Earnings Labs

Main Street Capital Corporation (MAIN)

Q1 2024 Earnings Call· Fri, May 10, 2024

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Transcript

Operator

Operator

Greetings, and welcome to the Main Street Capital First Quarter Earnings Conference Call. [Operator Instructions] As a reminder, this conference is being recorded. It is now my pleasure to introduce your host, Zach Vaughan. Thank you, Zach, you may begin.

Zach Vaughan

Analyst

Thank you, operator, and good morning, everyone. Thank you for joining us for Main Street Capital Corporation's First Quarter 2024 Earnings Conference Call. Joining me today with prepared comments are Dwayne Hyzak, Chief Executive Officer; David Magdol, President and Chief Investment Officer; and Jesse Morris, Chief Financial Officer and Chief Operating Officer. Also participating for the Q&A portion of the call is Nick Meserve, Managing Director and Head of Main Street's Private Credit Investment Group. Main Street issued a press release yesterday afternoon that details the company's first 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 May 17. 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, May 10, 2024, 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…

Dwayne Hyzak

Analyst

Thanks, Zach. Good morning, everyone, and thank you for joining us. We appreciate your participation on this morning's call, and we hope that everyone is doing well. On today's call, I will provide my usual updates regarding our performance in the quarter, while also providing updates on our asset management activities, our recent dividend declarations, our expectations for dividends going forward, our recent investment activities and current investment pipeline, and several other noteworthy updates. Following my comments, David and Jesse will provide additional comments regarding our investment strategy, investment portfolio, financial results, capital structure and leverage, and our expectations for the second quarter of 2024, after which we'll be happy to take your questions. We are pleased with our first quarter results, which were highlighted by an annualized return on equity of 17.2% for the quarter, a new record for NAV per share, and NII per share and DNII per share that significantly exceeded the dividends paid to our shareholders. In addition, our positive performance in the quarter increased our return on equity for the trailing 12-month period to an impressive 19.3%. Our DNII per share in the first quarter exceeded the monthly dividends paid to our shareholders by 54% and the total dividends paid to our shareholders by 9%, representing a significant level of dividend coverage. And this is after increasing the total dividends paid to our shareholders in the first quarter by 20% as compared to the same period of last year. We believe that these positive results demonstrate the continued and sustainable strength of our overall platform, the benefits of our differentiated and diversified investment strategies, the unique contributions of our asset management business and the continued underlying strength and quality of our portfolio companies. We are also very pleased that we generated growth in both our…

David Magdol

Analyst

Thanks, Dwayne, and good morning, everyone. As Dwayne highlighted in his remarks, we believe that our strong first quarter financial results continue to demonstrate the strength of Main Street's platform, our differentiated investment approach and our unique operating model. We are pleased to report that the overall operating performance for most of our portfolio companies continues to be positive, which contributed to our attractive first quarter financial results. Each quarter, we try to highlight key aspects of our differentiated investment strategy. This quarter, we'd like to revisit several reasons why we believe that our structure as a publicly traded BDC with the significant benefits of permanent capital is a great match with our focus on investing in both the debt and equity capital in lower middle market businesses. First, on a new lower middle market investment side, we believe that our permanent capital structure allows us to be an ideal long-term to permanent partner for the owners of privately held businesses. One of the challenges of a typical limited-term-specific private equity fund is that they cannot represent a long-term partnership solution for a retiring business owner or their management teams. Our permanent capital structure and long-term to permanent investment strategy in the lower middle market allows us the flexibility to compete for new investments by providing significantly more beneficial structural consideration as opposed to relying solely on price to gain a competitive advantage. Ultimately, we believe this can generate highly attractive investment structures that more traditional private equity funds cannot provide. In addition, our ability to be a long term to permanent partner to the companies we invest in allows the long-term owners of these businesses and their management teams the ability to maintain the identity and independence of their companies while also achieving the best long-term outcomes for all…

Jesse Morris

Analyst

Thank you, David. To echo Dwayne's and David's comments, we are very pleased with our operating results for the first quarter. Our total investment income for the first quarter was $131.6 million, increasing by $11.4 million or 9.4% over the first quarter of 2023 and by $2.3 million or 1.8% from the fourth quarter of 2023. Positive momentum we experienced during 2023 continued in the first quarter and resulted in strong levels of investment income, which we believe, as Dwayne and David touched on, demonstrates the continued strength of our differentiated investment and asset management strategies. The first quarter included elevated levels of certain income considered less consistent or nonrecurring in nature, which include dividends from our equity investments and accelerated prepayment, repricing and other activity related to our debt investments. In the aggregate, these items totaled $7.5 million and were $2.1 million higher than the average of the prior 4 quarters, $2.2 million higher than the fourth quarter and $1.8 million lower than the first quarter of 2023. Interest income increased by $6.7 million from a year ago and decreased $0.6 million from the fourth quarter. The increase over the prior year was driven primarily by increases in benchmark index rates and increased net investment activity. The decrease from the fourth quarter was primarily driven by a decrease in accelerated OID income, partially offset by increased net investment activity. Dividend income decreased by $1.4 million or 5.9% when compared to a year ago, driven primarily by a $5.3 million decrease in less consistent or nonrecurring dividends. The $3.9 million increase in dividends deemed recurring is a result of the continued underlying strength of the majority of our portfolio companies and the recurring benefits from our asset management business. Dividends decreased by $1 million or 4.2% from the fourth quarter…

Operator

Operator

[Operator Instructions] Our first question comes from Bryce Rowe with B. Riley Securities.

Bryce Rowe

Analyst

Dwayne, I wanted to maybe start on the comments Jesse made around using more debt to fund growth here in '24. Maybe you could kind of help us think about that relative to where the regulatory leverage is now and where your target is. Do you expect to try to get back into that target range? Or will you still run conservatively below that target range?

Dwayne Hyzak

Analyst

Sure, Bryce. I'll give you a few comments there, and then I'll let Jesse remind everyone what our long-term new target expectations are for leverage. So I'd start off just saying we've been well below our targets for a while. That was really in anticipation of the May 1, 2024 maturity that we just had that we repaid here over the last week or so. So we intentionally were being more conservative in advance of that because the markets, as you've heard us say before, have been very uncertain, and we weren't sure what we would be able to accomplish from an unsecured IG issuance standpoint. So we had intentionally built more cushion, more conservatism in that ratio over the last 12 months or so than what we would have otherwise kind of executed on from a leverage and overall capital structure standpoint. But as you've heard us say in the past, we're always going to be more conservative in this space. We view our ability to generate best-in-class, best-in-industry ROE as fundamental. It's a different investment strategy. It's good underwriting. It's a long-term to permanent approach. So we really look at focusing on the fundamental investment strategies that we have to produce our return on equity and not use excessive leverage or financial engineering to get there. So we'll always be more conservative in the space, and we don't think anything would change there. That being said, because we have been in a more conservative position for a while, what Jesse is trying to indicate or message in his comments was that we will be moving from our current position towards our long-term targets over the next 12 to 24 months as we continue to execute the growth of our investment portfolio. But maybe I'll let Jesse remind everybody what those long-term targets are.

Jesse Morris

Analyst

Sure. Thanks, Dwayne. And as I said on the call, our leverage targets are 0.8x to 0.9x. As a reminder, the way we define that, we exclude our SBIC debentures due to our exemption there. And at the end of the quarter, we had moved closer to that, as you probably saw, Bryce, to 0.7x. So we made the same comment in the last quarter. We made some movement closer to those targets. And we're still more conservative to those, and we're expecting to continue to move closer to those.

Bryce Rowe

Analyst

All right. Maybe just on that same topic, it looks like the SBA debenture is outstanding, went down. Were -- did you all prepay some? Or was that just an existing maturity?

Dwayne Hyzak

Analyst

Yes, Bryce, those are just activities in relation to existing maturities. So we had 2 tranches that we paid off, and we'll be in the process of requesting new debentures to replenish that capacity from the SBA. We started that process. It just takes a while for us to get through the process with the SBA, but that's in process. It's just a matter of time before we hopefully have access to the full $350 million again.

Bryce Rowe

Analyst

Okay. All right. And then I'll ask one more and maybe jump back in queue if others don't ask other questions. So in terms of kind of the nonrecurring or less recurring income, especially on the fee side, is that more prepayment type of activity or amendment activity? Just help us think about that and kind of curious if it is prepayment type activity, what's driving that? Is that the tighter spreads that we've seen here recently, getting opportunity for refinance opportunities for your borrowers?

Dwayne Hyzak

Analyst

Sure, Bryce. When you look at that, that metric we provide long term, it would be a combination of each of the items that you referenced. Specifically in the first quarter, it was 2 repayments that occurred and they had protections or benefits upon prepayment or repayment that allowed us to accelerate -- or not accelerate, but to receive some additional benefits from a fee income standpoint. So I'd say the first quarter was a little abnormal. Obviously, you see it in the number there. But each quarter it's going to -- there's going to be peaks and values in that number just based upon the normal investment repayment or prepayment activities that happen across that broad portfolio.

Bryce Rowe

Analyst

Okay. And those were in the private loan portfolio, Dwayne, or lower middle market?

Dwayne Hyzak

Analyst

The 2 bigger ones that I'm referencing were both in the private loan portfolio.

Operator

Operator

Our next question comes from Robert Dodd with Raymond James.

Robert Dodd

Analyst · Raymond James.

On the dividend income from the portfolio companies, not the asset management, it was down a little bit this quarter, which you did highlight. It looks kind of like a 5.9% yield on portfolio company equity, down from last year, but the same as first quarter '22, I think, right, from a yield perspective. So I think Jesse said something about the vast majority are doing fine. Where they are at the margin, a couple of portfolio companies that are now deciding to reserve a little cash rather than distribute, is that becoming an emerging theme in the portfolio? Or is it just one of those random things that happens?

Dwayne Hyzak

Analyst · Raymond James.

Thanks for the question, Robert. I'd just say we pointed to or attribute more to just a random quarterly fluctuation. The companies that are contributing to our dividend income continues to be a broad group of people, just like it's been -- or broad group of companies, just like it's been in prior quarters. So we haven't seen the concentration increase materially. We haven't seen the composition of the companies that are contributing to that dividend income on a quarterly basis change materially. We do have, from time to time, the nonrecurring stuff, which we always try to do our best to call that out. But if you look at the fundamental performance of the company is contributing to dividend income today versus what's been there the last couple of quarters, really over the last 6 or 8 quarters, I wouldn't say that it's changed significantly. You just have fluctuations quarter-to-quarter that drive that dividend income.

Robert Dodd

Analyst · Raymond James.

Got it. On the asset manager, and I'm not talking about -- not just this quarter, but kind of thematically over the next couple of years, maybe. Can you give us any indication if plans have developed about how you'd like to handle MSC or if there are other initiatives that you plan on undertaking? I mean obviously, you have the 2 private loan funds in there as well. Just any more color on what you think is going to go, the outlook for that really high return on risk-adjusted capital, if you will, business within Main over the next couple of years?

Dwayne Hyzak

Analyst · Raymond James.

Sure, Robert. So similar to what you just said there, we view the asset management business for us to be extremely attractive. It's something that's very unique to Main Street in relation to other BDCs. It has been and continues to be a very large contributor to our return on equity and our recurring net investment income. So it's something that we put a lot of value on, and we find it highly attractive just like we think most of our stakeholders do. So when you look at that, and you've heard us say this in the last couple of quarters, we have been and continue to be focused on trying to grow it, and we can grow it a couple of ways. One is through the private loan activities that we've had. Obviously, we're not planning to double the growth of that there. Those -- the growth through those private loans will be very, very deliberate and as a result, it will probably be more moderate. Longer term, if we can find a solution that works for both us and for the shareholders of MSC Income Fund to grow that, we think that's the biggest opportunity, and we continue to look at different strategic initiatives or activities that we can take on that front to allow us to both deliver really, really good returns for their shareholders, but also deliver additional benefits to Main Street through the growth of that entity of that fund. I don't have anything today that I can share with you, but I think you would expect, just given the comments I just provided in our prior comments, that we continue to work on that, and we're hopeful that at some point in the future, we'll have a really good outcome for all parties.

Operator

Operator

Our next question comes from Mark Hughes with Truist Securities.

Mark Hughes

Analyst · Truist Securities.

Yes. Dwayne, you talked about the you're seeing more interest from several buyers. You also categorized your pipeline as above average compared to average last quarter. What -- could you expand on that a little bit more? Uptick clearly in deal activity that you're seeing, do you think that's broader? What's driving all that?

Dwayne Hyzak

Analyst · Truist Securities.

Sure, Mark. Thanks for the questions. I would say, taking those 2 questions in reverse order, when you look at the activity both on the lower middle market side and the private loan side, we have seen a noticeable uptick on both sides. As you heard in our script and you saw in the numbers, we had really good investment activity in both strategies in the first quarter. And as you took from my comments, the pipeline in both situations or both cases continues to be positive. I'm not sure if you just attribute that to the overall market kind of becoming more active or if it's something that we've done specifically. I think it's probably a combination of the two. I think, more broadly, you probably heard other BDCs or other private equity, private debt investors saying for the last couple of months that the market has become more active. We've definitely seen that on the front end of the funnel. And I think we've seen or experienced more success here recently, both in the lower middle market and private loan strategies and having more success on opportunities moving through the funnel and resulting in actionable items that we get the opportunity to execute on. So nothing huge or significant, just the market has improved and we're doing a good job of capturing those opportunities. On your first question about the uptick in potential realizations, from time to time, we'll see that activity ebb and flow. It does not always mean that we get to an exit because there's a lot of things -- just like on our new investment activity, a lot of things have to go well in order for us and our portfolio company to get to a good outcome from an exit standpoint. But we have seen that increase, both in terms of at least one company where our partners in the business have an increased desire to seek liquidity, and then a couple of others where it's inbound activity, kind of unsolicited activity from third parties that has prompted some activity there. So we'll continue to execute on that, work to realize the best outcome for us and our partners in those lower middle market portfolio companies and hope for a good outcome. If we don't exit, the companies that we're referencing are all very strong, high-performing companies, and we'd be happy to continue to be invested in those companies long term.

Mark Hughes

Analyst · Truist Securities.

Any observation about the kind of valuations? Are you seeing perhaps more attractive valuations that would prompt more realizations?

Dwayne Hyzak

Analyst · Truist Securities.

I don't know if I'd say there's a big change there. I mean the market has gotten a little more heated or competitive. So overall, say, today, valuations are probably a tick higher than they would have been 12 or 18 months ago. But I wouldn't say that there's anything that's materially different. I'll let David -- see if he has anything he wants to add, but it's a healthy market, it's a productive market, but not anything that we think is kind of a significant uptick. So Dave, I don't know if you'd add anything?

David Magdol

Analyst · Truist Securities.

Yes. Only thing I'd add is that if you look at the longer term for our size transactions, there has not been a material change in the recent past. We did see some reluctance for sellers to come to market when interest rates ticked up kind of more suddenly and there was concerns about the financing. So we saw some degradation in valuation multiples. Now that there's some normalcy in the new interest rate environment, it's stabilized, put us back to historical norms for our lower middle market investment portfolio.

Operator

Operator

[Operator Instructions] Our next question comes from Erik Zwick with Hovde Group.

Erik Zwick

Analyst · Hovde Group.

First, just wanted to start on the second private loan funds. If you could just provide maybe an update on activity there in the first quarter? And then also, I think you've previously indicated that you're targeting between $100 million and $300 million. And curious if you've kind of narrowed that range or set a more kind of precise target? And then ultimately, what factors do you consider in determining when to do the final closing? Is it just timing or size or a change in market activity?

Dwayne Hyzak

Analyst · Hovde Group.

Sure, Erik. Thanks for the question. When you look at the current activity in the first quarter, I said we didn't have a huge increase in equity commitments from LPs. We had some slight kind of moderate increase there, but continue to have active dialogue with new investors about either joining the fund or existing investors about increasing their commitments. So we hope to continue to add onto that over the next year or so. Just to give you a number, we're probably at about $80 million or just over $80 million of LP commitments in that second fund. When you look at the range we provided, which was $100 million to $300 million as you indicated, today I would say we're probably expecting to be somewhere closer to the $150 million would be more realistic. Unless we have significant success with some institutional investors coming in, it's unlikely we get to $300 million, but we still think it will be larger than the first fund. And if we are successful in increasing it, when you put leverage on top of that, it is a nice increase to our asset management business long term. So we continue to be excited about the fund and continue to work on those fundraising activities. In terms of the time line that you asked about, that's contractual. Like any other fund, when we go out and we start the fundraising period or process, you typically set a date for how long that fundraising period will last. So we're no different. And when we set it, we set it for 18 months. So the fundraising process will continue for that 18-month duration. We started, I believe, in September of last year, off the top of my head. So it will last through March of 2025, at least directionally. I think that's -- if that's not exactly right, that's pretty close to what time period is.

Erik Zwick

Analyst · Hovde Group.

That's very helpful. And second one for me. Just given the diversity -- industry diversity within your existing portfolios as well as the current pipelines, there's still, I think, some degree of uncertainty over the economic trajectory in which sectors or maybe industries are performing better or worse, I guess. Are you able to see -- do you have kind of a glimpse through all of your activities of how the economy is underperforming? And are there any industries or sectors that you feel have kind of weakened and that you're shying away from at this point at all?

Dwayne Hyzak

Analyst · Hovde Group.

Sure, Erik. I would say there's not a change from what you've likely heard us say over the last 12 to 24 months. If I was to look at the industries and the portfolio of companies that we're invested in broadly, we have more companies today that are overperforming than are underperforming. And if you look at the overperformance, I'd say the overperformance is pretty broad based if you look at it from an industrial or kind of a B2B standpoint or even businesses that are focused on the higher-end consumers from a demographic or from a customer base standpoint. We have been and continue to be risk off or shy away from companies that are more focused on the consumer, particularly the lower end of the consumer. I think you probably heard this, not just from BDC or investment firm calls over the last couple of quarters, but I think you're interestingly hearing it more broadly across the U.S. economy that the lower end of the consumer is being cost-conscious. He or she is trading down in terms of what they're buying, how much they're buying, et cetera, and we've definitely seen that. In the quarter, we had really good performance broadly across the portfolio. We did have a couple of companies that had significant underperformance. And as a result, we recognized meaningful unrealized depreciation on those companies, and they were both businesses that have significant consumer exposure, and I would say kind of broad, kind of lower end consumer exposure. So the risk we've been concerned about for the last couple of years, I think you're -- that's an area you've seen really start to impact things here the last 3 to 6 months or so. But other than that, I wouldn't really hit on anything else, but that has been a headwind here more recently.

Operator

Operator

Our next question is from Bryce Rowe with B. Riley Securities.

Bryce Rowe

Analyst

Told you I'd be back. Dwayne, maybe just a couple more for me. Can you talk about some of the yield dynamics within the 3 portfolios? You laid out in the press release, it looks like there was a bit of compression in the lower middle market in the private loan. Just assuming that is reflective of where spreads have gone over the last 3 months or so?

Dwayne Hyzak

Analyst

Sure, Bryce. Thanks for joining us again. Thanks for the follow-up question. I'll give some color on the lower middle market side and then I've got Nick Meserve here with -- who leads our private credit group. I'll let him give some additional color on the private loan side. On the lower middle market side, I wouldn't say that we've seen the interest rate environment, our ability to get good yields on new investments change. We're very disciplined and we continue to be disciplined there and haven't really seen any impact. When you look at our lower middle market rates change, if it is going down, it's more a result of our existing portfolio companies, particularly the ones that are performing really, really well. It's not uncommon for them to have an interest rate pricing grid in place. And as they perform, grow, delever and move down that grid from a leverage standpoint, they'll see a benefit. So if you see some reduction in the rates on our lower middle market portfolio, it's really going to be that which we -- obviously, we take a balanced approach. We think we've got some great companies and we'd rather keep those companies in the portfolio longer term as opposed to have them exit. So we don't necessarily view that as a bad thing. On the private loan, private credit side, I do think, and you've probably heard this from others, I do think you're seeing some pressure there. The pressure is more -- in my opinion, more on the rate side, less on kind of structure and leverage, but I'll let Nick give some additional color there.

Nicholas Meserve

Analyst

Yes, Bryce, I'd say we're probably back to '21, '22 spreads after kind of the spread widening of last year. And so we're probably in sort of between 50 and 75 basis points over the last 6 to 9 months as the market has gotten a little more competitive and people are out there trying to put more money to work. I'd say it's more really focused on spreads so far and less on incremental debt leverage or deal terms.

Bryce Rowe

Analyst

Okay. Yes, and I think that's pretty consistent with what we've heard throughout or from the other BDCs. Maybe another one for Jesse. You guys have clearly outearned the dividend even with the supplementals. Jesse, do you have a good, maybe an estimate of where spillover is sitting at this point?

Jesse Morris

Analyst

Yes, Bryce. I think from memory, spillover was around $70 million to $80 million. I can pull that up for you and get back to you.

Bryce Rowe

Analyst

Okay. Okay. And then last one for me. It looked like nonaccruals were down for the quarter on a cost basis. Any color there? Is it just normal ebbs and flows of nonaccruals in and out of that bucket?

Dwayne Hyzak

Analyst

Yes. There's, Bryce, on the nonaccruals, nothing significant. We had one company that we had a realized loss on. Obviously, that company, when it was on nonaccrual, comes off nonaccrual. And then we had one new addition, a small addition to the nonaccrual, which is why you saw that stat go down when you look at it on a percentage basis. Going back to Jesse's, your question for Jesse, we're just under 90 -- I'm sorry, just under $80 million of spillover. So right at a buck a share from a spillover income standpoint at the end of the quarter.

Operator

Operator

This concludes our question-and-answer session. I'd like to turn the floor back over to management for closing comments.

Dwayne Hyzak

Analyst

We just want to say thank you again, everyone, for joining us this morning, and thank you for your continued long-term support of Main Street, and we look forward to talking to you again in early August after our second quarter results.

Operator

Operator

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