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Main Street Capital (NYSE:MAIN)

Q1 2014 Earnings Call

May 09, 2014 10:00 am ET

Executives

Ben Burnham - Vice President of Investor Relations Counsel

Vincent D. Foster - Chairman, Chief Executive Officer, President, Member of Credit Committee and Member of Investment Committee

Dwayne Louis Hyzak - Chief Financial Officer, Senior Managing Director, Treasurer and Member of Investment Committee

Analysts

Bryce W. Rowe - Robert W. Baird & Co. Incorporated, Research Division

Robert J. Dodd - Raymond James & Associates, Inc., Research Division

Vernon C. Plack - BB&T Capital Markets, Research Division

Christopher Nolan - MLV & Co LLC, Research Division

Operator

Good morning, ladies and gentlemen. Thank you for standing by. Welcome to the Main Street First Quarter Earnings Conference Call. [Operator Instructions] The conference is being recorded today, May 9, 2014. I would now like to turn the call over to our host, Mr. Ben Burnham. Please go ahead, sir.

Ben Burnham

Thank you, Elizabeth, and good morning, everyone. Thanks for joining us for the Main Street Capital Corporation's first quarter 2014 earnings conference call. Joining me today on the call are Chairman, President and CEO, Vince Foster; and Chief Financial Officer, Dwayne Hyzak. Main Street issued a press release yesterday afternoon that details the company's quarterly financial and operating results. This document is available on the Investor Relations section of the company's website at www.mainstcapital.com.

A replay of today's call will be available beginning about an hour after the conclusion of the call and will remain available until May 16. Information on how to access the replay is included in yesterday's press release. We also advise you that this conference call is being broadcast live through an Internet webcast that can be accessed on the company's webpage.

Please note that information reported on this call speaks only as of today, May 9, 2014, and therefore, you're advised that time-sensitive information may no longer be accurate at the time of any replay listening.

Our conference call today will contain forward-looking statements. Many of these forward-looking statements can be identified by the use of words such as anticipates, believes, expects, intends, will, should, may and similar expressions. These statements are based on management's estimates, assumptions and projections as of the date of this call, and they are not guarantees of future performance. Actual results may differ materially from these results expressed or implied in these statements as a result of risks, uncertainties and other factors, including, but not limited to, the factors set forth in the company's filings with the Securities and Exchange Commission, which can be found on the company's website or at sec.gov. Main Street assumes no obligation to update any of these statements unless required by law.

During today's call, management will discuss non-GAAP financial measures, including distributable net investment income and distributable net realized income. Please refer to yesterday's press release for a reconciliation of these measures to the most directly comparable GAAP financial measures. Certain information discussed on this call, including information related to portfolio companies, was derived from third-party sources and has not been independently verified.

Now I'll turn the call over to Vince.

Vincent D. Foster

Thanks, Ben, and thank you, all, for joining us today. I will comment on the performance of our investment portfolio, discuss our recent dividend announcements and our dividend outlook, discuss our recent equity offerings and conclude by commenting on our investment pipeline. Following my comments, Dwayne will cover operating performance in more detail and comment on our first quarter financial results and originations, our current liquidity position and certain key portfolio statistics, after which, we will take your questions.

Our investment portfolio performed as expected from both an earnings and a balance sheet standpoint for the first quarter. Our lower middle market investments appreciated during the quarter by $8.1 million on a net basis, and 23 of our investments appreciating during the quarter and 7 depreciating. Our middle market private loan investments depreciated by $200,000 during the quarter. We finished the quarter with a net asset value per share of $20.14, a sequential increase of $0.25 a share over year-end 2013. In addition, our recent follow-on equity offering increased our per share net asset value post-quarter by $1.06 a share.

We decided to pursue our recent equity offering when we did, primarily because our shop registration was set to and did go stale on April 30. We had filed a new shelf that was under review by the SEC, as all BDCs unfortunately are required to do at least annually, if they want the ongoing ability to issue debt or equity capital publicly. It was unclear how long the review would take. As it turned out, we were without a shelf from May 1 through yesterday.

We follow the pattern similar to last April, when we issued our 10-year notes, have invested the offering proceeds in middle market first lien debt and also in a $20 million private loan investment with an equity component.

We expect, again similar to last April, to reduce the level of middle market investments as we complete new lower middle market opportunities. Similar to the last several years, the beginning of the year has been quiet from a lower middle market perspective. Unlike most sponsor-oriented BDCs, we take this opportunity to work more closely with our portfolio of companies, in which we have outright or shared control and help them with critical operational and or balance sheet issues. This was again the case during the first quarter, when we were able to fully exit one investment at 16% IRR, recapitalize 2 others into what are now control positions and help several of these companies develop 2014 operating and capital budgets.

Our lower middle market companies ended the quarter with $123 million in cash on their balance sheets. We also continue to exhibit highly conservative leverage and debt service coverage ratios, which Dwayne will cover in greater detail.

Last month, our board declared our midyear semiannual supplemental cash dividend of $0.275 a share, payable to stockholders of record as of June 20. Earlier this week, our board declared our third quarter regular monthly dividends, which are consistent with our second quarter monthly payout rate of $0.165 or $0.495 for the quarter. We expect to be in a position to recommend a dividend increase to our board as we deploy our offering and other proceeds into higher-yielding assets.

During the course of our last conference call, I referenced our spillover taxable income of $44 million at year end. At the end of the first quarter, we estimate that our spillover taxable income was $46 million. We continue to expect that we will pay semiannual supplemental dividends in addition to our regular monthly dividends, as long as we are in a significant spillover income composition.

As of today, I would characterize our investment pipeline as modest but selective and growing. We continue to seek and receive significant equity participation in our lower middle market investments, and as of quarter end, we maintained an average of 33% fully diluted equity ownership position in the 95% of these investments in which we currently have equity exposure.

Our officer director group has continued to purchase shares via our dividend reinvestment plan, investing over $0.5 million in this program during the first quarter. With that, I'd like to turn the call over to Dwayne Hyzak, our CFO and Senior Managing Director, to cover our portfolio performance in more detail.

Dwayne Louis Hyzak

Thanks, Vince. We're pleased to report another quarter with operating results that are consistent with our long-term goals of generating sustainable growth in our recurring investment income and continued appreciation of our net asset value per share. The first quarter of 2014, our total investment income increased by 20% over the same period in 2013 to a total of $30.8 million. This increase was primarily driven by increased amounts of interest income associated with higher levels of portfolio debt investments and increased dividend activity from portfolio equity investments, partially offset by decreases in fee income and investment income related to the accelerated prepayment and repricing activity of certain debt investments to marketable securities investments.

First quarter operating expenses, excluding noncash share-based compensation expense, increased by $1.4 million over the same period in 2013 to a total of $9.2 million. This increase was primarily the result of a $1.4 million increase in interest expense.

Our total operating expenses, excluding interest expense, as a percentage of our average total assets, was 1.4% on an annualized basis for the first quarter of 2014 compared to 1.7% for the first quarter of 2013 and 1.8% for the full year in 2013, representing continued improvement in a ratio which already compares very favorably to other BDCs and which illustrates the significant benefits associated with our internally managed operating structure.

Our increased total investment income and the continued leverage of our efficient operating structure resulted in a 21% increase in distributable net investment income for the first quarter of 2014 to a total of $21.6 million or $0.54 per share, which is in line with our previously provided guidance and which exceeded our recurring monthly dividends paid for the quarter by $0.045 per share or 9%.

We reported net annualized appreciation of $6.7 million in the first quarter of 2014 which consisted of net appreciation on the investment portfolio of $6.9 million, as Vince previously discussed, and $1 million of net appreciation on marketable securities investments, partially offset by $1.2 million of depreciation on the SBIC debentures held by one of our wholly-owned SBIC subsidiaries. Our operating results for the first quarter of 2014 resulted in a net increase in net assets from operations of $27.2 million or $0.68 per share.

Our investment activity in the first quarter resulted in a net increase in our portfolio investments of $9 million. Investment activity included a decrease in our lower middle market portfolio of $15.2 million, primarily as a result of the full exit of our investment in one company and the repayment of our debt investment in another existing portfolio company, net increase in our middle market portfolio of $17.5 million and a net increase in our private loan portfolio of $6.7 million.

On a capital resources front, our liquidity and overall capitalization remains strong. At quarter end, we had $24.4 million of cash, $11.3 million of marketable securities and $209 million of unused capacity under our credit facility.

After our follow-on equity offering in April, through which we received net proceeds of $139.6 million and increased our net asset value by over $1 per share, today, we have over $20 million of cash, $10 million of marketable securities and $284 million of unused capacity under the credit facility, providing a significant liquidity for future growth.

We continue to explore various financing sources and structures to support our future operational and investment activity, and we remain focused on maintaining significant liquidity and matching the expected duration of our borrowing arrangements with our investment assets.

As we discussed on our last conference call, beginning in the first quarter of 2014, our external investment manager began accruing management fees related to its investment sub-advisory relationship with HMS Income Fund. During the first quarter, this relationship generated approximately $300,000 of contribution to our net investment income. We currently project that this relationship will contribute $0.03 to $0.05 per share of net investment income for the full year 2014. Based upon HMS' current fund-raising efforts and activities, we expect that this amount could increase later in 2014.

As we look forward to the second quarter of 2014 and consider our current investment portfolio, our second quarter investment activity to date and the short term dilutive impact of our April follow-on equity offering, which increased our outstanding shares by over 11%, we currently expect that we will generate second quarter of 2014 distributable net investment income per share in a range of approximately $0.51 to $0.53 per share or $0.02 to $0.04 above our previously announced regular monthly dividends for the second quarter at $0.495 per share, which is consistent with our previously discussed policy of setting our regular monthly dividend at 90% to 95% of our distributable net investment income.

Now, let me finish with a few portfolio statistics, all as of March 31. Our investment portfolio continues to be extremely diversified, with investments in 167 companies across our lower middle market, middle market and private loan portfolios. These companies are diversified across over 50 different industries. The portfolio continues to be well diversified by end market, geography and vintage. We believe that this diversification adds significant protections to our investment portfolio, our recurring investment income and cash flows and provide significant benefits to our shareholders.

In our lower middle-market portfolio, we had 61 investments, representing approximately $654 million of fair value, which is approximately 23% above the cost basis of approximately $531 million. Consistent with our investment strategy, approximately 75% of our lower middle market portfolio investments at cost on the form of secured debt investments, and approximately 86% of those debt investments held a first lien security position.

The weighted average effective yield on our lower middle-market portfolio debt investments was 15.1%. As Vince mentioned, we continue to hold equity positions in 95% of our lower middle market portfolio of companies with an average fully diluted equity ownership position of approximately 33%. We believe that these equity ownership positions provide significant value to our shareholders, and they are the primary driver behind our significant net unrealized appreciation of over $3 per share and our growing levels of dividend income.

At the lower middle market portfolio level, the portfolio's median net senior debt-to-EBITDA ratio was 2.3:1 or 2.4:1 including portfolio company debt, which is junior in priority to our debt position. Based upon our internal investment rating system, with a rating of 1 being the highest and 5 being the lowest, with all new investments entering the rating system with an initial 3 rating, the weighted average investment rating for our lower middle market investment portfolio was 2.2 on March 31, which is unchanged when compared with the ranking at December 31, 2013.

In our middle market portfolio, we had investments in 89 companies, representing approximately $492 million of fair value that were generating a weighted average yield of approximately 7.6%.

Our middle market portfolio investments are primarily in the form of debt investments, approximately 92% of our middle market portfolio debt investments at cost of the first lien security position. The weighted average EBITDA for the companies in the middle market portfolio was approximately $71 million.

Our private loan portfolio, we have investments in 17 companies, collectively totaling approximately $117 million in fair value. Weighted average EBITDA for the companies in the private loan portfolio was approximately $7 million.

Approximately 96% of our private loan portfolio investments are in the form of debt investments, and 99% of such debt investments held a first lien security position. Weighted average annual effective yield on our private loan portfolio and debt investments was approximately 11.1%.

The total investment portfolio at fair value at March 31 was approximately 111% of the related cost basis, and we had 2 portfolio investments on nonaccrual status, which comprise approximately 2% of the total investment portfolio at fair value and 4.6% at cost. We exited one of these nonaccrual investments in early April at our reported March 31 fair value, reducing our investments on nonaccrual status to approximately 1.3% of the total investment portfolio at fair value and 3.3% at cost.

With that, I will now turn the call back to the operator, so that we can take any questions.

Question-and-Answer Session

Operator

[Operator Instructions] And our first question is from the line of Bryce Rowe with Robert W. Baird.

Bryce W. Rowe - Robert W. Baird & Co. Incorporated, Research Division

Just a question on the HMS relationship, Vince and Dwayne, and just curious, where is it -- where is the fee income, the related fee income, on the income statement? Dwayne, just curious if it's in the, I guess, the breakdown of the fee income that you've shown previously in the Q.

Dwayne Louis Hyzak

So when you look at HMS, or the fee income that comes from HMS, because the external investment manager is not consolidated, that fee income does not show up in our income statement today. What happens with our first quarter income statement is we allocate expenses from Main Street to that portfolio company, so it shows up as an offset of about $300,000 of our expenses for the first quarter. Going forward, as the activity with HMS grow and we generate additional fee income, eventually, in addition to the offset of some of our experiences, we will start recording dividend income from that subsidiary, once it starts announcing and accruing dividends for the fee income off of the HMS relationship.

Bryce W. Rowe - Robert W. Baird & Co. Incorporated, Research Division

Okay. And then I guess, a follow-up to that, you guys talk about HMS having $160 million of outstandings at the end of March. Just any idea what the pace of growth there is or any estimates?

Vincent D. Foster

Yes, Bryce. What I have been telling people to expect is about $1 million a day on a leverage basis of additional assets is what we would expect for the intermediate future, the next quarter, quarter or 2.

Bryce W. Rowe - Robert W. Baird & Co. Incorporated, Research Division

Okay, that's helpful. And one more question then. In your prepared remarks, you talked about cycling out of some of the middle market investments that built up with some of the proceeds here recently. Is it fair to assume that we'll start to see I guess, the percentage of the lower middle market portfolio within the total portfolio that starts to grow again as we kind of move out through 2014?

Vincent D. Foster

Absolutely, yes. Just like last year. We don't want to just sit on the IPO proceeds, because we have to pay a dividend on them, so we want to at least try to break even with respect to that dilution. So we've invested nearly all of that, just to try to minimize the dilution as the temporary basis. But that has not stopped us from looking at lower middle market deals, which we continue to do. So yes, I would expect that that's going to be the case just like last year.

Operator

And our next question is from the line of Robert Dodd with Raymond James.

Robert J. Dodd - Raymond James & Associates, Inc., Research Division

In terms of just some more market color, could you give us -- particularly in the lower middle market, obviously, any ideas about the kind of flow you're seeing? Obviously, I mean, your valuation multiples are up, et cetera, I mean, in the broad market. Lower middle market is somewhat of a different animal, obviously, but are you seeing, as a result of that, kind of maybe a disproportionate flow of lower quality deals that basically all the bad companies looking to sell while they can, whereas the good ones are more inclined to wait out because they think their future's brighter anyway. Is there any kind of mix between quality versus activity levels that you're anticipating for the rest of the year?

Vincent D. Foster

Sure, Robert. I'll cover kind of 3 different areas in terms of what we're seeing that's different than prior years. In terms of lower quality companies, particularly in our part of the country, on the Gulf Coast, in the oil patch, there's a lot of small oil service companies that have kind of come out of nowhere and start from making $1 million or $2 million of earnings to $10 million and want to sell, right? So you have to be really careful of that, and you won't see us participating in many of those transactions, unless it's a real special situation. The second category that's kind of new is if you have a company in kind of a hot area, maybe it's a hot segment, hot high-growth, perceived to be high growth segment, health care for example, we're seeing extremely high valuations for fairly small companies. We're not seeing that for moderate growth companies that are smaller but what we are seeing that's new is it almost doesn't matter how small a company is, if it's in a hot area, software as a service, what have you, you might have to pay 8x or 9x EBITDA for that company. We really haven't seen that in the past. Finally, the other comment I'd make about where we are participating in the market, our average EBITDA over the last 8 quarters for our lower middle market companies has grown from about $3.5 million to about $5.25 million. And as you -- and so it's going up a couple hundred thousand dollars a quarter or $0.25 million a quarter, as we start to approach $10 million, we're not on a pace to do that for several years, the valuation multiples are going up, and it remains to be seen. Hopefully, the quality of companies go up too. There's less volatility in earnings. There's also more leverage and some more questionable structures. So we're still comfortably below that level, where you really are seeing some lower quality opportunities in terms of how much you have to pay and how much leverage goes on them. But we're creeping towards there and our challenge is to make sure that the quality of the company, the increased quality of the company is offset by the higher valuation.

Robert J. Dodd - Raymond James & Associates, Inc., Research Division

Very helpful. If I can kind of follow up with that and turn it around the other way, like you said, with your companies now on average north of $5 million, and we know there's, like you said, there's a change in kind of valuation framework when you [indiscernible] go above $10 million, but from what I know, there's also something of a change when they go over $5 million. So are you -- any color -- and obviously, you don't control this timing et cetera, but has there been any meaningful change in your portfolio companies now being -- starting to look at strategic alternatives, whatever, looking to sell given they've grow that EBITDA and what the outlook is for your realizations, which are obviously very difficult?

Vincent D. Foster

That's a good question. We benefit from that trend, as well as potentially be impacted by it negatively. We have 2 companies that are in the market right now running processes, and the valuations we're hearing are pretty amazing. I mean, they're consistent with the valuations I just expressed. We're a little bit agnostic about selling them, because they're typically going to be some of your better, faster-growing companies, but the numbers we're hearing are nowhere near how we're marking them, and it will be little interesting to see how those processes conclude. We're hearing very positive things, and we would expect we're going to get at least 2 sales in the next couple of quarters and maybe more. And again, we have mixed feelings about it, but to the degree that happens, then it will verify the fact that we're able to participate from these higher valuations with respect to the sector, the smaller companies that are perceived to be in a hot position. Dwayne, would you add any color to that?

Dwayne Louis Hyzak

No, I agree with that.

Operator

[Operator Instructions] And our next question is from the line of Vernon Plack with BB&T Capital Markets.

Vernon C. Plack - BB&T Capital Markets, Research Division

Another question on the lower middle market. I'm just curious, Vince, in terms of growth this year in the portfolio. If I look year-over-year, at least on a fair value basis, the portfolio grew something like 25%. I think you went from 57 companies up to 61. Are you expecting that type of growth again in 2014?

Vincent D. Foster

Yes. Well, about all we can control are the gross originations. Some of these management teams when we're in shared control positions, if they want to sell, they'll sell. But assuming that the pace of sales doesn't really ramp up, yes, I would expect similar levels of growth. And again, ideally, it would not necessarily be in the numbers of company, but it would be more in the size of companies. We're not trying to -- we don't want to wake up 2 or 3 years from now and have 120 companies that have $5.25 million in EBITDA. We'd rather have 60 or 70 or 80 companies that have $6 million or $7 million or $8 million in EBITDA. So that's kind of where we're trending. We are seeing back-ended growth. We've seen it over the last several years. I don't know why that is. I don't particularly like it, but I think we're on track to see similar levels of growth again on a gross origination perspective.

Vernon C. Plack - BB&T Capital Markets, Research Division

Okay. So at least as far as the lower middle market goes...

Vincent D. Foster

Correct.

Vernon C. Plack - BB&T Capital Markets, Research Division

Okay, and I just wanted to confirm the numbers. I think net investments for the quarter were around $16 million, is that right? And in terms of the number...

Dwayne Louis Hyzak

Yes, the net in total, Vernon, is $9 million.

Vernon C. Plack - BB&T Capital Markets, Research Division

$9 million, okay. And...

Dwayne Louis Hyzak

So when you look at the numbers, if you're just trying to put the balance sheet, you have to remember, you got to take into consideration the appreciation in the quarter, but actual net dollars out was $9 million.

Vernon C. Plack - BB&T Capital Markets, Research Division

$9 million. And so new investments were roughly what and repayments exits were what?

Dwayne Louis Hyzak

So in the lower middle market, it was a net decrease of about $15 million, with $1 million of follow-on in the existing portfolio and $16 million of exits. And then the middle market was net of $17.5 million and the private loan was net of $6.7 million.

Operator

And our next question is from the line of Christopher Nolan of MLV & Co.

Christopher Nolan - MLV & Co LLC, Research Division

I apologize if you might have touched on this earlier, the 2 credits last quarter, which were nonaccrual and the company took a write-down on, were those the credits which the company reinvested in this quarter. Or can you give us any update on that, which...

Dwayne Louis Hyzak

There was no reinvestments in those 2 companies in the quarter, Chris. The only activity that happened in those 2 portfolio companies was post quarter end. And in early April, we exited one of those 2 at a valuation at the equivalent of our fair value market at 3 31. Outside of that, there was no additional activity there.

Christopher Nolan - MLV & Co LLC, Research Division

Okay. And so, you just have one of the credits remaining, correct?

Dwayne Louis Hyzak

Correct.

Vincent D. Foster

Correct.

Operator

And I am showing no further questions. I would like to turn the call back over to management for any closing remarks.

Vincent D. Foster

Great. Well, thank you, all, for participating. We know it was a busy Friday morning, and we look forward to talking to you again in August.

Operator

Thank you. Ladies and gentlemen, this concludes our conference call for today. We'd like to thank you for your participation. And if you would like to listen to a replay of today's conference call, please dial (303) 590-3030 or dial 1 (800) 406-7325 and enter access code 4680547. We'd like to thank you for your participation, and you may now disconnect.

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