Main Street Capital Corp (MAIN) 2018 Q1 法說會逐字稿

Greetings, and welcome to the Main Street Capital Corporation First Quarter 2018 Earnings Conference Call. (Operator Instructions) As a reminder, this conference is being recorded. It is now my pleasure to introduce your host, Mark Roberson, Dennard Lascar Investor Relations. Thank you. You may begin.

Thank you, operator, and good morning, everyone. Thank you for joining us for Main Street Capital Corporation's First Quarter 2018 Earnings Conference Call. Joining me on the call today are Chairman and CEO, Vince Foster; President and 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 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 about an hour after the completion of the call and will remain available until May 11. 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 over the Internet and can be accessed on the company's homepage. Please note that information reported on this call speaks only as of today, May 4, 2018, and therefore, you're 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 Vince.

Thanks, Mark, and thank you all for joining us today. I will comment on the performance of our investment portfolio, discuss our recent dividend announcements and a few other recent developments and conclude my comment -- and conclude by commenting on our investment pipeline. Following my comments, Dwayne Hyzak, our President and Brent Smith, our CFO, will comment on our first quarter financial results, recent originations and exits, our current liquidity position and certain key portfolio statistics, and other recent developments, after which we will take your questions.

We were pleased with our first quarter operating results. Our lower middle market portfolio, our primary area of focus, depreciated by $3.3 million on a net basis during the quarter, with 26 of our investments appreciating during the quarter and 9 depreciating. Our middle market loans, private loans and our other assets ended the quarter collectively appreciating by $3.1 million. Overall, the portfolio was essentially flat from a valuation standpoint during the quarter. We finished the quarter with a net asset value per share of $23.67, a sequential increase of $0.14 over the fourth quarter. Our lower middle market companies collectively continue to exhibit very conservative leverage ratios on a relative basis, which Dwayne will cover in greater detail.

Earlier this week, our board declared our third quarter 2018 regular monthly dividends of $0.19 a share in each of July, August and September of 2018, maintaining our second quarter payout rate. The ex-date for these dividends are June 28, July 19 and August 20th, respectively. And last month, our board declared a $0.275 a share semi-annual supplemental dividend to be paid on June 26.

We wanted to note the recent enactment of the Small Business Credit Availability Act, which passed recently as part of the omnibus spending bill. We've been working for several years with the Small Business Investor Alliance or SBIA, our industry association on the legislative and regulatory process that led to this bill. The bill allows BDCs the opportunity to increase regulatory leverage, subject to board or shareholder approval and contains regulatory modernization changes that provide for certain SEC communication and offering rules to apply to BDCs that are currently only available to other public-operated companies. We were very pleased with the modernization aspect of the changes as it will allow for increased efficiency in our SEC reporting. With respect to the potential for increased leverage, while we think the optionality it provides in the event of unforeseen circumstances could be beneficial, we have proven throughout -- through our historical performance that we do not need access to additional leverage to provide market-leading returns. We've also had several discussions with Standard & Poor's regarding regulatory leverage changes, and are aware of their position regarding the potential impact to existing investment grade ratings. As we've previously discussed, we greatly value our triple B flat rating, which makes us the only BDC with such a rating from S&P that is not on negative credit watch. Therefore, we are currently not asking our board or shareholders to approve the ability to access the additional leverage.

We've originated lower middle market and private loan investments of roughly $310 million so far this year, including our lower middle market originations of $151 million during the first quarter. As of today, I'd characterize our lower middle market investment pipeline as above average. 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 38% fully diluted equity position in the 97% of these investments in which we currently have equity exposure. Our officer director group has continued to be regular purchasers of our shares, investing approximately $0.5 million during the first quarter. With that, I'd like to turn the call over to Dwayne to cover our performance in more detail.

Thanks, Vince, and good morning, everyone. We're pleased to report another quarter, during which we grew our total investment income and distributable net investment income, both in total and on a per share basis and again generated distributable net investment income in excess of our monthly dividends. In addition, as a result of our unique focus on investments in the both debt and equity in the lower middle market, we were also able to generate $7.5 million of net realized gains from our investment portfolio. Primarily, from the successful exits of our investment in Hydratec and Soft Touch Medical.

We're also pleased that our operating results for the trailing 12-month period ended March 31, represent a GAAP return on equity, or ROE of 13.1%. ROE is our principle metric for evaluating our performance internally. And we're pleased that our most recent results are in line with our stated long-term goal of producing an ROE percentage in the low to mid-teens. We believe that these results illustrate the significant benefits of our unique investment strategy in the lower middle market, which combined with our efficient operating structure and other complementary investment and asset management activities, continue to provide a value proposition that differentiates Main Street from other yield-oriented investment options and generates the premium total returns realized by our shareholders. We believe that the primary driver of our long-term success has been and continues to be our primary 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 a financing source.

Each quarter, we try to highlight different aspects of our unique investment strategy. This quarter, given the successful exit activity in our lower middle market portfolio, we'd like to highlight several points related to the recent exits of our investments in Hydratec and Soft Touch, as both of these investments illustrate the favorable returns that our lower middle market investment strategy can generate for our shareholders. In the case of Hydratec, the exit generated a $7.9 million realized gain and a cumulative 17.9% internal rate of return, and a 2.7x money invested return on our cumulative debt and equity investments in Hydratec over our 10-year holding period. In the case of Soft Touch, the exit generated a $5.2 million realized gain, and a cumulative 24.2% internal rate of return, and a 1.8x money invested return on our cumulative debt and equity investments in Soft Touch. In the case of both exits, the final value received in the exit transaction was at or above our prior period fair value marks for these investments, confirming our historical fair market valuations.

In addition, both investments provide evidence of the significant value investment return opportunities provided by our investments in our lower middle market companies and the significant benefit of being both a debt and an equity investor in these companies as opposed to just being a lender. Without our unique focus on a combination of senior secured debt with meaningful direct equity investments on our lower middle market companies, it would be very difficult to deliver these types of returns and benefits to our shareholders. Given our view of the significant value associated with our focus on the lower middle market, we're pleased that despite the competitive market conditions that most of our peers are facing in the current environment, we have continued to find attractive new investment opportunities that match our historical investment profile. As evidence of our ability to continue to find attractive opportunities in the current market, our lower middle market originations in the first quarter represented our strongest quarter of lower middle market originations to date in our history.

Now turning back to our most recent operating results. Consistent with prior quarters, the contributions from our lower middle market portfolio continue to be well diversified, with 43 of our 71 lower middle market companies with equity investments having unrealized appreciation at quarter end, and with 29 of these companies that are flow-through entities for tax purposes or 56% of our total investments in these types of entities, contributing to our dividend income in the last 12 months. We also have several equity investments in C corporations, which have contributed to our dividend income. We believe that the diversity of our lower middle market portfolio is very important when analyzing the benefits from our lower-middle-market strategy. And we believe that this diversity provides visibility to the recurring nature of these benefits in the future.

Now turning specifically to our investment activity in the first quarter and our investment portfolio at quarter end. Our investment activity in the first quarter included total investments in our lower middle market portfolio of approximately $151 million, which after aggregate repayments on debt investments and return of invested equity capital resulted in a net increase in our lower-middle-market portfolio of approximately $121 million. We had a net decrease in our middle-market portfolio of approximately $1.3 million and a net increase in our private-loan portfolio of approximately $32 million. As a result, at March 31, we had investments in 187 portfolio companies that are in more than 50 different industries across the lower-middle market, middle market and private loan components of our investment portfolio. The largest portfolio company represents approximately 2.9% of our total investment portfolio fair value at quarter end, with the majority of our portfolio investments representing less than 1% of our assets. 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 73 companies, representing approximately $1 billion of fair value, which is approximately 17% above our cost basis. At the lower middle market portfolio level, the portfolio's median net senior debt-to-EBITDA ratio was a conservative 3.0:1 or 3.1:1, including portfolio company debt, which is junior in priority to our debt position. As a complement to our lower middle market portfolio, in our middle-market portfolio, we had investments in 59 companies, representing approximately $620 million at fair value. In our private-loan portfolio, we had investments in 55 companies, representing approximately $500 million at fair value. The total investment portfolio at fair value at quarter end was approximately 107% of the related cost basis, and we had 6 investments on nonaccrual status, which comprised approximately 0.8% of the total investment portfolio at fair value and 3.3% at cost. In summary, Main Street's investment portfolio continues to perform at a high level, and continues to deliver on our long-term goals. With that, I will turn the call over to Brent to cover our financial results, capital structure and liquidity position.

Thanks, Dwayne. We're pleased to report that our total investment income increased by 17% for the first quarter over the same period in 2017 to a total of $55.9 million, primarily driven by an increase in dividend income of $6.8 million and an increase in interest income of approximately $1.1 million. The total investment income includes an elevated amount of dividend income activity, partially offset by a decrease of $1.8 million, related to lower accelerated prepayment, repricing and other activity for certain debt investments when compared to the same period of 2017. First quarter 2018 operating expenses, excluding noncash share-based compensation expense, increased by $2.2 million over the first quarter of the prior year to a total of $16.7 million. The increase was primarily related to a $1.7 million increase in interest expense and a $1.1 million increase in compensation expense. These increases were partially offset by an increase of $0.5 million in costs we allocated to the External Investment Manager for services provided to it. 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 our operating efficiency, was 1.5% on an annualized basis for the first quarter compared to 1.6% during the same period of the prior year. Our increased total investment income and the continued leverage of our efficient operating structure resulted in a 17% increase in distributable net investment income for the first quarter of 2018 to a total of $39.3 million or $0.67 per share, which exceeded our recurring monthly dividends paid for the quarter by approximately 18%. The activities of our External Investment Manager during the first quarter and its relationship with the HMS Income Fund benefited our net investment income by approximately $2.6 million in the first quarter of 2018, through a $2.1 million reduction of our operating expenses for costs we allocated to the External Investment Manager for services we provided to it, and $0.6 million of dividend income from the External Investment Manager.

We recorded a net realized gain of $6.1 million during the first quarter, primarily related to the realized gains from the exit of two lower middle market investments, as well as activity in the other portfolio, partially offset by realized losses related to 2 middle market investments and a realized loss related to the prepayment of certain SBIC debentures.

And as Vince discussed, we recorded net unrealized depreciation on the investment portfolio of $0.2 million in the first quarter, primarily resulting from $7 million of appreciation on our External Investment Manager. This appreciation was partially offset by $3.3 million of net depreciation on our lower-middle-market portfolio, $2.6 million of net depreciation on our private-loan portfolio, $0.3 million of net depreciation on our middle-market portfolio and $1 million of net depreciation on our other portfolio. We estimate that approximately $18 million of the net depreciation on our lower middle market portfolio was due to a decrease in the value of certain cryptocurrencies owned by our portfolio company CBT Nuggets, effectively representing a reversal of the unrealized appreciation previously recognized due to the increase in the values of cryptocurrencies during the fourth quarter. Excluding this impact, the net appreciation on the lower middle market portfolio was approximately $15 million during the first quarter.

Additional details for the change in our net unrealized appreciation can be found in our earnings release. Our operating results for the first quarter of 2018 resulted in a net increase in net assets of $34.5 million or $0.59 per share. On a capital resources front, our liquidity and overall capitalization remained strong. At the end of the first quarter, we had $29 million of cash, $397 million of unused capacity under our credit facility and approximately $32 million of incremental SBIC debenture capacity, for total liquidity of approximately $460 million. Currently, we have approximately $26 million of cash, $297 million of unused capacity under our credit facility and $32 million of incremental SBIC debenture capacity.

During the first quarter, we raised approximately $11.3 million in net proceeds under our ATM equity program with an average sale price of $37.27 per share. As we look forward to the second quarter of 2018, and taking into account that dividend income may return to more normal levels following elevated activity in the first quarter, we currently expect that we will generate distributable net investment income of $0.62 to $0.64 per share during the quarter. This estimate is $0.05 to $0.07 per share or approximately 9% or 12% above our previously announced monthly dividends for the second quarter at $0.57 per share, maintaining our conservative approach to our monthly cash dividends. With that, I will now turn the call back over to the operator, so that we can take any questions.

(Operator Instructions) And our first question is from Robert Dodd from Raymond James.

Going back to the Vince's few comments on the leverage, and obviously, I don't think you've ever really approached 1:1 and clearly demonstrated that you don't need it in your market to generate the top of the peer group ROE, right? But you also mentioned that you had the discussion with S&P, with the -- in the past, you had given us some indications on what S&P had told you about leverage limits, et cetera, that would be acceptable to maintain your investment grade rating. How -- can you remind us what that is or whether that's changed at all? I mean, obviously, we've heard what they said, ask for double leverage, lose at least a notch. Beyond that, have they given any other updates to kind of their indication of what they are looking for -- from people to maintain that rating?

Yes, Robert, the answer is, they have made a slight tweak to their criteria. There is a two-part test, and essentially, Brent and I tried to come up with a scenario, an asset mix and liability mix where it would actually make a difference, and it was really hard and we kind of found one theoretical example. So essentially, their criteria hasn't changed. But Brent will tell you what the two tests are.

Yes, so on the leverage, as you said, we've discussed this before, the first one is a total debt-to-ATE, in which the ATE is adjusted equity to exclude any cumulative unrealized appreciation or depreciation. And total debt, so including SBIC debt and all debt, that ratio ultimately has to be below 1.5x, but below 1x to avoid scrutiny over certain income ratios. So generally speaking on that ratio for an investment-grade company, they want to be below 1x total debt-to-ATE. If you go above 1x, you're going to be subject to other ratios. Then on the regulatory limit, they like to have a certain amount of cushion, and they're -- for right now they're not changing that, even though the BDCs have the opportunity to get shareholder or board approval to change that regulatory limit. Right now, it's unchanged, they like to have you at 0.85x on a debt-to-equity basis on a regulatory basis.

Excluding your SBAs.

Yes, regulatory excluding.

And is that 0.85 on adjusted equity as well?

That's regular equity.

It's just straight up. Okay.

They like to have a 20% cushion under the legacy regulatory limit.

Got it.

So if you have both SBA debt and other debt which most of the BDCs do that are in the SBIC program, then you just have to stay at less than 1:1, and you don't have to run any income tests, and the income tests get involved in PIK and stuff like that.

Fair enough. I appreciate that. And just then on the market. I mean, obviously, the economy seems healthy -- very healthy, unemployment now under 4%. Are you seeing any changes in either early stage interest and obviously, your lower middle market really isn't direct -- not necessarily directly tied to that, right, because this is estate planning, et cetera. Have you seen any changes either -- because people are more optimistic about the future in terms of people will -- coming to you with interest of partnering? Or maybe the potential retiree, being more willing to sell equity at higher value? Any -- there's a lot going on, and obviously the tax law changes, have there been any kind of follow-on effects from that, that maybe weren't what you expected? Because you've given us really good color on your expectations regarding the tax stuff in the past.

I don't see -- I don't think we've seen that yet. Frankly, I don't think the average person has fully digested the tax law yet. And they're not going to file their returns until next April. And I think there's a fair amount of confusion how the 20% pass-through works and all of that. So I think for a lot of people, depending on the state you live in, it's largely kind of a push and it's complex, and I don't think it's altering behavior that we've seen. I will say one thing that we've seen in the last 12, 18 months is, some of the larger private equity firms seem to be more interested in the buy and build than a roll-up-type strategy. So some of our firms have an increased level of interest from household name private equity firms that you would normally not associate -- with -- with our size. Dwayne, would you expand on that?

Yes, I agree with what you said. and I think the market for us continues to be favorable. We had a great first quarter. And I think Vince covered in his comments that we continue to see a healthy amount of good opportunities going forward. So I think, we're very pleased and haven't seen a lot of changes here in the recent market versus what we've been experiencing for the last couple of years, which is one of the reasons that we find the lower middle market so attractive in comparison to other parts of the broader market.

Got it. And just on that point. If the larger PE firms, which have a history of wanting to replace management teams, are looking at your companies, and a lot of your companies have gotten involved with you guys because they wanted to maintain control. Is that still the traditional legacy butting of heads? Or is it more of a meeting of the minds about whether your type of companies and larger PE firms are on the same page about how that happens?

Yes. I think what's causing that trend is, if the larger PE firms are looking at a market where they have got to pay 12x, 14x EBITDA for a transaction, the equity return requirement that they have that they sold their LPEs on can't be achieved. So what can you do? Well, so maybe what you do is you pay up for a platform company, 12x, 14x and then try to find smaller companies to add on to average down your cost and achieve that arbitrage, in which case, our kinds of companies are attractive to that model.

The only thing I would add to that, Robert, is the relationship we have with our portfolio company managers continues to be the same, but if there's an opportunity to achieve valuations that exceed what we've been able to generate historically from a value standpoint, at some point that valuation makes sense not only to Main Street, but it makes sense to portfolio manager of the individual company, that's our equity co-investor. So at some point, they decide that coming together with a larger entity at the right valuation makes sense for the overall opportunity.

Right. Everybody has their price ultimately, right? And just on HMS, very successful relationship, I-45. Any other initiatives in the pipeline? Obviously, these things are great from the sense of generating returns to the Main Street shareholders without putting necessarily more capital at risk, right? It's just leveraging expertise into earnings, it's tremendously accretive. Any other opportunities that you're looking at working on to potentially increase that even more?

Yes, we're always thinking about and looking at other opportunities to leverage the talent that we have here without necessarily writing a check. And I would say that if there's not an HMS 2.0 type vehicle within the next 12 or 18 months, there's a high likelihood that you will see something else get done that would involve us as an adviser, sub-adviser or something. There are just -- there are that many opportunities out there. And we're -- have a real open mind in terms of what we evaluate. And then, it's just very ROE driven in terms of either if we hit -- either if it involves an investment that's strictly ROE driven, if it does involve an investment that's more subjective, it's kind of a return on our people's time, because we don't have unlimited bandwidth to do something else, but we are geared up to take on another pool of assets, whether it's with an HMS-type vehicle or something else.

Our next question is from Douglas Mewhirter from SunTrust Robinson Humphrey.

This is Michael in for Doug. We just want to drill down on the state of the lower-middle-market companies a bit. So recently, the National Center for Middle Market just released their first quarter middle market indicator report. And it was interesting, they suggested that for lower middle market companies, the appetite to make an acquisition increased from the prior quarter, along with their willingness to take on debt. However, the appetite to be acquired or merge with another company remained flat along with the willingness to open up new lines of credit. So we were just curious, are you seeing similar characteristics from your portfolio companies or companies you're working with in the pipeline?

I think we expect to see an elevated interest in M&A for the -- simply for the following reason: Most lower middle market M&A is done as an asset deal for tax purposes, because you have a flow-through buying another flow-through, without getting too technical. Well, when you're doing an asset acquisition, and under the new tax law, any purchase price that you allocate to depreciable assets is immediately expensable for the next few years. Well, you're looking at being able to expense a huge percent of your acquisition, we've never had that in terms of U.S. tax policy. I don't think going back to 1915 or whenever when we first had a first income tax. So that has to be a motivating factor if you can buy your competitor and expense a lot of the purchase price. So I think that's where that's coming from, rather than anything happening in the economy.

Okay, great. Thank you for that. And I guess, just as follow-up to that question. Have you seen, with those sort of characteristics we just mentioned, have you seen any difference between lower middle market companies and just straight middle market companies?

I don't think so. I think the same trends that Vince outlined would apply to the broader middle market as well. Obviously, that part of the market has always had a larger M&A appetite as part of their growth strategy, but I think it's similar in impact to what Vince said, given the tax rate changes or the tax code changes.

Okay, great. And then, I guess, just lastly, we noticed your stock has been sort of relatively strong since the end of the quarter. Any change to your ATM program?

In the first quarter, we did approximately $11 million, as I said on the call, in net proceeds under the ATM. Really that was more of just -- obviously, the market was somewhat volatile, our stock price was somewhat volatile and we're very conscientious in our program. We don't want to contribute to a down day or a downward trend and put more pressure on the stock price. We had certainly plenty of liquidity in first quarter. And I would say, with the market being a little more stable and our stock price specifically being a little more stable, I would expect us to ramp up the ATM activity in second quarter to be higher than first quarter. And hopefully, if all things work out more in line with most of the quarters for 2017.

Our next question is from Timothy Hayes from B. Riley FBR.

This is actually Makenzy Brown on for Tim Hayes today. So just a question kind of around higher rates and kind of if they have affected your strategy at all over the quarter? And how you are kind of thinking about that? I know you mentioned on the last call about offering companies possibly the ability to choose between fixed and floating options. So are you structuring deals in a way that may incentivize companies to use floating? Or kind of your thoughts around all that would be great.

Yes. I would say we haven't really changed anything about how we're approaching it. Obviously, there is increased sensitivity to floating rates, so I think we continue to try and provide options and structures that fit for the needs of the portfolio company but also fit with the needs on the Main Street side. And I think we've been successful in continuing to do that over the last three to six months and I wouldn't say that we really changed our approach. Different portfolio companies are going to view their interest rate sensitivity differently and that's why we think providing them options and letting them pick from those options is a good approach from a market-facing standpoint.

Great, thank you for that. And then just kind of a follow-up to that. How have coupon rates on first lien investments trended over the past several months? Any material change there?

Yes. I would say, obviously the floating market rates continue to change. But I think the spread, if you look at the broader middle market has contracted some. So I think, when look at the rate that's being experienced by the portfolio companies in the middle market, actually there's not been a significant change there. I think the lower-middle market, while we continue to look at the sensitivity, I would say you've had a similar result where the rates we're charging today would be fairly consistent with what's been charged over the last couple of quarters.

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

Great. Thank you all for joining us, and we look forward to talking to you again next quarter. Bye.

This concludes today's teleconference. You may disconnect your lines at this time. Thank you for your participation.