Main Street Capital Corporation (MAIN) Q4 2019 Earnings Report, Transcript and Summary

Greetings. Welcome to the Main Street Capital Corporation Fourth Quarter Earnings Conference Call. [Operator Instructions]. It is now my pleasure to introduce your host, Zach Vaughan with Dennard Lascar Investor Relations. Thank you, Zach. You may now begin.

Thank you, operator, and good morning, everyone. Thank you for joining us for Main Street Capital Corporation's Fourth Quarter 2019 Earnings Conference Call. Main Street issued a press release yesterday afternoon, that details the company's fourth 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 March 6. Information on how to access the replay was included in yesterday's release. We also advise you that this conference call is being broadcast live through the Internet and can be accessed on the company's home page. Please note that information reported on this call speaks only as of today, February 28, 2020, 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 companies, was derived from third-party sources and has not been independently verified. And now I'll turn the call over to Main Street's CEO, Dwayne Hyzak.

Thanks, Zach, and thank you all for joining us today. Joining me for our call today with prepared comments are David Magdol, our President and Chief Investment Officer; and Brent Smith, our CFO. Also joining us for the Q&A portion of our call are Vince Foster, our Executive Chairman; and Nick Meserve, our Managing Director and Head of our Middle Market Investment Group. On today's call, I will start by providing a recap of our overall performance in the fourth quarter, and I will also comment on some current activities in our asset management business. I'll discuss our recent dividend announcement and other recent developments. And I will conclude with some remarks on our investment activities and our current investment pipeline. Following my comments, David and Brett will provide additional comments on our investment strategy, investment portfolio and financial results, after which we'll be happy to take your questions. We are pleased that for the fourth quarter and full year, we again generated distributable net investment income or DNII per share, in excess of our regular monthly dividends, exceeding the monthly dividends paid in the fourth quarter by approximately 7% and for the full year by approximately 10%. During the quarter, we continued to focus our efforts on sourcing transactions in the lower middle market that are consistent with our historical investment profile and executing against our previously stated goal of growing our private loan investment portfolio, while being highly selective with new investments in our middle market portfolio. Despite our successes in 2019, our actual results were below our stated long-term goals with an ROE, or return on equity, of 8.5%. And as a result, we executed on our core principle of maintaining alignment between our management team and our shareholders by reducing the amount of incentive cash compensation paid to our executive and senior management team when compared to prior years. We continue to believe that the advantages of our differentiated investment strategy, diversified investment portfolio, efficient operating structure and the alignment of interest with our shareholders, combined with our conservative capital structure and strong liquidity position, have us very well-positioned for long-term growth and continued future success. Over the past several months, we have taken significant steps in our ongoing efforts to organically grow our asset management business. And we expect to be in position to announce a new strategic initiative in this part of our strategy in the near future. We also continue to actively review viable acquisition opportunities as we evaluate multiple options to grow our asset management business. Earlier this week, our Board declared our second quarter 2020 regular monthly dividends of $0.205 per share payable in each of April, May and June, an amount that is unchanged from our monthly dividends for the first quarter and representing a 2.5% increase from the second quarter of prior year. Consistent with our prior practice, and as part of the execution of our plan to absorb our semiannual supplemental dividends into our regular monthly dividends, we currently expect to recommend that our Board declared a supplemental dividend payable in June of $0.23 per share, representing a decrease of $0.01 from our December 2019 dividend. We continue to expect that our dividend transition plan will take several years, with the ultimate timing and outcome of this transition, impacted by the level of our investment originations and repayments, the performance of our investment portfolio, and changes in the overall interest rate environment and the overall economy. Now turning to our investment activities in the quarter and our current investment pipeline. We completed lower middle market investments of over $36 million in the quarter, and as of today, I would characterize our lower middle market investment pipeline as significantly above average. We continue to be focused on maintaining a disciplined and selective approach to new investment opportunities, and we remain confident in our future ability to continue to originate new investments, consistent with our historical investment profile. In our comments over the last few quarters, we noted that we are experiencing increased third-party interest in a few of our existing lower middle market portfolio companies. These activities have continued, and these ongoing activities could result in additional attractive exits over the next few quarters. We also continued the successful focus of our non-lower middle market investment growth on our private loan portfolio, resulting in this portfolio growing by over $71 million on a net basis in the quarter, while our middle market portfolio decreased by over $18 million. As of today, I would characterize our private loan investment pipeline as average. And in closing, our officer and director group has continued to be regular purchasers of our shares, investing approximately $600,000 during the quarter and owning Main Street shares valued at over $143 million at quarter end. With that, I will turn the call over to David.

Thanks, Dwayne, and good morning, everyone. The year-end provides a good opportunity to look back at our history and recap the benefits of our unique investment strategy and efficient operating structure and discuss how those factors have enabled us to deliver attractive returns to our shareholders over an extended period of time. Since our IPO over 12 years ago, we have increased our monthly dividends per share by 86%, and we have declared cumulative total dividends for our shareholders of over $28 per share or 189% of our IPO price of $15 per share. As we have previously discussed, we believe that the primary drivers of our long-term success has been and continue to be our focus on investing in both debt and equity investments in the underserved lower middle market, our third-party asset management business and related economics, which directly benefit our shareholders, our industry-leading low-cost structure and the strong alignment of interest that exists between our management team and our shareholders through the meaningful stock ownership we have throughout our organization. Most notably and uniquely, our lower middle market strategy provides attractive leverage points and yields on our first-lien debt investments also allowing us to be a true partner to the management teams of our portfolio companies through our equity ownership positions. In short, we believe that we have significant downside protection through our first-lien debt investments, while still benefiting from significant upside potential with our equity investments. As a result of this strategy, in 2019, we were able to generate approximately $13 million of net realized gains and approximately $35 million of dividend income from this segment of our business. Given our success in the lower middle market, we are pleased that we continue to find attractive new investment opportunities in the market. Our ability to provide customized capital solutions for the predominantly family-owned businesses that exist in the lower middle market has been and continues to be a strong differentiator for us in the marketplace. In 2019, Main Street invested in 5 new lower middle market portfolio companies. This pace was slower than what we expect to achieve in any given annual period of time. That said, our origination volume can be lumpy in the lower middle market. And to reiterate what Dwayne mentioned in his opening remarks, as of today, we would characterize our lower middle market pipeline at significantly above average. We look forward to making press announcements in the very near future about some exciting new investments that we currently have in the final stages of completing. As a part of our constant effort to provide value to our lower middle market portfolio companies, we hosted our Fourth Annual Main Street President's Day event last fall. For those of you who may be unfamiliar with President's Day, is a Main Street hosted event, which we invite a majority of our lower middle market portfolio company leaders to share best practices, learn from each other and benefit from being part of the broader Main Street portfolio. The event continues to improve each year, and we received very positive feedback from our lower middle market portfolio company executives. Topics covered in our most recent meeting included industry-oriented workgroups, sales generation techniques, cybersecurity briefings and other timely matters that are top of mind for our portfolio company executives. 12 years ago, we could not have imagined we would be able to build this type of collaborative community event and bring such robust benefits to our portfolio companies. As a result, our portfolio companies have done business together, referred business to each other and made friendships that are invaluable. One other example of topics covered at Presidents Day is voluntary participation in a cost savings initiative that we undertook approximately 2 years ago. With our platform of 69 lower middle market companies, each can benefit from group savings in several expense categories that will be difficult for our companies to replicate on their own. Some examples include savings for travel, shipping, small parcels, and insurance. As Main Street continues to grow, we are excited to provide our lower middle market portfolio companies the opportunity to participate in this highly effective annual event. Now turning to our current investment portfolio. As of December 31, we had investments in 185 portfolio companies spanning across more than 50 different industries. Our largest portfolio company represented 5.1% of our total investment income for the year and 2.8% of our total investment portfolio fair value at year-end. The majority of our portfolio companies, investments, represent less than 1% of our income and our assets. Our lower middle market portfolio included investments in 69 companies, representing approximately $1.2 billion of fair value, which is approximately 20% above our cost basis. The contributions from our lower middle market portfolio continue to be well-diversified with 40 of the 69 lower middle market companies having unrealized appreciation at year-end and 35 of these companies contributed to our dividend income in 2019. In the past 12 months, we successfully exited 4 lower middle market companies, which generated a net realized gain of approximately $13 million. At the lower middle market portfolio level, the portfolio's median net senior debt-to-EBITDA ratio was a conservative 2.8:1 and the total EBITDA to senior interest ratio was 2.9:1. As a complement to our lower middle market portfolio, we had investments in 65 companies in our private loan portfolio, representing approximately $690 million of fair value and in our middle market portfolio, we had investments in 51 companies, representing approximately $520 million of fair value. As we have discussed on previous conference calls, given our favorable view of the lower middle market and private loan opportunities that exist today, we have primarily focused our investment activities on these segments of the business with our middle market activities focused on highly selective investments instead of a growth-oriented strategy with the intent to shrink the middle market portfolio on a relative basis compared to our lower middle market and private loan portfolios. As a result, during 2019, we increased our private loan portfolio by 33% and decreased our middle market portfolio by 6%. The total investment portfolio at fair value at year-end was approximately 107% of the related cost basis, and we had 8 investments on nonaccrual status, which equaled 1.4% of the total investment portfolio at fair value and 4.8% of cost. Additional details on our investment portfolio at year-end are included in the press release we issued yesterday. With that, I will turn the call over to Brent to cover our financial results, capital structure, and liquidity positions.

Thanks, David. We are pleased to report that our total investment income increased over the same period in 2018 to a total of $60.6 million, primarily driven by an increase in dividend income. The change in total investment income is after a decrease of $0.4 million related to lower levels of accelerated income for certain debt investments when compared to the fourth quarter of last year. The overall increase in investment income is also after the negative impact to interest income from lower LIBOR rates when compared to the fourth quarter of last year. Our operating expenses, excluding noncash share-based compensation expense, increased by $3.7 million over the same period of the prior year to a total of $18.6 million, primarily related to an increase in interest expense and an increase in compensation expense. The increase in compensation expense is primarily due to an increase in the fair value of our deferred compensation plan assets, which is an expense that is solely based on the public stock market price movement of these assets. It has no impact on our net income due to the offsetting unrealized appreciation on those same deferred compensation plan assets and a net decrease in the nonrecurring expense reduction or benefit to income that was recorded relating to the conversion of a cash bonus into a noncash restricted stock grant. The ratio of our total operating expenses, excluding interest expense as a percentage of our average total assets was 1.2% for the fourth quarter on an annualized basis and 1.4% for the full year. The combination of our unique investment strategy and leverage of our efficient operating structure resulted in distributable net investment income of $42.1 million or $0.66 per share, which exceeded our monthly dividends paid for the quarter by approximately 7%. The activities on our external investment manager benefited our net investment income by approximately $2.8 million through the allocation of $1.7 million of operating expenses for services we provided to it and $1.1 million of dividend income. We recorded a net realized loss of $0.9 million during the fourth quarter, primarily relating to the realized loss from the restructure of our middle market investment, partially offset by a realized gain related to the exit of a private loan investment. We recorded net unrealized depreciation on the investment portfolio of $23.5 million, primarily resulting from $10.8 million of net depreciation related to our middle market portfolio, $6.9 million of net depreciation on our lower middle market portfolio, $6.9 million of net depreciation on our private loan portfolio and $3 million of net depreciation on our other portfolio, partially offset by $4.2 million of appreciation relating to our external investment manager. Our operating results for the fourth quarter resulted in a net increase in net assets of $16 million or $0.25 per share. Our overall capitalization and liquidity remains strong, as our total liquidity was approaching $500 million at the end of the year. During the fourth quarter, we repaid our $175 million investment-grade notes that matured in December, and we were also very pleased to be able to increase our $250 million investment-grade debt issuance from this past April by $75 million. The additional $75 million was issued at a yield to maturity of 3.95% and brought the total issuance to $325 million, representing our first index eligible investment-grade debt deal in what we view as an important capital markets milestone. We also raised approximately $35 million in net proceeds under our ATM equity issuance program during the fourth quarter, with an average sale price of nearly $43 per share. As we look forward to our expected results for the first quarter of 2020 and taking into account the impact from the decline in LIBOR rates that occurred during 2019, which we estimate is a net -- as a negative net impact of approximately $0.04 per share in the upcoming first quarter when compared to the first quarter of last year, and taking into account our expected origination and repayment activity, we expect that we will generate distributable net investment income of $0.62 to $0.63 per share during the first quarter of 2020. This estimate is $0.005 to $0.015 per share or approximately 1% to 2% above our previously announced monthly dividends for the first quarter of $0.615 per share. With that, I will now turn the call back over to the operator so we can take any questions.

[Operator Instructions]. And our first question is from the line of Robert Dodd with Raymond James.

First, well, both questions really relate to the same thing kind of COVID-19. With -- can you give us any color on any discussions you've had with your portfolio companies, primarily on the lower middle market side, I would say? About -- not their exposure because, obviously, they're domestic companies, but their supply chain exposure? And if there's any particular areas where they do have supply chain to China, particularly if it's Hubei province? And if there's any concentration in supply chain that touches on China in any of your businesses?

Yes. Thanks, Robert. What I would say is, as you touched on, our lower middle market portfolio is largely domestic U.S.-based companies and not only the U.S.-based, most of their vendors and customers, as we talked about in the past, we're also going to be predominantly U.S.-based. We have had conversations with our portfolio companies on this topic. And I would say that the current expectation is the impact is not overly significant, definitely not as significant as you might see from the broader market or broader economy. We do expect that as the issue continues to play out and works its way through all the supply chain issues, and we will have some impact. But again, I think we look at the impact and think it will be less significant on our side than it would be for the overall economy. I think the areas where you would expect to see more impact would be areas where you've got heavy electronics. That's an area where I think we would expect to see some of the impact first. But again, I think we're in a more of a wait-and-see position until its got -- until these supply chain issues really work their way through.

Got it. I appreciate that. And then, I mean -- sort of tied to the same thing. You characterized your lower middle market pipeline significantly above average. And I mean, you said today, but that may have been last week. Do you think -- is this kind of noise you think likely to have any impact on that either increasing it? Because again, family-owned businesses maybe with time and planning or reducing it as people decide to sit on hands and kind of wait things out a little bit?

Yes. I would say it's -- again, I think it should be little bit of a wait-and-see. I would say our current pipeline, as I said in my earlier comments, is significantly above average. The pipeline today is very robust. Obviously, the impact of coronavirus and the indirect impact to supply chain is something that we have to take into consideration as we work through our due diligence processes. But I would say that the characteristics of our current pipeline is consistent with the types of companies that we've executed historically in the lower middle market. So going back to my earlier response, while it's something we have to watch, it's not something that has a significant an impact as you might see from a broader economy standpoint.

Right, right. And then if I can, one follow-up to that since it's still related to the same topic. On the potential for exits. And again, it's very early days. But have you seen anything over the last week of any of the -- typically, when there's an exit, it's either M&A, private equity, whatever somebody coming in to take, in many cases one of these businesses as an add-on or a whole variety of things? But has there been any movement on that, that you've seen so far, I mean, literally days into this but...

Yes. Today, we've not. So again, it will be interesting to see how things play out over the coming weeks. But as we sit here today, we have not seen a material impact on that front either.

The next question is coming from the line of Bryce Rowe with National Securities.

Dwayne, obviously, you highlighted the asset management initiative that you hope to talk about here in the near future. Obviously, you're probably a bit constrained in what you can say. But I am curious how comparable will that be to the HMS situation? Is it a deviation from that? And so any kind of color around that asset management initiative would be helpful?

Sure. So as you expected, Bryce, we're going to be limited on what we can say. But as we've talked about for a number of years, we've been actively looking for ways to grow our asset management business. It's a core part of our overall strategy. So I'd say the most recent progress we've made is that we worked through the process of looking at what we could do on a new private fund. So it would be different than what we would do with an HMS or if we were to do something from an M&A standpoint. From a -- from a BDC industry standpoint, it will be different from that. And I'd say we're kind of in the prelaunch stage of looking at what we can do on the private -- the new private fund that we would put in place. In terms of the goals, obviously, it's -- the goal is to grow our asset management business and to continue to diversify the funds that we manage. And I would say that the size of the opportunity will largely be dictated by what happens after we get through this prelaunch phase that we're in today.

Okay. That's helpful. And then a couple of more questions. Number one, you obviously highlighted incentive comp being down here in the fourth quarter. Could you remind us when we think about incentive comp, is there a set ROE target that you have, that really doesn't change year in, year out? Or does that fluctuate on an annual basis?

I would say, it fluctuates on an annual basis based upon what's going on in the marketplace, the overall economy and specifically in our portfolio. So I would say that's kind of on an annual -- year-to-year basis. I would say, long term, the ROE targets or goals do not move as much. So I'd say that our goals continue to be consistent with what we've given in the past. So I think long term, we expect to be in that same range from an ROE standpoint, which would be something in the 10-plus percent to mid-teens range. So I think long term, we continue to believe that we can achieve those types of ROE goals or targets. But I do think, on a year-to-year basis, you do adjust that based upon what's going on in the current time period.

Got it. Okay. And then lastly, this is kind of been an ongoing trend with the middle market portfolio, shrinking in absolute dollars and in relative and private loan growing. Is there -- is there any way to think about the middle market portfolio, will it continue to shrink? You talked about it in terms of relative there in your prepared remarks, but just curious where you kind of see that going over the next couple of years in terms of maybe absolute and relative terms?

Yes. So what I would say is, you've heard us say this before. In general, when you compare the middle market opportunities to the private loan opportunities, we believe we're seeing more attractive opportunities in the private loan space. That's largely dictated by what we believe are better terms, whether that's legal documentation or kind of legal protections or if it's the ability to be closer to the company, whether it's closer to the sponsor, closer to the management team or just closer overall to the business in terms of what you can do from an underwriting or a due diligence standpoint. So I think our position today continues to be what it's been for the last couple of years. We -- all things being equal, we favor the private loan opportunities above the middle market. That being said, as you've also heard us say in the past, to the extent we see good opportunities in the middle market, and we feel like there's acceptable terms, whether it's legal docs or otherwise, you'll continue to see us take opportunities as they come up in the middle market. But in general, you'll continue to see us move more towards the private loan opportunities and away from the middle market opportunities.

[Operator Instructions]. The next question will be coming from the line of Kenneth Lee with RBC Capital Markets.

Just want to get your sense if you have any updated thoughts on expectations for leverage over the near-term under the current conditions?

Yes, this is Brent. I'll take that question. We ended the year on a total debt-to-equity at 0.73x and on a regulatory basis, just over 0.5x. So consistent with our historical track record, we're maintaining a conservative leverage profile. I believe that our intent is certainly to maintain that going forward. We don't have any initiative to significantly increase leverage as we move forward. And I think it's prudent to do so given the uncertain economic environment.

Okay, very helpful. And just 1 follow-up, if I may. Just on the funding costs, and I saw that you recently issued some notes, and just given the current interest rate levels, do you expect any further changes in terms of your funding mix going forward?

I would say, generally, not. I think 1 thing we'll probably do is utilize revolver a little bit more in 2020. If you recall, when we did the investment-grade notes offering in the first one in April of last year, we used those proceeds to repay the revolver. So on the whole, or on the balance of 2019, we had a lower revolver balance than we typically do. So I'd expect to have a higher revolver balance, which I think will be good to have some more variable rate -- a floating rate debt obligations out there. But generally speaking, we expect to maintain conservative -- the leverage profile and a mix of the debt and equity going forward.

Our next question is a follow-up from the line of Robert Dodd with Raymond James.

Yes, just a follow-up. On the asset management business, I mean, just -- and again, you can't say much, but would you expect the accounting treatment to be the same? Hypothetically, if you're getting fees from that, would it show up as dividend and then a cost offset kind of a kin to HMS? Or would there be some -- is there something about the contemplated structure that would differ from that kind of treatment?

Yes, Robert, I would expect that the benefit to Main Street, and the goal we have is really to grow that asset management business, and it would come in the form to us from a benefit standpoint, largely through the asset management fees similar or consistent to what we receive on the HMS front.

Thank you. This will conclude our question-and-answer session. And I'll turn the call back to management for closing comments.

We thank everyone for joining us again this morning, and we'll look forward to talking after our first quarter results are issued. Thank you.

Ladies and gentlemen, thank you for your participation. This concludes today's teleconference. You may now disconnect your lines and have a wonderful day.