Main Street Capital Corp (MAIN) 2018 Q2 法說會逐字稿

Greetings, and welcome to the Main Street Capital Second 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 Second 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 detailed the company's second 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 August 10. 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, August 3, 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 by 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 the 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, then conclude by commenting on our investment pipeline.

Following my comments, Dwayne Hyzak, our President; and Brent Smith, our CFO, will comment on our second 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 second quarter operating results. Our lower middle market portfolio, our primary area of focus, appreciated by $13.3 million on a net basis during the quarter, with 19 of our investments appreciating during the quarter and 16 depreciating. Our middle market loans, private loans and our other assets collectively appreciated by $10.8 million on a net basis.

We finished the quarter with a net asset value per share of $23.96, a sequential increase of $0.29 over the first 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 fourth quarter 2018 regular monthly dividends of $0.195 a share in each of October, November and December, increasing our third quarter monthly payout rate. The ex dates for these dividends are September 19, October 18 and November 19, respectively. We expect to ask our Board to declare a $0.275 a share semiannual supplemental dividend to be paid in December as well.

We have continued to work closely with our industry association, the Small Business Investor Alliance, or SBIA, on important industry issues that impact our constituents. Currently, our focus has been directed primarily on the acquired fund fees and expenses, or AFFE rule, as it affects BDCs, and a special deduction for individuals that receive dividend income from REITs and MLPs. After the first item, we are working with the SEC to either eliminate or at least modify the rule that effectively resulted in the elimination of BDCs' eligibility for index fund inclusion.

As to the second item, we are working with congressional staff to include BDC dividends as being eligible for the deduction so as to level the playing field with REITs and MLPs. We are happy to hear from you with respect to these issues and would welcome any input or support you can provide.

We've originated new lower middle market and private loan investments of roughly $400 million so far this year, including lower middle market originations of $52 million during the second quarter. As of today, I would 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, on average, a 38% fully diluted equity ownership position in the 99% 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 $1.6 million during the second quarter.

With that, I'd like to turn the call over to Dwayne to cover our performance in more detail.

Thanks, Vince. Good morning, everyone.

We are 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 generated record quarterly distributable net investment income per share. We were also able to generate a meaningful increase in our net asset value per share, and we believe that our ability to consistently generate increases in both our net investment income and net asset value per share continues to illustrate the unique benefits of our differentiated investment strategy and efficient operating structure.

We are also pleased that our operating results represent a GAAP return on equity, or ROE, of 13.6% for the trailing 12-month period and 15.6% for the quarter ended June 30. ROE is our principal metric for evaluating our performance internally, and we are 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, we'd like to revisit several reasons why we believe that our structure as a publicly traded BDC, with the significant benefit of permanent capital, is a perfect match with our focus on investing debt and equity in the lower middle market.

First, we believe that our permanent capital structure allows us to be the ideal partner for owners of privately held businesses that are seeking either a liquidity event or a long-term growth capital partner, as we can eliminate the concerns typically associated with the limited holding periods required by traditional private equity funds. This flexibility allows us to compete for transactions based upon beneficial structure considerations, as opposed to solely on price, generating what we believe are highly attractive investment opportunities. This flexibility also gives us continued comfort in investing across different economic and investment cycles, including the current cycle where many industry participants have noted concerns about elevated enterprise values and leverage levels.

Second, our desired long-term holding period has generated a diversified portfolio for mature companies with reasonable leverage, providing these companies the ability to work through negative economic cycles and take advantage of opportunities as they arise. Our long-term holding period also provides for a less frequent portfolio turnover, resulting in improved portfolio diversity each quarter and providing opportunities for increased dividend income as the portfolio companies continue to mature.

Our long-term approach is best demonstrated by the fact that we currently have 14 companies that have been in our lower middle market portfolio for longer than a decade.

Our long-term partnership approach also provides us the opportunity to work with the management teams of our portfolio companies to create value at the portfolio company level, and in June, we hosted our portfolio companies at our Annual Presidents' Day Meeting in an effort to further these efforts and allow them to share best practices and ideas for everyone's benefit.

As a result of the continued attractive opportunities we are seeing in the lower middle market, coupled with what we believe are growing attractive opportunities in the private loan investment strategy, we have continued to focus on growing our team of investment professionals. Since the beginning of this year, we have expanded our investment team by 4 additional members, several of which were participants in our internship program last year. And consistent with the past several years, we currently have 5 investment interns working with us this summer and are excited about having this pipeline of potential new additions to the team for future years.

We put significant value on our internship program, as our goal of this program is to train these potential new employees the Main Street way of investing and to hopefully provide them a career opportunity after graduation that allows us to retain them long-term as valued Main Street investment professionals.

Now turning back to our second quarter operating results, consistent with prior quarters, the contributions from our lower middle market portfolio continued to be well diversified, with 42 of our 69 lower middle market companies with equity investments having unrealized appreciation at quarter-end and with 31 of these companies that are flow-through entities for tax purposes, or 63% 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 second quarter and our investment portfolio at quarter-end, our investment activity in the quarter included total investments in our lower middle market portfolio of approximately $52 million, which, after aggregated repayments on debt investments and return of invested equity capital, resulted in a net increase in our lower middle market portfolio of approximately $11 million.

We had a net decrease in our middle market portfolio of approximately $23 million, and a net increase in our private loan portfolio of approximately $21 million. As a result, at June 30, we had investments in 181 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 less than 3% of our total investment portfolio fair value, 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 70 companies, representing approximately $1.1 billion of fair value, which is approximately 19% above our cost basis. At the lower middle market portfolio level, the portfolio's median net senior debt to EBITDA ratio was a conservative 3.3:1.

As a complement to our lower middle market portfolio, in our middle market portfolio we had investments in 57 companies, representing approximately $592 million of fair value. In our private loan portfolio, we had investments in 54 companies, representing approximately $517 million at fair value. The total investment portfolio at fair value at quarter-end was approximately 109% of the related cost basis, and we had 5 investments on nonaccrual status, which comprised approximately 1.2% of the total investment portfolio at fair value and 3.5% 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 are pleased to report that our total investment income increased by 19% for the second quarter over the same period of 2017 to a total of $59.9 million, primarily driven by an increase in dividend income of $5.6 million and an increase in interest income of approximately $5.2 million, partially offset by a decrease of $1.2 million in fee income. The total investment income includes $3.5 million in elevated dividend income activity, which may not be recurring at these same levels in future periods, partially offset by a decrease of $1.2 million related to lower accelerated prepayment, repricing and other activity for certain debt investments when compared to the same period in 2017.

Second quarter 2018 operating expenses, excluding noncash share-based compensation expense, increased by $3.1 million over the second quarter of the prior year to a total of $17.9 million. The increase was primarily related to a $2 million increase in interest expense and a $1.1 million increase in compensation expense.

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 1.6% an annualized basis for the second quarter compared to 1.7% during the same period in the prior year.

Our increased total investment income and a continued leverage of our efficient operating structure resulted in 18% increase in distributable net investment income for the second quarter of 2018, to a total of $41.9 million or $0.70 per share, which exceeded our current monthly dividends paid for the quarter by approximately 23%.

The activities of our External Investment Manager during the second quarter and its relationship with the HMS Income Fund benefited our net investment income by approximately $2.7 million in the second quarter of 2018 through a $1.7 million reduction of our operating expenses for costs we allocated to the External Investment Manager for services we provided to it, and $1 million of dividend income from the External Investment Manager.

We recorded a net realized loss of $15.5 million during the second quarter, primarily relating to the realized losses from the exit of 2 lower middle market investments that had materially impaired on unrealized basis several quarters ago, the realized loss from the exit of a middle market investment and a realized loss related to the early redemption of our baby bonds. Partially offsetting these losses was a realized gain related to the exit of a private loan investment.

And as Vince discussed, we recorded net unrealized appreciation on the investment portfolio of $24.1 million in the second quarter, primarily resulting from $13.9 million of appreciation on our External Investment Manager, $13.3 million of net appreciation on our lower middle market portfolio, $0.8 million of net appreciation on our private loan portfolio and $0.5 million of net appreciation on our other portfolio. This appreciation was partially offset by $4.4 million of net depreciation on our middle market portfolio. Additional details for the change in our net unrealized appreciation can be found in our earnings release.

Our operating results for the second quarter of 2018 resulted in a net increase in net assets of $55.5 million or $0.93 per share.

On the capital resources front, our liquidity and overall capitalization remained strong. At the end of the second quarter, we had $40.5 million of cash, $366 million of unused capacity under our credit facility and approximately $32 million of incremental SBIC debenture capacity for total liquidity of approximately $439 million.

Currently, we have approximately $37 million of cash, $415 million of unused capacity under our credit facility and $32 million of incremental SBIC debenture capacity for a total liquidity of approximately $484 million. This strong liquidity position, which represents approximately 20% of our total assets, puts us in a great position to continue to grow over the next 12 months as the market opportunities allow.

During the second quarter, we called or redeemed our outstanding baby bonds, which had 5 years remaining until maturity. At the time of the repayment, we estimated the annual interest expense savings to be approximately $2.7 million. We were also pleased to extend the maturity of our revolving credit facility to September 2023 and increased the commitments under the facility by $95 million to a total of $680 million, including the most recent increase in July. This extension and increase of capacity significantly enhances our flexibility for managing the maturities of our liabilities as well as our overall liquidity.

In addition, following the announcement on our last earnings conference call that we would not be seeking Board or shareholder approval to access the additional leverage provided for in the recently passed legislation, S&P reaffirmed our investment-grade rating of BBB flat with a stable outlook. With that rating, we are currently the highest-rated BDC by S&P, and the only BDC with a BBB flat rating.

We also raised approximately $42.3 million in net proceeds under our ATM equity program during the second quarter, with an average sale price of $38.30 per share.

As we look forward to the third quarter of 2018, we are providing a $0.01 broader range for our distributable net investment income as we expect dividend income to remain more volatile than our historical results as our lower middle market equity portfolio continues to grow, and for our dividend income to return to more normal levels following the elevated activity in the first and second quarters.

Based on our current outlook, we expect that we will generate distributable net investment income of $0.61 to $0.64 per share during the quarter. This estimate is $0.04 to $0.07 per share or approximately 7% to 12% above our previously announced monthly dividends for the third quarter of $0.57 per share, maintaining a conservative approach to our monthly cash dividends.

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 here is from Robert Dodd from Raymond James.

Vince, you made comments at the beginning of the call that your lower middle market pipeline is above average. It sounds really good. Obviously, a great quarter this quarter as well. Then the liquidity between the cash and the SBA, obviously, you've got a lot of liquidity available on the revolver, but you tend to not utilize that for the lower middle market piece of the portfolio. So do you think the existing liquidity that you do have, plus, obviously, the access to the ATM facility, which is accretive when you use it, is sufficient to match up to the kind of lower middle market pipeline that you see right now? Or are you going to have to take other steps?

Yes, Robert, that's a good question. Thanks for asking that. So if you think about a new lower middle market investment, say it's a $40 million investment and it involves -- round numbers of $10 million equity co-investment and a $30 million unit tranche, first lien. That first lien component is borrowing-base eligible. So that can be financed out of our -- the revolver at the BDC level, or if there's room, the SBIC. The equity has to be financed, not out of the revolver, but either through our ATM program, or proceeds of our unsecured notes, and, if there's room, down in the SBIC.

So if it was -- we'd have a problem at some point matching up, potentially, if all we did was equity, right, that's borrowing-base ineligible. Would you put it any other way, Brent?

No, that's a good way to put it. We're fine putting the lower middle market debt investments in the revolver. Some of it's just timing. So later on, when we do more investment-grade notes, you kind of theoretically think about the revolver borrowings switching to that for the lower middle market debt investments.

So for us, every Friday, when I look at the revolver balance, it used to be if it began with a 3, when we really didn't want to get up past $400 million, that's when we'd start thinking about matching up the pipeline with available liquidity. And now, because everything is kind of increased, we're -- that would be -- if it began with a 4, that would be kind of a signal that we need to term some of that out or maybe sell a little bit more equity. But we're in really good shape now, I would say, for the next several quarters. We're probably a phone call away from maybe an M&A transaction, where all bets are off and we'd have to do something.

Right, fair enough. Then on the dividend income, obviously this quarter a very high number, I mean. And to the point you said some of that might not be recurring, but it's fair to say, you didn't expect it to be in a quarter, it did.

Could it -- question, how possible is it that it could happen again? And two, I guess, with some of the excess, like Drillinginfo that you've now exited in this press release yesterday or day before yesterday, was it -- it's been a very successful long-term investment for you. Was that a big dividend payer? Or a relatively big dividend payer? And is that a dynamic that's at play in the dividend income?

Yes, thanks, Robert. I would say, in the case of Drillinginfo, that was a C corporation. And as you've heard us talk about in the past, most of our dividend income will come from LLCs or other flow-through entities for tax purposes.

Drillinginfo did make a distribution, I think it was third or fourth quarter of last year. I can't remember the exact timing. But outside of that, the value we've gotten out of Drillinginfo was really appreciation and now the realized gain.

I think the change in our commentary this quarter versus last quarter on the dividends is, we're always talking to our portfolio companies, and there have been some larger contributors to our dividend income in both Q1 and Q2 of this year. And as we look at those companies, I would say, we have a greater expectation this quarter than last that some of that dividend that we had in Q1 and Q2 will not recur in Q3. But it's just hard to predict because it's not contractual, and we don't want 100% control when those dividends get paid out. And that's what makes it hard for us to predict it for purposes of our future estimates.

Got it. And if I can cheat and get one more in, another kind of going back to the -- you mentioned also in the prepared remarks, there's some concern out in the market about elevated enterprise multiples. So I mean, some businesses are transacting at high multiples out there, a great time to exit. At the same time, your pipeline looks really good. So -- and you guys are not exactly known for paying big multiples for businesses. So can you give us some more color on how that is? Is it you're seeing a lot of -- a lot in your pipeline, but is there a big gap between the -- what the seller wants and what you're willing to pay? Or how is that working out right now?

So Robert, I think as you've probably heard us say in the past and what I tried to address in my previous comments is, when you look at why we are comfortable continuing to invest in this cycle is that we're not competing just on value. Obviously, we have to have a fair value. But where we really are successful from a competitive standpoint is by providing an option that's not otherwise available in the marketplace. And that's why if you looked at our deals, we are commonly a meaningful equity participant but not always control. We do a lot of investments where we're 30% or 40% to 50% or 60%.

So when we can go in and provide fair value, maybe not the highest value but a fair value, but also allow that management team and that ownership team to continue to have a significant ownership position going forward and provide a one-stop shop solution on the financing side, it really plays well in certain situations.

It doesn't play well in every situation. If the owner of the business is just trying to maximize value, and those are the transactions that we won't be successful on. But for a company that's looking for a long-term partner that provides fair value and some liquidity but also allows for the future upside, those are the transactions where our unique solution is a very, very good fit.

You're next question is from Tim Hayes from FBR.

As it relates to the proposed tariffs on Chinese imports, do you expect there could be some supply chain disruptions with your portfolio companies? And have you seen any -- have you seen that drive any change in demand from portfolio companies looking for capital?

Yes, Tim, thanks for the question. I would say that if you looked at our portfolio, most of our companies are focused heavily on domestic activities, both from a sourcing and a sales standpoint. We do have some companies that will have more interaction with activity outside of the U.S., and we're in constant conversation with those companies, given what's going on from a tariff and an international business activity standpoint.

And I would say, to date, while you've seen some impact on steel prices and some other commodities, the feedback we're getting is that if they're -- as long as they're managing their business well, which is the intent for all these companies and that's why we're talking to them on a consistent basis, they're able to pass some of that on to customers. And for the others, while they are actively monitoring the situation, to date it has not been a significant disruption or issue in their businesses.

Yes, but look, I think it's fair to say it probably has been a distraction. If you're a headline away from being impacted and -- it is causing some distraction out there but nothing -- not disruption yet for us.

Okay. So you don't expect really any meaningful kind of sector rotation in the portfolio to address the potential impacts there?

I would say no, but I think that's partly because, as I said earlier, our businesses -- the vast majority are domestic-focused, both on the sales and on the raw material or sourcing side of things.

But it's fair to say, it's maybe not a new diligence item on the checklist, but it's an enhanced one.

Okay, understood. And just one more for me. How is the flow of potential M&A or portfolio sales and/or subadvisory opportunities been over the past few months? Have you seen more deals come your way? And how many of those are really fitting your credit standards and return hurdles?

Well, I would say, on -- it's really kind of 3 different questions there with respect to the portfolio of company sales. When you look at the 70, 75 lower middle market companies, we kind of expect, on average, once a quarter, they're going to get a phone call from private equity that needs our company as a bolt-on to one of their platform companies, and they just need it to exit and put out a number that our management team finds attractive. And we'll -- so we can't really control that, but probably 4, 5 companies a year will look to exit because opportunistically they receive an unsolicited offer.

This year, we had a determined effort to try to exit 2 or 3 of our companies, which is kind of unusual for us, and Dwayne can give you the background there.

Yes, I mean, I think it's -- when you look at it, obviously, it's a good M&A market. Obviously, the transaction that we announced yesterday morning with Drillinginfo, was a very good outcome. So I think you can see -- continue to see that. But our goal with our portfolio of companies is to have a very long-term holding period. So the driver of an exit is very rarely going to be Main Street. So it really comes down to what the other owners of the business and the management team wants to do.

I would say, in terms of the -- some of the investments that we think we can get a higher-return elsewhere for, that we've been in...

I'm sorry, yes. And so if you look at our portfolio count, you would see that we did exit a couple of positions. So one of the things that we're always looking at is, what's the return that Main Street's getting on those investments, whether it's a scenario where it's not producing enough current income or appreciation, or if it's a smaller investment where it's taking significant amounts of time and effort on our side. And that's where you've seen us continue to focus on ways to redeploy those resources, whether it's capital or it's people, into new investments that have an opportunity to provide additional value going forward.

And then you asked about subadvisory opportunities out there. And I'll let Nick Meserve, who runs that part of the business for us, respond.

Yes, thanks, Vince.

On the subadvisory side, we're always in the market, evaluating what's out there. And I might say, one thing we've done is being fairly picky on what we'll enter into. We want to make sure it's valuable to the shareholders and the investors in those funds and also valuable for us from a time perspective. Obviously, our partnership with Hines has been great on HMS Income Fund. We're still in the market there of looking to do what's the next product and what's the best thing to move forward there. I think there'll be news, hopefully, the next few quarters of what we do going forward. But we're always in the market there and evaluating different opportunities and finding the right fit for us.

And then your -- I think the -- if I understand right, the last part of your question, is M&A opportunities generally. And I would say that in light of what's happened this year and TCAP closing yesterday or today or whatever the schedule is, when you look to valuations that are available for a BDC Board to consider and you look at -- what I kind of like to look at, the favorable tax aspects to the buyer of potentially paying for an advisory agreement and being able to deduct that payment according to a ruling that came out to the IRS last year. You put all that together, and it's a very attractive time to consider doing something with an asset that might otherwise be considered unperforming or underperforming. And there's some nice valuations out there, at least if it's $1 billion on a leverage basis asset or bigger.

What we don't know is what kind of valuations you might expect if it's a $0.5 billion on a leverage basis asset or, at least, I'm -- Nick, I'm not -- I have -- we haven't seen many of those. There's -- we hear there's rumors, but we really haven't seen anything.

Yes, obviously, TCAP is closing this week or next. But other than that, we haven't really seen anyone else come to the market that looks attractive to us or has really been out there. But we're also, obviously, always keeping our doors open and seeing what comes in the market.

(Operator Instructions) And if there are no further questions, I'd like to turn the floor back over to management for any closing comments.

Great. Well, thanks for everyone that attended, and we look forward to talking to you again in early November. Bye.

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