminate its regular special dividends.

In turn, MAIN’s stock could face some pressure on its share price. Why does that matter to long-term investors who might be looking to own Main Street for many years, or even decades?

Simply put, the BDC business model requires frequent sales of new shares in order to grow the portfolio, DNII, and dividend. Main Street’s exceptional track record of disciplined and shareholder-friendly management has made it the darling of Wall Street.

In fact, Main Street has been the best performing BDC in America since its IPO, vastly outperforming its peers and the market at large.
Source: Main Street Capital Investor Presentation

As a result, MAIN’s shares trade at meaningful premium to the stock’s book value per share.

Remember how share prices tend to track book value per share over time?

Anytime a BDC can sell new shares at greater than book value, it is basically printing “free” money that automatically increases the company’s book value, and thus intrinsic value for existing shareholders.

Think of it like this. Main Street’s best-in-class leadership has so earned the trust of investors that they are willing to pay well over $1.50 today (based on the stock's premium to book value) for each $1 in new assets that the company’s freshly-issued shares represent.

That excess cash represents “free” money for management to invest on shareholders’ behalf and gives Main Street a major competitive advantage when it comes to raising profitable growth capital.

However, BDCs’ need to sell new shares does mean that Main Street, like all BDCs, is ultimately at the whims of a volatile and fickle stock market.

For example, during the 2008-2009 financial crash Main Street’s shares collapsed about 40% and its price-to-book value declined to 0.80.

In other words, during a market crash even the mighty Main Street Capital can fall into a liquidity trap in which it can’t raise equity growth capital without diluting and destroying shareholder value.

Then there’s the risk of increasing competition, which could result in falling net margin spreads. For example, the BDC industry has very low barriers to entry. Pretty much anyone who can raise $50-$100 million can start a BDC.

In a world awash in cheap capital, that has resulted in a boom in BDCs, all competing for a limited number of high quality investment opportunities.

Two negative trends for the industry have developed. First, the coupon yields on higher quality loans, those of lower-risk companies and first lien loans (those secured by valuable assets that can be sold to recoup losses in case of default), have declined due to rising competition.

In turn, this has caused many BDCs to go out further on the yield/risk curve, lending at increasingly competitive interest rates and with less secured loans to riskier companies.

However, as with all distressed debt, this approach is highly risky and almost sure to end in higher long-term cash flow volatility whenever the next recession ends up resulting in soaring default rates and substantial loan losses.

Fortunately, Main Street’s low-cost business model, diversification, and disciplined underwriting and investment approach have largely kept it out of this highly dangerous trend. In fact, of its roughly 200 investments, only six are on non-accrual (default) status, representing just 0.4% of its portfolio value.

Finally, we can’t forget that the factors that created this recent golden age of BDCs (e.g. low interest rates, banking regulations that prevented competition from major banks, slow but steady and protracted economic growth) could change in a hurry.

While a recession could end up devastating many of the lower quality BDCs, banking deregulation could once more allow large banks to lend to the middle market. Such a development would only put further pressure on the profitability of the industry, even best-in-class BDCs like Main Street Capital.

Closing Thoughts on Main Street Capital

As long as you understand that all BDCs are relatively higher risk stocks due to their subprime lending business model and reliance on external capital markets, then Main Street Capital can make for a reasonable addition to consider for a diversified dividend portfolio.

After all, Main Street’s long-term future is arguably among the brightest of any BDC in America. Such optimism appears to be supported by the firm’s numerous competitive advantages, which include one of the most experienced, shareholder-friendly and disciplined management teams; a low-cost business model; a well-diversified investment portfolio; and an unbeatable track record that has resulted in access to cheap equity capital.

That being said, conservative investors must appreciate the cyclical nature of this industry, in which investment income comes in booms and busts based on the strength of the economy. The company’s relatively high payout ratio, meaningful financial leverage, and dependence on capital markets increase dividend risk during downturns, so any position in Main Street should be sized appropriately.

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