7.6% Dividend Yield From This Sleep Well Best Of Breed BDC

Summary

• S&P recently expressed concerns about BDCs seeking to reduce asset coverage ratios and will be revising ratings "in the coming months as each BDC's leverage and strategic plans become clearer".
• MAIN is well-positioned and already has access to higher leverage without the need to seek approval. MAIN will benefit due to greater flexibility meeting the qualified asset requirement.
• MAIN's portfolio yield has started to rise and will likely continue as LIBOR hits new highs, increasing NII per share as shown in this article.
• On March 1, 2018, MAIN announced the redemption of its higher cost 6.125% Baby Bond reducing annual interest expense by $2.7 million, and I have included in the updated projections.
• Net interest margins, distributable NII, and dividends per share continue to increase as LIBOR rises while lowering expenses. Insiders continue to actively purchase shares and now have around $130 million.

Quick BDC Market Update

As discussed earlier this week in "3 Largest Business Development Companies Take Steps To Increase Returns To Shareholders":

"Over the last few days, the largest business development companies ("BDCs") have released SEC filings showing that their Boards are seeking to take advantage of the recently relaxed regulations for the sector. I believe that this sends a strong message and the other ~40 BDCs will likely follow suit over the coming weeks."

In the article, I discussed S&P Global Ratings of PSEC of BBB- with a negative outlook with the potential lower the ratings if:

• Reported debt to equity rises to 0.85x or higher, and we do not expect leverage to decline below 0.85x on a sustainable basis in the near term; or
• The investment portfolio's performance deteriorates, as indicated by rising realized and/or unrealized losses or nonaccruals.

Yesterday, S&P Global Ratings placed the 3 BDCs mentioned in the article on CreditWatch with negative implications:

• Prospect Capital Corp. (PSEC)
• Ares Capital Corp. (ARCC)
• FS Investment Corp. (FSIC)

Also, S&P affirmed issuer credit ratings but revised its outlooks to negative:

• Corporate Capital Trust (CCT)
• Goldman Sachs BDC Inc. (GSBD)
• Hercules Capital Inc. (HTGC)
• Main Street Capital Corp. (NYSE:MAIN)
• Oaktree Specialty Lending Corp. (OCSL)
• Solar Capital Ltd. (SLRC)
• TCP Capital Corp. (TCPC)
• TPG Specialty Lending Inc. (TSLX)

And, affirmed issuer credit ratings with outlooks that remain negative:

• Apollo Investment Corp. (AINV)
• BlackRock Capital Investment Corp. (BKCC)
• PennantPark Investment Corp. (PNNT)

I shared my opinions of the temporary downgrade by S&P in "S&P Global Ratings Update For BDCs", and it should be noted that most BDC stock prices were up yesterday after the announcement

BDC Buzz Articles Update

As mentioned in "BDC Buzz Begins Purchases Of Higher Quality BDCs," I have recently been buying additional shares of higher quality BDCs, especially given the oversold conditions driving higher yields. Over the coming months, I will be focused on some of the positive changes in the BDC sector, including:

• Relaxed regulations and tax reform
• Rising interest rates and portfolio yields
• Recent insider purchases

Seeking Alpha has decided to make articles such as this one available for free for the first 10 days only. I highly recommend enabling the "get email alerts" for the contributors that you are actively following:

• Link to: Change Author Email Alerts

The following articles are still available (for free) to all readers:

• "3 Largest Business Development Companies Take Steps To Increase Returns To Shareholders"
• "The High-Yield BDC Sector Gets A Boost From The Recent Spending Bill"
• "10.4% Yielding BDC Set To Benefit From Rising Rates"

The following information discussing Main Street Capital (MAIN) was previously made available to subscribers of Sustainable Dividends, along with target prices and buying points, real-time changes to my personal BDC positions, updated rankings and risk profile, real-time announcement of changes to dividend coverage, and worst-case scenarios, and suggested BDC portfolio.

Insider Ownership

MAIN is one of the few BDCs where most of the key players of management (more than just one or two people) actively purchase shares each quarter and have around $130 million in vested interest in the company.

"Our officer director group has continued to be regular purchasers of our shares, investing approximately $800,000 during the fourth quarter."

Source: MAIN Q4 2017 - Earnings Call Transcript

Source: MAIN Q4 2017 - Earnings Call Slides

Source: GuruFocus

Dividend Coverage Update:

MAIN has many advantages over other BDCs, including:

• Lower cost of capital
• Lowest operational cost structure
• Excellent history of portfolio credit quality that delivers a consistent stream of recurring interest income
• The potential for increased earnings through its asset management business and I-45 Senior Loan Fund
• The ability to use higher leverage through its SBIC licenses
• Management with a conservative dividend policy

For the quarter ended December 31, 2017, MAIN beat my best-case projections, covering its dividend by 113%, mostly due to increased portfolio yields (see following table) and $2.7 million related to interest income activity from portfolio companies that is considered to be less consistent on a recurring basis or non-recurring driving higher-than-expected interest income. Distributable net investment income ("NII") was $0.69 per share for the quarter compared to regular dividends of $0.57.

Vincent D. Foster, Chairman and CEO, stated, "We are pleased with our operating results for both the fourth quarter and full year 2017, periods during which we increased our total investment income, our distributable net investment income per share and our net asset value per share, in each case over the same periods in the prior year and for the fourth quarter on a sequential basis over the third quarter of 2017. As a result of our positive performance, we again generated distributable net investment income per share in excess of our regular monthly dividends, exceeding the regular monthly dividends paid during the quarter and year by approximately 21% and 15%, respectively. In addition, we maintained our supplemental dividends at $0.55 per share. We also completed our second investment grade debt offering, which provided significant enhancement to our already strong capital structure."

Source: MAIN Earnings Press Release

There was no portfolio growth, and the company has the lowest use of leverage (debt-to-equity of 0.37 excluding SBA debentures) since 2014, giving the company plenty of growth capital for 2018.

Source: SEC Filings & BDC Buzz

As shown in the table below, yields have started to rise for its lower middle market ("LMM") and middle market ("MM") investments that account for around 72% of the portfolio:

Source: SEC Filings & BDC Buzz

Interest Rate Sensitivity Analysis

Interest rate sensitivity refers to the change in earnings that may result from changes in interest rates. I am expecting higher yields over the coming quarters as LIBOR continues to rise:

Source: FRED Economic Data

Q. "My last question relating to interest rates, a lot of your lower middle market first lien loans and some of them are fixed or sort of semi fixed, but a relatively high coupon. So you get a pretty nice spread off of LIBOR even if LIBOR being up, but that being said now that LIBOR has crept up and your funding costs have crept up a little bit. Is that sort of feeding back into the lower middle market, debt conversations? Or is sort of the clearing rate of your first lien coupons still in that sort of 10% to 12% range?"

A. "I would say in general we'll still on that range, what I would say that we've done in the last couple of years which you would not have seen doing four to five years ago was that just from a negotiating standpoint with our companies, as we look at new investments is giving them an option as a fixed versus floating, and letting them pick between the two. We look at that as something that was good from a market competition standpoint, but at the same time as you said, it allowed us to have some of our lower middle market debt portfolio being floating rates given the current interest rate environment and the outlook going forward. But outside of that change, I would not say that we've seen a significant shift in our strategy or approach as it relates to the interest rates on our lower middle market debt investments."

Source: MAIN Q4 2017 - Earnings Call Transcript

As of December 31, 2017, around 72% of portfolio debt investments bore interest at variable rates, all of which are subject to interest-rate floors, and only 8% of borrowings are also at variable rates. I consider MAIN to have average-positioning for rising interest rates.

Source: SEC Filings & BDC Buzz

NAV per share increased by $0.51 per share, or 2.2% (from $23.02 to $23.53 per share), or an increase of $0.79 per share, or 3.4%, after excluding the effect of the semi-annual supplemental cash dividend paid in December 2017.

MAIN currently pays 14 dividends per year (monthly plus semiannual) currently $2.83 annually or 7.6% yield at current stock price. However, it continues to grow its per share economics year over year, including distributable net investment income, which is the primary driver for supplemental and increased dividends as well as continued higher returns to shareholders.

"We are pleased to report another quarter and another year 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."

Source: MAIN Q4 2017 - Earnings Call Transcript

Source: MAIN Q4 2017 - Earnings Call Slides

Senior Loan Funds And Asset Management Business:

As mentioned in previous articles, the relaxed regulations should provide BDCs with greater flexibility, meeting the qualified asset requirement, which applies to Senior Loan Funds and JVs that use off-balance sheet leverage will have increased capacity to add or grow additional funds.

Management previously announced the ability to continue to grow its I-45 Senior Loan Fund over the coming quarters due to the amended credit facility. I believe that these continued accretive impacts as well as lower cost of capital could provide for continued dividend growth.

Source: MAIN Q4 2017 - Earnings Call Slides

MAIN's growing asset management business (sub-advisory agreement with the HMS Income Fund) contributed $2.5 million in NII during Q4 2017. This relationship should continue to contribute approximately $0.04 to $0.05 per share of NII per quarter, over the next few quarters.

"Our external investment manager's relationship with the HMS Income Fund benefited our net investment income by approximately $2.5 million in the fourth quarter of 2017, through a $1.6 million reduction of our operating expenses for cost we allocated to the external investment manager for services we provided to it and $0.9 million of dividend income from the external investment manager."

Source: MAIN Q4 2017 - Earnings Call Transcript

Management indicated the potential for a second fund in 2019:

Q. "You still get that a nice little kicker from your relationship with Hines and HMS growth with the continued delay to the DOR rule and this I also follow LPL which is one of the largest distributors and they have talked about how the pressure, the regulatory pressure is not nearly as great as many people thought. Do you expect sort of a restart of the growth in the HMS income fund because of the less regulatory pressure? Do you think brokers are still going to be really cautious just because they know what's around the corner?"

A. "I would say, our thought on kind of a second vehicle with HMS it's more of a 2019 timeframe for us. We do think, we are talking to broker dealers out there the LPL is the world, there is an appetite for more products and they do you want to place, they want more PDCs or closing bonds with yield. They are just trying to get the right structure that works for their investors and works for us as well. And that's what the market started with right now is what is that structure and how you pay for it going forward."

Source: MAIN Q4 2017 - Earnings Call Transcript

Source: MAIN Q4 2017 - Earnings Call Slides

Leverage And Capital Structure:

As mentioned in previous article, management has been opportunistically repaying higher rate and near-term maturities to lower its borrowing costs as well as extending overall debt maturities. On March 1, 2018, MAIN announced the redemption of 100% of its higher cost 6.125% Baby Bond (MSCA) reducing its annual interest expense by around $2.7 million, and I have taken into account with the updated projections.

Source: MAIN Press Release

Previously, MAIN announced that it had priced an offering of $185 million in 4.50% notes due 2022.

MAIN has a near-perfect approach to managing its capital structure and should be used as an example. Initially, the company uses its low-cost credit facility (LIBOR + 1.875%) to fund net new investments as well as the additional $125 million from the third SBIC license (~3.6% 10-year fixed rates) for eligible investments. The SBIC was funded with the at-the-market ("ATM") program of slowly issuing small amounts of shares at a significant premium to net asset value ("NAV") and accretive to shareholders. Management has mentioned that it will likely continue to use the ATM program for raising equity capital, rather than larger offerings, "absent an unexpected need for proceeds". I agree with this approach for many reasons, including being more efficient and delivering higher net proceeds to the company and less disruptive to market pricing. MAIN has a much lower cost of capital than other BDCs due to using lower cost borrowings and raising equity capital at a premium.

Source: MAIN Q4 2017 - Earnings Call Slides

During the three months ended December 31, 2017, the company issued around 0.8 million shares of its common stock at a weighted-average price of $40.22 per share (~75% premium to previous NAV) raising almost $33 million of net proceeds under the ATM Program.

"We also continue to be pleased with the execution of our ATM equity issuance program. During the fourth quarter, we raised nearly $33 million in net proceeds with an average sales price of $40.22 per share."

"In an ideal situation, we're issuing our shares in a year to replicate the dividends that we paid and would be able to synthetically retain our earnings, using that as about how we usually could have sold, we could have sold a lot more. Brent gives the desk daily instructions and a typical day might be within certain valuation parameters 5% of the volume. And would you add more color to that? I mean the answer, I forget definitely modulate based upon where the stocks are trading and we've done that and we've been on the market for several days and we didn't like where the stock was trading. The good thing is that we've talked about before. We control when we sell, so it's very easy to start or stop and change any parameters, and we've been very active in that regard. So, I think obviously as we have said the stock price will determine how much we're willing to sell, but long term we still do believe in the benefit of the permanent capital especially as it relates to our lower middle market strategy. And we do expect to be in the ATM program, but we'll do so on a very guarded and carefully thought out process."

Source: MAIN Q4 2017 - Earnings Call Transcript

Source: MAIN Q4 2017 - Earnings Call Slides

The recently stated S&P concerns were mostly related to BDCs reducing their asset coverage ratios for the ability to increase leverage. However, BDCs such as MAIN have maintained lower debt-to-equity ratios while already having access to higher leverage through SBIC licenses. In August 2016, MAIN received a third SBIC license that provided the company with an additional $125 million of leverage capacity for total access of up to $350 million in low-cost SBA funding, which will allow it to grow the portfolio while keeping leverage within its stated goals.

"On the capital resources front, our liquidity and overall capitalization remained strong. At the end of the fourth quarter, we had $51.5 million of cash, $521 million of unused capacity under our credit facility and approximately $54 million of incremental SBIC debenture capacity, for total liquidity of approximately $600 million."

"Currently, we have approximately $68 million of cash, $472 million of unused capacity on our credit facility and $44 million of incremental SBIC debenture capacity. In November, we issued a $185 million of investment grade unsecured notes with the five-year term and a fixed 4.5% coupon. We believe providing additional long-term fixed rate debt capital in a rising interest environment significantly enhanced our capital structure and has us well positioned for 2018 and 2019."

Source: MAIN Q4 2017 - Earnings Call Transcript

To be a successful BDC investor

• Establish appropriate price targets based on relative risk and returns (mostly from dividends).
• Identify BDCs that fit your risk profile (there are over 50 publicly traded BDCs, please be selective).
• Diversify your BDC portfolio with at least five companies.
• Be ready to make purchases during market volatility and look for opportunistic buying points.
• Closely monitor your BDCs, including dividend coverage potential and portfolio credit quality.

Analyst’s Disclosure: I am/we are long MAIN. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.