Main Street Capital (MAIN 0.23%) just wrapped up what must be considered a transformational quarter. The company became one of just five investment-grade-rated business development companies, conducted its first institutional bond offering, and secured long-term capital to make new investments.
Here's what you need to know now from its third-quarter conference call.
1. Main Street turns meta
Main Street CEO Vince Foster explained what the company learned from its first-ever bond sale:
One lesson learned about the investment grade offering that you guys co-managed was they really, really, really, don't like less than quarter-billion dollar issuances. We kind of learned the hard way. And so, to try to do $175 million was tough ... we will not do another $175 million one, right?
You know we like that space, you like to be a repeat issuer, we're going to get significantly lower rates, particularly if we do a bigger deal, and particularly if you're not a first time issuer. And you need growth to be able to utilize that market, because we're on the small size of utilizing that market.
There are several things here. First, Wall Street doesn't like to deal with sub-$250 million bond sales. That's not news, but it does go a long way to explain why BDCs exist in the first place. Business development companies exist to provide capital to businesses with needs too big for banks and too small for the public.
Main Street Capital's next bond offering will be larger, and it will likely price lower than the already extremely attractive terms the company got this time around. That's good news any way you slice it.
2. HMS Income Fund is a true asset
One thing that separates Main Street Capital from practically every other BDC is that it has a portfolio company that makes money by managing another BDC. This unique setup is starting to pay dividends for Main Street Capital shareholders.
Foster explained how HMS fits within the broader Main Street Capital platform:
And in addition the real wild card for us is the HMS, the growth in the HMS platform, because they now have about $400 million of assets growing by the day. They are in fundraising periods and they are now taking about 20% of each of our deals, which is kind of nice, because we've historically had to go out and find co-investors for about a third of our deals.
If they want to launch a 2.0 vehicle that would lower the growth rate on our balance sheet, because then you have potentially another group that we're originating assets for and/or it might be a fall in offering our first or even larger. And as you know in the non-listed space when they announce the closing, that's when the growth really occurs. It's in the last kind of quarter of the fundraising period. So, we're not able to predict our growth, we can kind of predict our originations, but what we can't really predict who is going to own them, but we're going to grow.
There is a lot to love here. First, HMS Income Fund is pretty big: with $400 million in assets, it is about 25% of the size of Main Street Capital. Second, if the current fund closes for the launch of a second fund, the size of the existing fund should grow substantially as brokers pound the telephones to sell the fund to investors who are on the fence.
Finally, and probably most importantly, Main Street Capital is perfectly happy to let originations it would normally keep for itself go to its managed funds. Why not? The fee stream is about as lucrative as it gets, given the company is effectively adding earnings without adding credit risk.
Main Street Capital now believes HMS will generate $0.02-$0.03 per share in net investment income in the fourth quarter; call it 5% of net investment income, give or take.
3. On the company's income sources
Main Street stands out as an above-average generator of dividend income. Because many of its investments in portfolio companies are more than a decade old, the equity investments are now paying large dividends.
CEO Dwayne Hyzak commented generally about the company's dividend income:
What you would see is it, typically, is going to be the companies that have been in the portfolio for two or three years or longer because that's given them an opportunity to delever and then start using some of the excess cash flow for something other than debt service. You may have one or two companies that are larger amounts, but rough math if I have at least 10 companies that are above $200,000 a quarter and a number of other companies are above $100,000 so it's a pretty diversified group that's contributing to the dividend income.
For the quarter, dividend income tallied to $5.9 million, or about 15% of the company's total interest, fee, and dividend income. That's well above the average BDC, and confirmation that its equity marks are probably pretty reasonable.
4. Houston exposure isn't a problem
Main Street Capital is based in Houston. Many of its investments are in Houston, and a substantial portion are in Texas. Analysts rightfully want to know how plummeting oil prices might impact the local economy, and thus many of the company's stakes in its lower middle-market investments.
Foster explained Houston's relationship with the energy industry:
When you read The Wall Street Journal, they have more of oil price focus, and when you read the Houston Chronicle, it's much more gas-price focused. That's kind of what drives the economy relatively more than oil here. And the gas industry -- the gas industry has learned how to deal with $3.80-an-MCF world.
In short, Houston has more exposure to gas than oil, and lower prices don't seem to be much of a problem for producers, their employees, or the economy as a whole. Good to know.
5. On legislation in the BDC industry
For years we've heard that Congress might pass legislation that would increase the government's support of SBA-subsidized leverage and increase the leverage limit for BDCs from 1:1 to perhaps as high as 2:1.
Just last year, one bill promised to increase Small Business Administration-provided leverage to $350 million from $225 million per entity. It never really went anywhere. Main Street Capital President Vince Foster thinks 2015 might finally be the year: "The issue has kind of been in the Senate. So, I think our prospects are much better, maybe there is a 50% likelihood, we can get something done next year."
I know I sound like a broken record talking about how good the SBA's SBIC program is for BDCs. It's not because I get paid by the word -- I don't. It's because this program is truly lucrative. Where else can you borrow at 1:1 and earn net interest margins in excess of 10%? Nowhere! And that's what makes it by far one of the best attributes of the best BDCs, Main Street Capital included.
