Hold On To Main Street Capital To Walk Through Interest Rate Changes Safely

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If you are not new to Main Street Capital (NYSE:MAIN) or the BDC sector, please feel free to skip the first section of this article, as it was prepared with newcomers in mind.

Let me brief you on what we have on the agenda today:

• My investment thesis (summary of what’s next to come)
• Let’s Talk Risk Before Tackling Return Potential
  • MAIN’s portfolio structure & diversification
  • The matter of rising non-accruals
  • Increased market volatility lurks behind the corner
  • Three reasons why MAIN will manage
• The Issue With MAIN
  • How’s the dividend coverage?
  • Valuation outlook
• The Bottom Line

New To MAIN? Here’s Some General Information To Get You Started

What is a BDC?

For those new to the BDC (business development company) sector, these entities help fill the financing gap for smaller or middle-market companies that often struggle with acquiring bank or public financing. The beginning of business development companies dates back to 1980 when Congress authorized BDCs as a new business form due to a substantial deficit of financing possibilities for SMEs.

However, it’s worth to realise that BDCs’ journeys didn’t really launch until late 1990s / early 2000s:

Although the regulation for BDCs was passed in 1980, the creation of these companies did not come until the late 1990s and early 2000s. Furthermore, they did not begin to gain popularity until Apollo Investment Corporation raised $930 million in three months in 2004. This ignited a stream of BDC IPOs over the years following.

Nice to meet you, MAIN – what’s your capital allocation approach?

Main Street is one of the most popular business development companies due to its outstanding track record, internally managed structure, and stable monthly dividend payments (which is an upside for some investors).

MAIN distinguishes two main investment strategies and one that the Company has also historically realised:

• (main) Lower Middle Market (LMM): secured debt and equity investments in US-based LMM businesses with revenues ranging from $10m to $150m. The investment size typically ranges from $5m to $100m
• (main) Private Loan: this segment mostly comprises debt investments to LMM or MM companies. Investment tickets typically range from $10m to $100m
• Middle Market: primarily debt investments, syndicated loans to larger entities (middle market as opposed to LMM), with revenues generally ranging from $150m to $1.5b. The average investment size is noticeably smaller than in the abovementioned strategies, as it ranges from $3m to $25m

Please review the table below for details regarding the share of the structure of the abovementioned strategies (at cost to provide an overview of MAIN’s capital allocation approach).

The Company also realises investments outside the scope of its main strategies (Other) and distinguishes the External Investment Manager segment. Both segments represented ~7% of the company’s total investments’ fair value as of June 30, 2024.

Internally managed BDC

Most of the sector representatives are externally managed, which involves paying external investment advisory fees and potential misalignments of interests. As MAIN points out itself:

Because we are internally managed, we do not pay any external investment advisory fees, but instead directly incur the operating costs associated with employing investment and portfolio management professionals. We believe that our internally managed structure provides us with a better alignment of interests between our management team and our employees and our shareholders and a beneficial operating expense structure when compared to other publicly traded and privately held investment firms which are externally managed, and our internally managed structure allows us the opportunity to leverage our noninterest operating expenses as we grow…

For instance, the Company’s ratio of total operating expenses (excl. interests) to quarterly total assets (on average) amounted to 1.3% for the TTM ending June 30, 2024.

Without Further Ado – Investment Thesis

For transparency, I am not MAIN’s shareholder, but I believe I will become one within the next couple of quarters as the market volatility resolves my main issue with MAIN – its valuation.

I have no reason not to like its business, as it has:

• great diversification (geography, sector-wise, target-wise)
• high share of first-lien debt within its debt investments
• low non-accruals
• solid dividend coverage with a strong track record that stood the test of time
• safe financing structure
• internally managed organization
• well-prepared structure for the upcoming market changes

However, MAIN trades at a significant premium to NAV. I don’t consider it a ‘sell’, and a lot would have to happen for me to do so. I’d be much closer to considering it a ‘buy’, but I believe that the upcoming quarters will provide BDC investors with some market turmoil that will allow many opportunities to emerge – that may include MAIN.

I’m a great fan of Benjamin Graham’s Mr. Market metaphor, which states (in simple words) that nothing necessarily has to change regarding the intrinsic value of the business for Mr. Market to offer you either substantially lower or higher prices. Mr. Market just needs some noise to commit to its regular ‘mood swings,’ and that’s when the opportunity emerges.

Opportunity for trading? No, not my piece of bread – I am a buy-and-hold investor who uses valuation aspects to ensure an appropriate margin of safety, which may very well differ from person to person.

To put it briefly – I don’t believe the recent (slight) pullback indicates anything going south in MAIN’s fundamentals. However, its valuation and my market expectations are enough rationales to keep my patience and wait for a possibility to initiate my position at a noticeably lower valuation. Therefore, MAIN is a ‘hold’ for me, and the switch to ‘buy’ lies solely within its valuation, thus potentially – Mr. Market’s mood swings.

Let’s Talk Risk Before Tackling Return Potential

MAIN’s portfolio structure by investment type

As indicated earlier, MAIN’s investments are primarily debt investments with a defensive approach, as most are first-lien debt. First-lien debt investments come with a higher payment priority in the case of the target company’s liquidation. Please review the basic ‘risk by investment type’ summary in the graphic below for reference.

On the riskier side of its portfolio, MAIN has 27% of its total investments at fair value engaged in equity, 0.2% in second-lien debt, 0.2% in equity warrants, and 0.2% in other types of investments.

For those concerned with a noticeable share of equity investments and their riskier nature, some factors limit the risk accompanying these investments. For instance:

• 64% of equity investment businesses in the LMM portfolio pay dividends
• potential interest rate cuts will give these businesses some breath and incentivize them to undertake more investment activities, leading to more dynamic growth
• MAIN takes good care of its margin of safety, as the entry levels range from 4.5x to 6.5x EV/EBITDA, which is a very conservative approach not only from the stock market perspective but also from the private transactional market (speaking from my M&A practice)

Diversification is key

MAIN’s portfolio is highly diversified from various perspectives:

• target company size
• target company share in total investments
• target company industry
• target company geography

As of June 2024, its primary investment strategies included 83 portfolio companies for LMM, 92 for Private Loan, and 19 for Middle Market. Not keeping all eggs in one basket is public knowledge, and MAIN has done its homework.

The Company didn’t have any investment, accounting for over 3.3% of its assets’ fair value, and its Top 1 sector had a share of 8.4% at fair value. Its capital was ‘fairly’ distributed across the US.

Non-accruals are rising – according to expectations

What are the expectations I’m referring to? Let me quote the comment of Ares Capital’s (ARCC) management shared during the Q4 2023 Earnings Call, as I believe that it painted a clear picture on this matter:

We’ve said this in the past that we’re likely to see defaults in the industry just increased this year. It does take a little bit of time for that to manifest itself, right? So in the bottom quartile of our portfolio and probably everybody else is, you have some companies that are making interest payments but continue to live off revolver availability, cash, et cetera, but the liquidity is getting tighter and tighter.

And so my expectation is that the fall will go up this year, probably more towards the historical norm. We’ve had a little bit of amendment activity that’s elevated; I think others probably have two but nothing that’s causing us a whole lot of concern. I think it’s just a regular letting out as obviously rates are higher and companies have higher debt service costs and all that. But generally, I think we’ll see that as well others.

MAIN’s non-accruals represented 1.2% of its portfolio fair value as of June 2024 (3.6% at cost), which was noticeably higher than 0.6% recorded at year-end 2023 (2.3% at cost). However, these are still relatively small percentages, and I am not overly concerned with them or their increases. Nevertheless, investors should remember that there are more defensive BDCs with significantly lower non-accruals. For instance, Blackstone Secured Lending (BXSL), which is one of the best-prepared and defensive BDCs out there (in my taste), recorded 0.2% non-accruals at fair value (0.3% at cost).

Increased market volatility lurks behind the corner

There’s one more thing to consider, apart from rising non-accruals, when discussing the potentially upcoming market uncertainty surrounding the BDC sector – the interest rate environment.

Most BDCs rely primarily on debt investments (which is also the case for MAIN), which are typically structured through a floating interest rate, they benefited while the interest rates were on the rise, as it positively impacted their income.

That may raise concerns across investors, even regarding MAIN, in light of the market expecting a 100% chance for the interest rate cut in September, followed by another easing policy leading to a substantially lower interest rate environment by the end of July 2025:

However, that is not entirely the case for MAIN, as the potential interest rate cuts will have a limited negative impact on its business due to a few factors:

Firstly, unlike many other BDCs, MAIN’s debt investments aren’t close or even 100% constructed through a floating interest rate. While 97% of its Private Loan debt investments have a floating rate component, as well as 81% of MM investments that still don’t make a significant share of its portfolio, the strength lies within LMM investments. As MAIN’s management indicated during the Q4 2023 Earnings Call:

we have historically and continue to view our position to be a little less sensitive than other BDCs as purely attributable to the fact that our lower middle market strategy is predominately fixed rate as opposed to floating whereas most the spaces as you know is a 100% if not 100% or close to 100% floating.

That adds up to 66% of MAIN’s debt investments bearing a floating rate component, which is a substantially lower share than investors may typically see in most BDCs. Moreover, most of them are subject to certain floors that protect MAIN from significant, dynamic interest rate cuts.

Secondly, ~28% of MAIN’s outstanding debt bears a floating interest rate. Therefore, a potential decrease in interest rates would offset the decrease in investment income through the decrease in interest expenses (to some degree).

Through the combination of the above factors, MAIN prepared a brief analysis of the interest rate sensitivity ranging from a 100 bps decrease to a 100 bps increase:

We will get back to that while talking about dividends, but before we do that – let’s not forget about another factor that will likely accompany a market environment of decreasing interest rates.

Thirdly, as interest rates rose, the cost of capital for investment vehicles increased. For example, many REITs reduced their investment activity due to the high interest-rate environment, which led to a relatively wide gap between buyers’ and sellers’ expectations, reducing transactional market activity. The opposite will likely happen with the decreasing interest rate environment, leading to potentially more intensive deal sourcing and a better investment pipeline.

Gradually Approaching The Issue With MAIN

We do this for income

BDCs generally have riskier investing characteristics; however, they also offer a reward as high-yielding investments. Considering the risks discussed earlier, let’s examine MAIN’s dividend coverage.

Two perspectives:

• regular dividend coverage (DPS) ranged from 60.3% to 67.3% during Q2 2023 – Q2 2024
• total dividend coverage (DPS + Special DPS) ranged from 80.4% to 95.3%

Both perspectives are calculated by referring to Distributable Net Investment Income (DNII). Please review the chart below for details.

What would happen if the interest rates were 100 bps lower? According to the table I discussed earlier, MAIN’s NII would decrease by $0.17 per share (without accounting for potentially improved deal flow). Under such assumptions, the regular DPS coverage would range from 70% to 80% during the same period, while the supplemental dividend would be endangered (probably lowered), as its coverage would often exceed 100% of DNII.

Another thing to consider is even more substantial interest rate cuts. Still, overall – I believe MAIN’s dividends (even just regular DPS) are not only attractive but also well-covered and time-tested.

There’s the issue – valuation

When I look at such a high-yielding business, I don’t require much capital appreciation (if at all). Still, I am a total return-oriented investor who takes the valuation into account, even in the case of high-yielders.

Why? As mentioned earlier, it’s a matter of margin of safety. While I am not concerned with MAIN’s regular dividend payments, even with substantial interest rate cuts, I can’t consider its valuation attractive.

As of June 30, 2024, the Company recorded $29.80 NAV per share, constituting a ~65% premium (at current prices), which is very high compared to other leading BDCs.

Although the Company has a history of trading at a premium to BV, which reflects its high quality and esteem among investors, there were some opportunities to build a position at a significantly lower premium.

The Bottom Line

One can’t deny the quality of MAIN’s business, and its well-prepared structure (relative to most BDCs) for the upcoming shifts in the market environment. The Company showcases:

• limited sensitivity to interest rate cuts
• safe financing structure
• still low non-accruals
• great diversification
• ‘sleep sound’ regular dividend coverage

There’s one issue stopping me from buying MAIN – its significant premium to NAV, making the business too pricey from my perspective. I don’t consider it a ‘sell’, and a lot would have to happen for me to do so. I’d be much closer to considering it a ‘buy’, but I believe that the upcoming quarters will provide BDC investors with some market turmoil that will allow many opportunities to emerge – that may include MAIN.

Therefore, MAIN is a ‘hold’ for me, and the switch to ‘buy’ lies solely within its valuation, thus potentially – Mr. Market’s mood swings.