Main Street Capital Corporation (MAIN 0.23%) has emerged as one of the best players in the BDC industry, outperforming its peers and delivering spectacular returns over time.
But now its wants to grow, and to do so, it's enlisting the help of bankers to sell 4 million new shares at $31.50 each. The announcement led to an immediate 5% decline in the share price.
And though 5% is hardly the difference between good and great valuation, a 5% discount is equal to about three quarters' dividends. Furthermore, Main Street Capital now trades at 1.41 times book value including proceeds from the offering, a price not seen since 2011.
Why Main Street Capital looks cheap right now
Main Street Capital certainly trades well above its peers at 1.4 times book value, but for good reason: Its asset yields are unmatched.
In the lower middle market, where it makes debt and equity investments in the smallest of private companies, it earns impressive 14.7% yields from a portfolio constructed of first-lien debt investments. Its true middle market portfolio yields 7.8%.
Yields in the true middle market have plunged. One BDC, THL Credit (FCRD), has seen its yields plunge quarter after quarter. Plunging asset yields put its dividend at risk.
This hasn't been the case at Main Street Capital, where yield compression has been modest, and thus far, temporary. The company's lower middle market debt portfolio yielded 14.8% in 2011, and 14.2% in 2012, compared to 14.7% at the end of 2013.
Banking on tiny companies
For as long as the lower middle market can be a gold mine for Main Street Capital, its shares should trade well above book value. The lower middle market is less efficient, and multiples are lower. Thus, Main Street Capital not only finances lower-leveraged businesses, it also buys equity stakes at lower multiples than other BDCs pay in the "true" middle market.
The latest presentation says a typical entry multiple is 4.5-5.5 times EBITDA, significantly lower than multiples for larger middle market buyouts. CapitalIQ data places the median middle market buyout at 8x EBITDA, funded with a combination of 61% debt, and 39% equity. It's pretty easy to see a difference in valuation. Bigger companies are pricier, and more highly levered.
When I look at Main Street Capital, I see a portfolio of very inexpensive, private businesses. The debt investments provide current income in the form of a robust dividend yield, but its equity stakes in lower middle market companies are the real kicker.
Main Street typically owns 33% of the equity in its lower middle market portfolio, giving investors huge upside potential as its debt investments are repaid and its lower middle market companies "grow up."
Over long periods of time, I can't help but think a combination of lower entry valuations and higher debt yields should make Main Street Capital a great buy at this price. The 7.8% current dividend yield is especially appetizing.
