Main Street Capital Corporation (MAIN) Q1 2015 Earnings Report, Transcript and Summary

Greetings, and welcome to the Main Street Capital Corporation's First Quarter 2015 Earnings Conference Call. [Operator Instructions] As a reminder, this conference is being recorded. I would now like to turn the conference over to your host, Ms. Jenny Zhou. Thank you. You may begin.

Thank you, Melissa, and good morning, everyone. Thanks for joining us for the Main Street Capital Corporation first quarter 2015 earnings conference call. Joining me today on the call are Chairman, President and CEO, Vince Foster; Chief Operating Officer, Dwayne Hyzak; and Chief Financial Officer, Brent Smith. Main Street issued a press release yesterday afternoon that details the company's first quarter 2015 financial and operating results. This document is available on the Investor Relations section of the company's website at mainstreetcapital.com. A replay of today's call will be available beginning about an hour after the completion of the call and will remain available until May 15. Information on how to access the replay is included in yesterday's press release. We also advise you that this conference call is being broadcast live through an Internet webcast that can be accessed on the company's webpage. Please note that information reported on this call speaks only of today, May 8, 2015, and therefore, you're advised that time-sensitive information may no longer be accurate at the time of any replay listening. Our conference call today 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 and similar expressions. These statements are based on management's estimates, assumptions and projections as of the date of this call, and they are not 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 and distributable net realized 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 have not been independently verified. And now, we'll turn the call over to Vince.

Thanks, Jenny, and thank you all for joining us today. I will comment on our performance of our investment portfolio, discuss our recent dividend announcements and conclude by commenting on our investment pipeline. Following my comments, Dwayne and Brent will cover our operating performance in more detail and comment on our first quarter financial results and originations, recent announcements, our current liquidity position and certain key portfolio statistics. After which, we will take your questions. We were pleased with our overall performance in the first quarter. Our lower middle market investments are a key focus area, appreciated by $3.8 million on a net basis, with 22 of our investments appreciating during the quarter and 13 depreciating. Our middle market loans appreciated by $1.6 million during the quarter on a net basis, and our private loans depreciated by $3.1 million during the quarter. Lastly, our investment in our External Investment Manager and our other investment assets appreciated by $9.7 million during the quarter. We finished the quarter with a net asset value per share of $21.87, a sequential increase of $1.02 per share over the fourth quarter. Our lower middle market companies with nearly $90 million of cash on their balance sheets collectively continue to exhibit highly conservative leverage ratios, which Dwayne will cover in greater detail. Earlier this week, our board declared our regular monthly dividends through the third calendar quarter of $0.175 a share in each of July, August and September. This represents an increase of 6% over the monthly payout of $0.165 a share in the third quarter of last year. On April 22, we declared our midyear, semiannual supplemental dividend of $0.275 a share, consistent with our year-end 2014 distribution. We continue to expect that we will pay semiannual supplemental dividends in addition to our regular monthly dividends as long as we are in a significant undistributed taxable income position. We began the second quarter of 2015 in roughly the same strong undistributed taxable income position we enjoyed at the end of calendar year '14. We therefore anticipate asking our board to declare a semiannual supplemental dividend payable in December in the range of $0.25 to $0.30 a share. As of today, I characterized our investment pipeline as average. With a large or lower middle market opportunities we are evaluating, we are seeing elevated transaction multiples being both expected and obtained by sellers. This is both an unfavorable trend from a new investment perspective and also a favorable trend from an existing investment perspective. We continue to seek and receive significant equity participation in our lower middle market investments and as of quarter end, we owned an average of a 36% fully diluted equity ownership position in the 94% of these investments in which we currently have equity exposure. Our officer director group has continued to be regular purchases of our shares, investing approximately $0.5 million during the first quarter. With that, I'd like to turn the call over to Dwayne Hyzak, our Chief Operating Officer and Senior Managing Director, to cover our portfolio performance in more detail.

Thanks, Vince, and good morning, everyone. We are pleased to report a good start to 2015 with another quarter during which our investment portfolio and operating structure allowed us to generate distributable net investment income in excess of our recurring monthly dividends and continued growth in our net asset value per share. We believe that the primary driver of our success continues to be our focus on the underserved, lower middle market and specifically, our investment strategy of investing in both debt and equity in the lower middle market and acting as a sponsor and a partner to the management teams of our lower middle market portfolio companies and not just as a financing source. We believe that our equity ownership positions in the lower middle market companies provide significant value to our shareholders. These investments are the primary driver behind our significant, pretax net unrealized appreciation of approximately $2.80 per share in our lower middle market portfolio as well as our historical net asset value per share growth. These equity investments also support growth in our realized income and therefore, the total dividend we pay our shareholders through the dividend income that we receive from these equity investments and the periodic gains realized upon the equity, the exit of these equity investments. In addition, the unrealized depreciation and realized gains from these equity investments provide an offset against the potential credit losses that may be experienced by anyone investing in non-investment-grade debt securities. We are pleased that since the end of the first quarter, we have already announced another favorable exit of one of our long-term, lower middle market investments. And as discussed on prior calls, we always have some level of exit activity and profit among our portfolio companies given the nature of our growing and diversified lower middle market portfolio of 68 companies. Now turning specifically to our investment portfolio. At quarter end and our investment activity in the first quarter, we're pleased to report that our overall portfolio performance remains strong, and the portfolio continues to improve its diversification each quarter, by issuer, industry, end markets, geography and vintage. Our investment activity in the first quarter included total investments in our lower middle market portfolio of approximately $47 million, primarily, as a result of our investments in 2 new portfolio companies, which, after aggregate repayments on debt investments and return on invested equity capital, resulted in a net increase in our lower middle market portfolio of approximately $40 million. We also had a net increase in our private loan portfolio of approximately $37 million and a net increase in our middle market portfolio of approximately $82 million, as we work to temporarily deploy the proceeds of our successful March equity offering. As a result, at March 31, our investment portfolio continues to be very diversified, with investments in 194 companies that are diversified across more than 50 different industries across our lower middle market, middle market and private loan portfolios. The largest portfolio company investment is approximately 2.7% of our total investment income and approximately 2.2% of our total portfolio. And the vast majority of our portfolio investments represent less than 1% of our income and our assets. We believe that the diversification of our investment portfolio continues to improve as we grow the portfolio. And we believe that this diversification provides significant protections to our investment income and cash flows and provides significant benefits to our shareholders. Additional details on our investment portfolio at quarter end are included in the press release that we issued yesterday, but I'll touch on a few highlights. Our lower middle market portfolio included investments in 68 companies at quarter end, representing approximately $778 million of fair value, which is greater than 21% above the cost basis. Consistent with our investment strategy, approximately 70% of our lower middle market portfolio at cost was in the form of secured debt investments, and approximately 90% of those debt investments held a first-lien security position. As Vince mentioned, we hold equity positions in 94% of our lower middle market portfolio companies with an average fully diluted equity ownership position of approximately 36%. I would characterize the bulk of our lower middle market portfolio as seasoned, as we have been in the majority of these investments for at least 2 years and in many cases, were significantly longer. The seasoned nature of our lower middle market portfolio is reflected in a deleveraged or lower risk position for many of these investments and an expanding list of equity investments with growing, unrealized appreciation. At the lower middle market portfolio level, the portfolio's median net senior debt-to-EBITDA ratio was 2.0:1 or 2.4:1, including portfolio company debt, which is junior in priority to our debt position. At March 31, our lower middle market equity investments had a fair value that was approximately 1.9x their cost basis, reflecting over $137 million of net unrealized appreciation. As a complement to our lower middle market portfolio, in our middle market portfolio, we had investments in 89 companies, representing approximately $628 million of fair value. And in our private loan portfolio, we had investments in 37 companies, representing approximately $248 million of fair value. Our middle market and private loan investments provide significant portfolio diversification and generate additional net investment income to fund our dividends. The total investment portfolio at fair value at March 31 was approximately 109% of the related cost basis, and we had 5 portfolio investments on non-accrual status, which comprise of approximately 1.2% of the total investment portfolio at fair value and 3.9% at cost, representing slight improvements over the non-accrual stats at year end. In summary, Main Street's investment portfolio continues to perform at a high level and continues to deliver upon our long-term goals of sustaining and growing our dividends as well as generating meaningful growth in our net asset value per share. With that, I will now turn the call over to Brent to cover our financial results and liquidity position.

Thanks, Dwayne. We are pleased to report that our total investment income increased by 21% for the first quarter over the same period in 2014 to $37.2 million for the quarter. The increase is primarily driven by increased interest income of approximately $4.3 million associated with higher levels of debt investments, increased dividend income of $1.1 million from equity investments and increased fee income of $0.8 million when compared to the prior year. The increase is also net of a $8.6 million decrease in investment income related to accelerated prepayment and repricing activity compared to the first quarter of 2014. First quarter 2015 operating expenses, excluding non-cash, share-based compensation expense, increased by $3.2 million over the first quarter of the prior year to a total of $12.4 million. The increase is primarily the result of a $2.5 million increase in interest expense due to issuance of our investment-grade notes in November 2014, and approximately $1 million relating to compensation. These increases were partially offset by an increase of $0.5 million in the cost allocated to our external investment manager. The ratio of our total operating expenses, excluding interest expense as a percentage of our average total assets, which we believe is a key metric in evaluating operating efficiency was 1.4% on an annualized basis for the first quarter and continues to compare very favorably to other BDCs. Our increased total investment income and continued leverage of our internally managed operating structure, resulted in 15% increase in distributable net investment income for the first quarter of 2015 to a total of $24.8 million or $0.54 per share, exceeding our recurring monthly dividends paid for the quarter by over 5%. The short-term dilutive impact of our March follow-on equity offering, which increased our operating shares by approximately 10%, was approximately $0.01 per share for the first quarter. Our External Investment Manager's relationship with the HMS Income Fund benefited our net investment income by $1.2 million in the first quarter of 2015 through a $0.8 million reduction of our operating expenses for expenses we charged to the External Investment Manager for services we provided to it and $0.4 million of dividend income from the External Investment Manager. Based on the HMS Income Fund's current fund-raising efforts and activities, we currently projected that this relationship will contribute approximately $0.03 per share of net investment income per quarter during the remainder of 2015. We recorded a net realized loss of $2.1 million during the first quarter, primarily relating to the restructuring of a middle market debt investment. And as Vince discussed, we recorded net unrealized appreciation on investment portfolio of $12 million in the first quarter, primarily relating to $3.8 million our lower middle market portfolio and $9.3 million relating to our External Investment Manager, partially offset by unrealized depreciation on our private loan portfolio. Additional details for the change in our net unrealized depreciation can be found in our earnings release. Our operating results for the first quarter of 2015 resulted in a 30% increase in net increase in net assets of $35.4 million or $0.77 per share. On the capital resources front, our liquidity and overall capitalization remains strong. We completed an equity offering in March through which we received net proceeds of approximately $128 million. We were also pleased to achieve an improved economics in the offering by significantly lowering the all-in discount when compared to our equity offering at April of 2014. At the end of the first quarter, we had $22 million of cash, $9.9 million of marketable securities and $408.5 million of unused capacity under our credit facility. Today, we have $16.8 million of cash, $9.3 million of marketable securities and $400.5 million of unused capacity under our credit facility, including the recent $25 million increase in commitments from one of our existing lenders. As we look forward to the second quarter of 2015, we currently expect that we will generate second quarter 2015 distributable net investment income of $0.55 to $0.57 per share. This estimate is $0.025 to $0.045 per share above our previously announced dividends for the first quarter of $0.525 per share. In addition, we want to provide guidance on the expected per-share difference between our distributable net investment income and net investment income for the second quarter. We currently expect the difference to be approximately $0.03 or $0.04 per share per quarter for the remainder of 2015. With that, I will now turn the call back over to the operator so we can take any questions.

[Operator Instructions] Our first question comes from the line of Bryce Rowe with Robert W. Baird. Bryce W. Rowe - Robert W. Baird & Co. Incorporated, Research Division: Vince, just wanted to follow up on your comments about higher leverage multiples being paid in the market right now. Does that change your appetite to -- from a portfolio perspective in terms of adding new investments?

Yes. Bryce, just to clarify, we're just seeing higher transaction multiples, so that might lead to a higher leverage multiples. We're seeing higher transaction multiples. And for the first time in my career, we're seeing -- and it's really kind of 2 types of transactions we're seeing, receive elevated multiples. The first type is -- and I'm talking about a lower middle market of $3 million to $15 million EBITDA area code. Anywhere in that area code, if you have a software as a service-type company that is growing and has a lot of promise, we're now seeing multiples, double-digit multiples or even mid-teen multiples for those kind of companies, which we've never seen before. And I do not know, Dwayne works in that area more than I do. But that seems to be the kind of a recent phenomenon, maybe going all the way back to the 2000 era.

That's right.

And so, we're-- our approach there would generally be to not be investing at that elevated level. We might be selling at that elevated level but we wouldn't be investing. And then, the other thing, the other kind of component of lower middle market that's seeing elevated multiples is the $10 million to $15 million EBITDA of companies. They won't even have to be that particularly attractive or in particularly attractive industries, but it's not unusual to see those go for close to a double-digit multiple as well in a competitive option. And again, we would tend to not transact. And so, our approach has been to be unaggressive there. But what you'll see is, in terms of new investments, we just -- it won't be populated by companies from those, in those categories. Dwayne, would you add anything to that?

No, I think you covered it. Bryce W. Rowe - Robert W. Baird & Co. Incorporated, Research Division: Okay. And then I guess, follow-up question to that. Does the private loan portfolio continues to grow at a fairly consistent clip every quarter? Just curious, is there a particular ceiling in terms of how big you want that portfolio to get or how big in absolute or percentage terms as a percentage of the overall investment portfolio?

Bryce, I think when you look at the private loan portfolio, if we can find attractive investments on a risk-reward relationship in that portfolio and do that in lieu of doing larger, middle market investment, we would do that as much as possible. It's just difficult some of the lower middle market portfolios finding those investments on a continuous basis. We formed some relationships over the last 12 to 24 months that have facilitated the growth of that portfolio. And to the extent we can continue to find those, we will continue to grow that as much as possible or as much as prudent based upon the attractiveness of the investment opportunities that we see.

Our next question comes from the line of Robert Dodd with Raymond James. Robert J. Dodd - Raymond James & Associates, Inc., Research Division: Kind of following on from Bryce's question, what do you think of the appetite -- I mean, talking about higher multiples, et cetera, and I'm potentially being a seller, I mean, when you look at the lower middle market guys, and obviously, in general, it's the business owner who's making the sell-no-sell decision rather than you guys. So I mean what's the appetite right now do you think in, not just in those particular subsectors you mentioned, but broadly, I mean, are your partners becoming more inclined to sell as multiples expand and we're hearing indications of private equity activities like you thought to ramp up in the second half of the year? I mean, can you give us any more color there?

Yes. I mean, obviously, when we see elevated multiples, we would have more of an inclination to sell than management. Remember with the earlier step, we're on average were a 36% equity holder. It's really not our decision. And as Dwayne point out, we really do want to partner with management. So what we typically find is, we're more inclined to sell prior to them being inclined to sell. It could -- we could be several years apart on that. But when you introduce elevated multiples, highly elevated multiples, then I think most of the management team -- most management teams that we work with would seriously consider a transaction. We're starting to see that now.

Yes, the only thing I would add, Robert, to the point is that when you look at our ownership of our companies, and I think, we've touched on this in prior calls, we are typically the only institutional investors. So just like prior to our investment, there may be other shareholders that, for some reason, based upon life on their side, health retirement or something else, want to seek liquidity. And if it's in a business that has attracted valuation, as opposed to us being able to just negotiate a transaction, what we and the other shareholders might opt, that one shareholder that may want to retire, just from a fiduciary standpoint the company may look at marketing the company, and as a result of that, get attractive elevation multiples, in which case, all the shareholders take a look at, do they want to exit or some liquidity as opposed to keeping 100% of their equity ownership part of their process.

It's one of the problems with the low interest rate environment. It can result in higher multiples being offered. But in addition, if you're the seller and you're going to live off the income, you need a high multiple to replace the operating earnings. So that's probably a better reason for some reluctance on the part of companies historically to want to sell at moderately high multiples. But now we're seeing very high multiples. So let's see what happens. Robert J. Dodd - Raymond James & Associates, Inc., Research Division: Okay, got it. Great. Tricky. On the just energy and not energy, I mean the secondary effects, I mean, obviously, you got a decent exposure to Southwest Texas, et cetera. Are you seeing, beginning to see more broadly, secondary effects from the lower energy prices, beyond the obvious directly energy exposed assets?

I think you're hearing people talk about it, but we're not really seeing it in the numbers. And it's as miserable to drive around Houston now as it has been in 15 years in terms of the traffic and infrastructure and everything else. So it's probably coming, if you have sustained depressed energy prices. But I'm not sure we've really seen it.

Our next question comes from the line of Vernon Plack with BB&T Capital Markets. Vernon C. Plack - BB&T Capital Markets, Research Division: Vince, I was looking for some of your thoughts on there's been some more talk recently on increasing the SBA limit as well as potentially allowing BDC to go to 2:1. And I would think that you would want to take advantage of the SBA limit if that goes up. But outside of that, let's say, that the regulations now lets you go to 2:1 in terms of leverage outside of SBA, I'm curious in terms of your thoughts on what's the ideal mix for you, and obviously, gives you more flexibility? But just wondering what this would mean, if in fact it is passed.

Right. So what I think, Vernon, we're going to have a very straightforward approach with respect to that, and that is, that we really want to retain our investment-grade rating. And so, we're going to be looking to the rating agencies, and right now, it's S&P from our perspective, to gauge their reaction, if any, to this. And I don't think they're going to necessarily have a reaction in the short term. We've targeted 75% leverage relative to the 100 max. Inclusive of SBA, they currently don't view SBA as any different than any other leverage, rightly or wrongly. And I don't believe that there's -- in that 75%, I think was a key component in getting our investment grade. And so, if we were to take that up, I think we'd risk losing it, whether there's legislation or not. And so, we see the legislation as a non-event, unless for some reason the rating agencies adopt a different view and use some different metrics, et cetera, which, if you look at the criteria, heavily. Brent, did Fitch just come out with some criteria as well?

S&P has clarified their criteria and S&P kind of threw out that they'd prefer you to be at 0.85 or below. I mean, they have all in 1.5x debt to adjusted equity. But that's like their maximum. We're well within their recognized...

So [indiscernible] rate from operation. We're just going to be guided by them. We think long term retaining that rating and possibly enhancing it if possible, is going to serve all of our investors' interest more than trying to maximize leverage. Vernon C. Plack - BB&T Capital Markets, Research Division: Okay. And then all-in number 1.5, that by all in, you mean including the SBA. Is that correct?

Yes. It's a particular S&P calculation, where they take your equity value but they back out any unrealized appreciation. So it's their own internal metric that is their absolute limit for anyone. But then, they have the sublimit, so to speak, of 0.85, et cetera.

And we don't -- we'd love to see the modernization, the BDC modernization legislation passed because there's a lot of things in it that everyone agrees with, aside from the enhanced leverage. And so, we work closely with SBIA, our industry association. Dwayne was just up for a fly in. In fact, he met with Senator Vitter, who chairs the Senate's Small Business committee. And so, we're lobbying hard on both fronts. So we'd love for the higher levers to get dropped, if that's what it took to get the rest of the modernization passed or would advocate 2 different bills, one that everyone could agree with and then you go to work on the other one. Vernon C. Plack - BB&T Capital Markets, Research Division: Do you think that's the real sticking point that you increased -- the thought of increasing the leverage at 2:1?

Yes. And what the industry association believes is -- I mean, here is the problem. If you were to do that, you're changing the rules retroactively with respect to existing investors. So you'd have to allow existing investors time to move out of the investment. If they didn't sign up for hard rights. So how long is that? Is that a year or is that 2 years? That can be done. And maybe, you make it subject to a shareholder vote. All that is fine. But when you get into the non-listed structures, how do those investors move out, right? If you all give them put rights, then you could force the structures to liquidate. That doesn't seem to be a real elegant solution there. And I think that's what our industry association is struggling with is, whoever had the concern, if we need to allow the existing investors to move out, there may be -- I don't remember. I don't know where that came from. It sounds reasonable. There hasn't been an acceptable way to address that, when you look at all the constituents. And I think that's one of the principal things that's holding it up. And we don't see a solution near term. Vernon C. Plack - BB&T Capital Markets, Research Division: What's the likelihood that you think that you will see either of these pieces of legislation passed in 2015?

Dwayne came back and said, "The SBA looks good and the BDC doesn't." And I think if we're going to get something done on the SBA front, we have the ideal situation up there right now absent the fact that the chambers don't work particularly well together. There seem to be some momentum there. I think there's a mark-up session coming up next week on the Senate side I believe. There isn't anywhere near that type of momentum on the BDC front. If you were to handicap it and you'd say maybe it's 50-50 or higher for SBA and it's slower than that for BDC.

[Operator Instructions] Our next question comes from the line of Christopher Nolan with MLV & Co. Christopher Nolan - MLV & Co LLC, Research Division: Vince, any update you can provide on the alternative strategy that you guys have discussed in recent calls?

Yes. We continue to focus on it. And we're focusing a lot of effort on trying to stay ahead of any regulatory pushback that may result -- may or may not result from some of the existing kind of senior loan structures you see out there. I don't think we'd be inclined to use one of the existing senior loan structures, senior loan fund structures, based on kind of what we're hearing anecdotally from the regulators. So we're trying to make sure that whatever structure we come up with, everyone's highly comfortable with, because the last thing anyone needs is have to undo or restate or something like that. So we've -- and I think, we'll probably come up with something. Christopher Nolan - MLV & Co LLC, Research Division: Great. And excuse me if I missed this in your comments earlier, but what is your sort outlook for gains? Because on one hand, you're talking about a higher multiple in the lower middle market, but on the other hand, you're thinking about potential slowdown in the oil patch, which counts roughly a third of your portfolio.

Yes. I don't think it's a third.

When you look at the oil and gas exposure, it's a low teen number. It has 11% or so, when you look at the portfolio. So it's not as significant as you referenced there. And I think in our comments and we've stated this on prior calls, given the fact that we've got 68 different companies in the lower middle market portfolio, and each of those companies' dealing with its own particular circumstances, there's always some level of exit activity. We have a couple of that are in kind of mature stages of exit activities. And then we have others that are, at least on some level, exploring it. But just like we did earlier this quarter to the extent we get to an exit, we'll announce it. So outside of that, there's not really much to update. I think, if you look at gains from the standpoint not just the realized but also unrealized, we, in this quarter, show continued appreciation. And while the oil and gas impact will have a negative impact, particularly on those investments that are in this space, we think that, that impact will hopefully continue to be offset by the other 90% of the portfolio that does not have direct exposure to the oil and gas space, similar to what it did in the first quarter.

I was going to say, so just to clarify Dwayne's comments, it's not that we're seeing more exit activity-type discussions, we're kind of seeing a normal amount. But the multiples at which those discussions are taking place, we haven't seen before. Christopher Nolan - MLV & Co LLC, Research Division: And what sort of third, your K mentioned about 30% of the portfolio seems to be in the Southwest or so? So just following up.

[indiscernible] That includes a restaurant chain in Dallas that benefits from lower energy prices because customers can get out and drive more. So I mean, we do not really look at it that way. Christopher Nolan - MLV & Co LLC, Research Division: Yes, but it also includes people can't afford their RVs, so that consignment RV place you have in Houston, is not selling as many RVs.

Actually, there are 2 RV operations are doing great. And each of which have just expanded into a new location, organically. Makes it is easier to drive an RV with lower fuel prices. Christopher Nolan - MLV & Co LLC, Research Division: It certainly does.

At this time, we've come to the end of our time for questions. I'd like to turn the floor back to management for any final remarks.

I hope -- I think we've covered everything. We thank everyone for joining, and we look forward to our next conference call this summer.