Main Street Capital Corporation: A Turning Point

Main Street Capital Corporation (MAIN 0.85%) has outgrown its britches.

It needs new funding and it's in the market to get it. Here's why shareholders should watch carefully.

A brief history of its balance sheet
Main Street Capital's balance sheet can be divided into two buckets. One bucket is its best-performing lower middle market investments. These assets have historically been funded with subsidized debt from the Small Business Administration.

The other bucket is its lower-yielding, true middle market bucket. These assets have been funded with a secured credit facility.

As the company added investments in the lower- and true middle-market portfolios, it would add new borrowings from their respective funding sources. But as the company has grown, it no longer has the capacity to fund its lower middle market portfolio. The SBA only allows for up to $225 million in leverage for its lower middle market investments.

So, if Main Street Capital wants to grow -- and it should, given its premium price to book value -- it will need to find new sources of leverage.

What Main Street is doing now
Main Street Capital hired a few investment banks to introduce it to a handful of fixed income investors. If they like the company, Main Street said that a "capital markets transaction" may follow. Translation: it will sell bonds.

The introduction apparently went pretty well. Main Street Capital filed to sell $100 million of institutional notes due in 2019. These are unsecured notes that are similar to debt recently issued by the likes of Fifth Street Finance, Ares Capital, and FS Investment Corp.

How these bonds price will be paramount to Main Street Capital's strategy going forward. Currently, Main Street Capital pays just 4.2% fixed on its 10-year SBA debt. When that funding is loaned to lower middle market companies, Main Street earns a net interest margin worthy of envy -- it nets out a spread bigger than 10%!

Obviously, Main Street Capital would like to earn those spreads in the future, too, but it can only do so by selling debt to private investors at a rate similar to what the SBA is offering.

My predictions on how this prices
Based solely on the metrics, Main Street Capital is one of the best credit risks in the BDC industry. On the expense front, it holds noninterest expenses to less than 20% of revenue. In 2013, it out-earned its interest expenses nearly five times over, and more than six times over in the most recent quarter.

The risk, of course, is that it takes significantly more liquidity risk than other BDCs, making lower middle market investments a cornerstone of its total portfolio.

Ultimately, though, I think Main Street Capital should be able to raise five-year unsecured funding at rates in line with its 10-year funding from the SBA. Rivals' debt maturing in 2019 trades at yields that can be triangulated to about the 4.2% rate Main Street Capital needs to match its government-subsidized borrowings.

Source: Morningstar/FINRA

It seems obscure, but...
So debt pricing is pretty obscure. It's not something you wake up thinking about, especially if you're a stock investor. But there may be no more important number for a BDC than its cost of funds. A BDC's cost of funds affects its competitiveness, and its ability to grow. 

And the cost of debt financing is perhaps more important to Main Street Capital than most BDCs. Main Street already has the advantage of having the lowest operating expenses. If it were to wrap up the lowest financing costs, it would be a tough company to beat in the world of private finance.

So, watch this with care. It's not an overstatement to say that the future of Main Street Capital lies in its ability to attract private capital -- it's too big for the free ride of cheap government financing. And it's too efficient to create serious improvements by cutting operating expenses. Financing costs are the final frontier.