Main Street Capital Corporation Stock Joins an Exclusive Club

Main Street Capital (MAIN 1.10%) joined an exclusive club of business development companies last week, grabbing an investment-grade rating from Standard & Poor's. In initiating the BBB rating, S&P cited insider ownership, the company's low-cost internally managed structure, and the diversification from its growing asset management business.

Despite how you might feel about investment-grade ratings for financial firms after 2008 -- just how many went under, again? -- this is a big deal for Main Street Capital.

What investment grade really means
Grabbing an investment-grade rating is crucial for a BDC to raise inexpensive, long-term debt capital. Many of the largest BDCs -- from Ares Capital to Fifth Street Finance -- have investment-grade ratings that allow them to borrow on favorable terms of five to 30 years.

Most recently, newly investment-grade FS Investment in July raised five-year debt at a price of just 4% per year, for a spread of roughly 230 basis points to the five-year Treasury yield at the time. Its short operating history of good underwriting makes it reasonably comparable to Main Street Capital, despite its much bigger size.

Now that Main Street can claim investment-grade quality, it's only logical that it will issue debt in the coming months. The company's current capital structure consists of maxed-out SBA debentures, a secured credit facility, and baby bonds.

Raising cheaper capital
One of the biggest problems for smaller BDCs is that their capital costs are significantly higher than larger BDCs. Whereas a major billion-dollar BDC can raise unsecured debt at a small 200-250 basis point spread over U.S. Treasuries, many smaller BDCs have to issue baby bonds or preferred stock at massive spreads over the risk-free rate -- think 400 or 500 basis point spreads and higher.

The best of the smaller operators use cheap funding from the Small Business Administration to remain competitive. However, with a leverage cap of $225 million, the amount of money a BDC can borrow through the program is, in all practical terms, negligible relative to the growing size of the average BDC.

Locking in rates
With short-term rates expected to move higher as the Federal Reserve tinkers with its interest rate policy, Main Street Capital's new rating couldn't come at a better time. Over the next few months, shareholders should expect  the company to make a trade-off, moving balances off its low-cost, floating-rate credit facility by issuing five- and probably 10-year debt, when possible.

While this shift might create a short-term headwind for earnings, locking in low rates now could be a boon for Main Street Capital as short-term rates rise. Besides, a debt-heavy balance sheet insulates stockholders in the event of a downturn, as unlike credit facilities, funding cannot be called or cut off in a time of crisis. That alone is worth paying more for. This is just good news all around for Main Street Capital.