Main Street Capital (NYSE:MAIN)
Q2 2012 Earnings Call
August 03, 2012 10:00 am ET
Vincent D. Foster - Chairman, Chief Executive Officer and Member of Investment Committee
Todd A. Reppert - President, Director, Member of Investment Committee and Member of Credit Committee
Dwayne Louis Hyzak - Chief Financial Officer, Senior Managing Director and Treasurer
Vernon C. Plack - BB&T Capital Markets, Research Division
Robert J. Dodd - Raymond James & Associates, Inc., Research Division
Ladies and gentlemen, thank you for standing by. Welcome to the Main Street Capital Second Quarter Earnings Conference Call. [Operator Instructions] Today's conference is being recorded, August 3, 2012. I would now like to turn the conference over to Ben Burnham of DRG&L. Please go ahead.
Thank you, Alicia, and good morning, everyone. Thanks for joining us for the Main Street Capital Corporation's Second Quarter 2012 Earnings Conference Call. Joining me today on the call are Chairman and CEO Vince Foster; President Todd Reppert; 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; it's main S-T capital.com. If you would like to be added to the company's e-mail list to receive press releases, please call (713) 529-6600.
A replay of today's call will be available beginning about an hour after the completion of the call and will remain available until August 10. 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 web page.
Please note that information reported on this call speaks only as of today, August 3, 2012, and therefore, you are advised that time-sensitive information may no longer be accurate as of the time of any replay listening. Our conference call today will contain forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. 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 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.
During today's call, management will discuss non-GAAP financial measures. Please refer to yesterday's press release, which can be found on the company's website, for a reconciliation to the most directly comparable GAAP financial measures.
And now with that, I'd like to 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 recently announced dividend increase and our dividend outlook, highlight our origination activity and conclude by commenting on the current investing environment. Following my comments, Todd will cover our second quarter portfolio activity in more detail and our current liquidity position, and Dwayne will comment on our second quarter financial results, after which we will take your questions.
Our investment portfolio continues to deliver strong performance during the second quarter. Our lower middle market investments appreciated during the quarter by $13.5 million on a net basis, with 21 of our investments appreciating during the quarter and 5 depreciated. And our middle market investments appreciated by $1.1 million during the quarter.
We finished the quarter with a net asset value per share of $16.89, a sequential increase of $1.17 a share over the last quarter. Our lower middle market portfolio companies ended the quarter with $80 million in cash on their balance sheets and averaged a very conservative net-debt-to-EBITDA ratio of 1.9:1 through our debt position and 2.2:1 including all debt.
Earlier this week, we announced that our Board declared an increase in our monthly dividend payout to $0.15 a share beginning with the October dividend. This brings our quarterly dividend payout rate to $0.45 a share, an 11.1 increase over the fourth quarter of 2011 payout rate. This was also our third dividend increase so far in 2012. We have increased our quarterly dividend payout by over 36%, from $0.33 per quarter at the time of our 2007 IPO, and have never decreased our dividend payout or made a return of capital distribution, thus continuing our commitment to sustainability and growth in our dividends.
Our spillover taxable income is estimated to be $27 million at June 30, 2012, or $0.87 a share. We further estimate that this amount will grow to roughly $30 million by year end. There's a limitation under the Internal Revenue Code rules for regulated investment companies under which we have elected to operate to avoid corporate level income taxes as to how much spillover income we can accumulated.
The limitation is a percentage of our dividends in the period following the spillover. At the projected $30 million level, we are approaching that limit. As a result, we expect to ask our Board to improve a special dividend that would be paid at year end to materially reduce the spillover balance. We estimate that this would equate to a per share amount of at least $0.25. If our current operating performance continues, we would likely ask our Board to approve similar future special dividends as well.
We made an announcement in March regarding our 2 portfolio company exit events, which will contribute to produce a significant long-term capital gain that will flow through to our shareholders during the 2012 tax year. We estimate that 50% of our dividends paid during the first half of calendar 2012 will be taxed at the maximum 15% rate for long-term capital gains. In calendar 2011, as a reminder, 26% of our dividends qualified for the 15% rate for long-term capital gains.
I would like to turn now to our second quarter originations, where our middle market activity significantly outpaced our lower middle markets. Part of this in balance was intentional due to the cash flow created by the 2 significant exit events in the first quarter that I just referenced, and by our equity follow-on that we just completed. We do not expect the relative split in originations to be this skewed in coming quarters.
Our officer director group has continued to increase their ownership of our shares via our dividend reinvestment plan and open-market purchases, investing over $625,000 in our shares during the second quarter, and over $1 million during the first half of 2012. Our lower middle market transaction pipeline is reasonably consistent with the levels we have experienced over the last few quarters. I would characterize the environment as stable in terms of transactional activity.
We continue to see significant equity participation in our lower middle market investments and as of quarter end, continue to average at 33% fully diluted equity ownership position in these companies. Our middle market investing activity continues to grow, as previously discussed. We continue to see attractive risk-adjusted yields and acceptable structures.
With that, I would like to turn the call over to Todd Reppert, our President, to cover our portfolio activity and liquidity position in more detail.
Todd A. Reppert
Okay. Great. Thanks, Vince, and good morning, everyone. We are very pleased to report another strong quarter, which reflects our long-term strategy of realizing sustainable growth in earnings and dividends per share, while also generating meaningful growth in NAV per share.
Our second quarter 2012 investment activity included total gross investments of approximately $163 million, including investments in 3 new lower middle market companies and 22 new middle market companies. We also received approximately $50 million in total cash payments and exit proceeds during the quarter, which primarily related to the middle market component of the portfolio.
This June 30 we have exited -- or excuse me, executed 3 term sheets for a new lower middle market investments and have closed approximately $12 million of net middle market investment activity. I'm also pleased to report that our overall portfolio performance remained strong and the portfolio continues to improve its diversification by issuer, industry, end markets and geography.
At June 30, we had investments in over 130 portfolio companies that are in approximately 50 different industries across both the lower middle market and middle market components of our portfolio. The largest portfolio company investment represents just over 2% of our assets and the majority of the portfolio investments represent less than 1% of our assets. This increasing diversity adds structural protection to our portfolio, our revenue sources and our cash flow, which translates into structural protection for our shareholders.
Our portfolio companies are performing well so far in 2012, with most of the portfolio experiencing growth in operating metrics such as revenues, earnings and backlog. These operating trends are reflected in the improving lower middle market portfolio company credit statistics, that Vince referenced in his comments, as well as our net portfolio appreciation during the first 6 months of the year.
The equity component of our investment strategy remains a significant differentiating advantage for Main Street. It has been paying off in the form of meaningful dividend income received on portfolio equity investments and also drove most of the $15 million of net portfolio appreciation recognized during the quarter. This portfolio appreciation, combined with underdistributing our net realized income and an accretive equity offering, allowed us to grow our NAV per share by over 11% during the first half of 2012. This follows 16% growth in our NAV per share for all of 2011, and demonstrates our ability to execute on one of our key strategies related to growing NAV per share.
On the capital front, Main Street's liquidity and overall capitalization remains strong. As of today, we have over $43 million of cash and cash equivalents, which is almost all held at our SBIC subsidiaries, and approximately $9 million of marketable securities. In June, we completed a follow-on stock offering, which raised $93 million of net proceeds after offering costs, and the offering was priced at a 43% premium to the latest recorded NAV per share at that time.
We also recently expanded our total commitments under our 3-year credit facility to approximately $287 million and currently have around $195 million of unused capacity under that facility. While we continue to explore various financing sources to support our future operational and investment activities, we remain focused on maintaining a liquidity cushion and duration alignment within all borrowing arrangements.
We also have $220 million of outstanding SBIC debentures with a weighted average fixed interest cost of around 5% and a remaining weighted average maturity of just over 6 years. In addition to maintaining ample liquidity and capital flexibility, we remain focused on maintaining a low-cost operating structure, which we view as a significant structural advantage. During the second quarter of 2012, Main Street's total operating and administrative expenses remained around 1.9% of our average assets, which is approximately half of the same metric for the BDC industry as a whole. This low-cost internally managed operating structure allows us to deliver a greater proportion of the gross portfolio returns to our shareholders. We estimate that our efficient cost structure generates around a 25% to 30% increase in our distributable net investment income when compared to a BDC industry average cost structure.
In summary, Main Street continues to perform at a high level and deliver upon our long-term goals of sustaining and growing our earnings, dividends and book value per share. We are pleased that this high level of corporate performance has translated into high level of total return for our shareholders.
With that, I'll turn the call over to Dwayne to cover our financial results and certain key portfolio statistics.
Dwayne Louis Hyzak
Thanks, Todd. As Vince and Todd previously mentioned, we are happy to report significant increases from the prior year in both total investment income and distributable net investment income, significant appreciation in our investment portfolio and a significant increase in net asset value per share for the second quarter ended June 30, 2012.
Total investment income for the second quarter increased by 29% over the same period in 2011, to a total of $20.8 million for the quarter. This increase was primarily driven by increased amounts of interest income associated with higher average levels of portfolio debt investments. The increase in investment income in the second quarter included an increase of approximately $400,000 and investment income associated with higher levels of accelerated prepayment activity for certain portfolio debt investments and marketable securities investments in comparison to the second quarter of 2011. The whole amount of investment income for the second quarter of 2012 from such prepayment activity was approximately $900,000, or $0.03 per share.
Second quarter 2012 operating expenses, excluding non-cash, share-based compensation expense, increased by $1.3 million over the second quarter of 2011, to a total of $7.4 million. The operating expense increase was primarily due to higher interest expense as a result of increased borrowing activity under our credit facility, and the issuance of $10 million of SBIC debentures subsequent to the second quarter of 2011. The increase also included higher accrued compensation and other operating expenses related to the increases in investment income and the investment portfolio, compared to the second quarter of prior year.
The ratio of our total operating expenses, excluding interest expense, as a percentage of average total assets, which we believe is a key metric in evaluating our operating efficiency, was 1.9% on an annualized basis for the second quarter of 2012, compared to 2.3% on an annualized basis for the second quarter of 2011 and 2.2% for the year ended December 31, 2011. We believe that this metric compares very favorably to other asset management firms.
Due to our increased total investment income and the leverage of our low-cost operating structure, distributable net investment income for the second quarter of 2012 increased by 33%, to $13.4 million, or $0.49 per share, in comparison to $10.1 million, or $0.43 per share, for the same period in the prior year. Our distributable net investment income for the second quarter exceeded our dividends paid by $0.07 and we estimate that our cumulative spillover taxable income is approximately $27.3 million, or $0.87 per share, as of June 30, 2012.
While the dollar amount of distributable net investment income increased by 33% over the prior year, the per share percentage increase was 14% due to the higher average number of shares outstanding compared to the corresponding period in the prior year, primarily due to the impact of the October 2011 and June 2012 follow-on stock offerings. All other second quarter 2012 per share measures were similarly affected by the higher weighted average shares outstanding.
Distributable net realized income for the second quarter of 2012 decreased by 2% in comparison to the second quarter of prior year, to a total of $10.1 million, or $0.37 per share. This decrease was primarily due to a $3.4 million realized loss on the exit of a lower middle market portfolio investment that had been fully impaired in prior periods, partially offset by the higher level of distributable net investment income during the second quarter of 2012.
As Vince previously mentioned, during the second quarter of 2012, we recognized $15.1 million of net unrealized depreciation on our portfolio investments and marketable securities and idle funds investments. This increase included net unrealized appreciation totaling $13.5 million in our lower middle market portfolio, resulting from appreciation on 21 portfolio companies and depreciation on the 5 portfolio companies. In addition to the appreciation on our lower middle market portfolio, our middle market investment portfolio appreciated by $1.1 million, and our other portfolio investments and marketable securities and idle funds investments appreciated by $500,000.
The net change in unrealized appreciation for the second quarter also included approximately $2.4 million of accounting reversals of net unrealized depreciation related to exits of portfolio investments and exits of marketable securities and idle funds investments during the second quarter. And approximately $1.8 million of unrealized depreciation related to our SBIC debentures held by our wholly-owned subsidiary, Main Street Capital II.
The operating results for the second quarter of 2012 resulted in a net increase and net assets from operations of $24.2 million, or $0.88 per share, or an increase of 37% compared to the corresponding period in the prior year. This increase was after a reduction for a tax provision of $1 million, primarily related to deferred taxes of $600,000 on the net unrealized appreciation on the equity investments held in our taxable subsidiaries. As a result of our increase in net assets from operations for the second quarter, and the accretive impact of our follow-on equity offering in June 2012, our net asset value per share increased by 7.4% from March 31, 2012, and by 11% from December 31, 2011, to a total of $16.89 per share as of June 30, 2012.
Now let me finish with a few portfolio statistics, all as of June 30. In our lower middle market portfolio, we had 54 investments representing approximately $423.6 million of fair value as of June 30, or approximately 24.3% above the cost basis of approximately $340.8 million. Consistent with our investment strategy, approximately 78% of our lower middle market portfolio investments at cost were in the form of secured debt investments, and approximately 95% of those debt investments held the first lien security position. The weighted average effective yield on our lower middle market portfolio debt investments as of June 30, 2012, was 15%. We held equity positions in 91% of our lower middle market portfolio companies with an average fully diluted equity ownership of approximately 33%. The fair value of our lower middle market portfolio of equity investments as of June 30, 2012, was approximately 208% of the cost of such equity investments.
As Vince previously noted, at the lower middle market portfolio level, the weighted average net-senior-debt-to-EBITDA ratio was 1.9:1, or 2.2:1 including portfolio company debt, which is junior in priority to Main Street's debt position, representing sequential improvement over the prior quarter and the credit stats for the lower middle market portfolio. We expect that these lower middle market portfolio level statistics, on a same-store basis, should continue to generally improve over time as these companies naturally delever. This deleveraging has the additional positive impact of increasing the fair value of our equity investments in these companies.
Based upon our internal investment rating system, with the rating of 1 being the highest and 5 being the lowest, the weighted average investment rating for our lower middle market investment portfolio was 2.1 on June 30, 2012, which is consistent with the weighted average investment ranking on March 31, 2012. During the second quarter, we had 5 portfolio companies improve their rating and 3 portfolio companies decrease their rating.
In our middle market portfolio, we had investments in 77 companies representing approximately $343.4 million of fair value as of quarter end that were generating a weighted average yield of approximately 8.7%. Main Street's middle market portfolio investments are primarily in the form of debt investments, and approximately 91% of our middle market portfolio debt investments at cost held the first lien security position. The weighted average revenues for the 77 companies in the middle market portfolio was approximately $519 million.
The total investment portfolio fair value at June 30, 2012, was approximately 112% of the related cost basis. And we had no portfolio investments on nonaccrual status and one fully impaired portfolio investment, representing approximately 0.2% of the total investment portfolio at cost.
With that, I will now turn the call back to the operator so that we may take any questions.
[Operator Instructions] And our first question comes from the line of Vernon Plack with BB&T Capital Markets.
Vernon C. Plack - BB&T Capital Markets, Research Division
I was interested in the portfolio of mix. Right now, I think on a cost basis you are at about 50-50 between lower middle market and middle market, if you look at just those 2 pieces of your portfolio. I was curious in terms of -- are there any at least self-imposed limitations or thoughts in terms of what the mix may look like going forward?
Vincent D. Foster
Yes. Vernon, this is Vince. That's what I tried to address here. I mean, I think, clearly, the originations in Q2 were highly skewed towards middle market for a couple of reasons. One, when we had a large amount of cash lodge in our SBIC subsidiaries from those 2 exits. And then the next quarter, we had another close to $100 million come in. And rather than wait to deploy that capital lower middle market, we put it to work in the proper place and portfolio. So will that get rotated into the lower middle market or will the lower middle market originations catch up? It's hard to say, but that was clearly kind of a coincidental and unusual that the both of those would coincide within 90 days of each other or less, so that's really the reason. And again, I don't think we have a self-imposed limit. Clearly, the lower middle market is important. It's a critical differentiating factor and do we panic if it went from 50-50 to 60-40 or 40-60? Not particularly. But it's -- I would say that it shouldn't be a lot different than it is now in the future, plus or minus probably 10%.
Vernon C. Plack - BB&T Capital Markets, Research Division
Okay. Well, that's helpful. And my follow-up question deals with one of your -- one of the big positives for Main Street is the low cost structure. And the number that you pointed out, the 1.9% in terms of operating expenses as a percentage of average total assets, I'm curious in terms your thoughts in terms of just how much more efficient can you get?
Vincent D. Foster
Well, Vernon, the way we're looking at that is I think we can continue to get more efficient. We have 5-year plan where, at end of the 5-year plan that we get to our Board, that's the first number I go to try to see how much more operating leverage we have. So the answer is it can continue to go down, but what will really drive it down is if we can -- if, again, it depends on how the accounting works because there's some strange things that happened in '40 Act accounting. But to the degree our third-party asset management activity gears up and that fee income comes in and either is accounted for as a reduction in SG&A or if it's kind of force-fee income, that's the real opportunity to drive that down. Todd, would you say that any differently, or Dwayne?
Todd A. Reppert
No. I think there's a practical limit to how efficient you can get and be responsible as an investor. So I wouldn't say that 1.9% goes to 1%, but I do think if we look out at our 5-year plan, as Vince referenced, and just in general for our planning, I do think we think that percentage can continue to get a little better as we go along, but I don't think you will see the same type of move that you've seen in it from when we went public to now.
Our next question comes from the line of Robert Dodd with Raymond James.
Robert J. Dodd - Raymond James & Associates, Inc., Research Division
Just going back to that third party. I mean, you applied for exemptive relief, a couple of days back with one of those relationships. I mean, can you give us any color on how the lack of that right now is affecting any of your investment decisions, if it this? And can you give us an idea of -- the follow-up, I guess, is what's the timeline for getting that relief, and having full accessibility in a way you put the capital?
Vincent D. Foster
Well, I mean, the relief you're talking about is our ability to co-invest with HMS Income Fund which is the non-listed BDC joint venture we have with Hines. And that's going to be -- probably be a while before we get that approved. And that's really just so that we can allocate a portion of some lower middle market activity due to supporting ASC restrictions to HMS, which is part of what our understanding of them is. So that's really all there is to that. I mean, it's really not anymore exciting or complex than that. And that was our intent all along. So on the HMS front, they are now effective. I think we'll have this disclosure on our 10-Q, but that fund is effective with the SEC. It has signed its first selling agreements and it is beginning to do the fundraising process. Those tend to have a slow ramp to them, if you'd study that space. And so we don't expect, at least as to how it impacts our earnings, from the fee stream we don't expect that to be a material contributor in our earnings for at least until the middle of 2013. And in fact, we have agreed to conditionally waive our fees just as Hines has until as the ramp period comes really for the first 12 months of that fund's exist. So I think long term, that can be a real contributor with the real high return on equity. But in the near term, it's not going to have a huge impact. In the long term, all the co-investment does is really gives us the right to jointly co-invest in lower middle market opportunities.
[Operator Instructions] And I'm showing no further questions in the queue at this time. I'd like to turn the conference back to management for any closing remarks.
Vincent D. Foster
Great. Well, with that, we'll conclude the call. Thank you all for joining and we'll talk to you again in November.
Ladies and gentlemen, this concludes our conference for today. If you'd like to listen to a replay of today's conference you may do so by dialing 1 (800) 406-7325 or (303) 590-3030 and entering the access code of 4555064 followed by the pound sign. Thank you for your participation. You may now disconnect.