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Main Street Capital (MAIN 0.45%)
Q2 2021 Earnings Call
Aug 06, 2021, 10:00 a.m. ET


  • Prepared Remarks
  • Questions and Answers
  • Call Participants

Prepared Remarks:


Greetings and welcome to the Main Street Capital Corporation's second-quarter earnings conference call. [Operator instructions] It is now my pleasure to introduce your host, Zach Vaughan with Dennard Lascar, investor relations. Thank you. Mr.

Vaughan, you may begin.

Zach Vaughan -- Investor Relations

Thank you, operator and good morning, everyone. Thank you for joining us for Main Street Capital Corporation's second-quarter 2021 earnings conference call. Main Street issued a press release yesterday afternoon that details the company's second-quarter financial and operating results. This document is available on the investor relations section of the company's website at mainstcapital.com.

A replay of today's call will be available beginning an hour after the completion of the call and will remain available until August 13. Information on how to access the replay was included in yesterday's release. We also advise you that this conference call is being broadcast live through the Internet and can be accessed on the company's home page. Please note that information reported on this call speaks only as of today, August 6, 2021 and therefore, you're advised that time-sensitive information may no longer be accurate at the time of any replay listening or transcript reading.

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Today's call will contain forward-looking statements. Many of these forward-looking statements can be identified by the use of words such as anticipates, believes, expects, intends, will, should, may or similar expressions. These statements are based on management's estimates, assumptions and projections as of the date of this call and there are no guarantees of future performance. Actual results may differ materially from the results expressed or implied in these statements as a result of risks, uncertainties and other factors, including, but not limited to, the factors set forth in the company's filings with the Securities and Exchange Commission, which can be found on the company's website or at sec.gov.

Main Street assumes no obligation to update any of these statements unless required by law. During today's call, management will discuss non-GAAP financial measures, including distributable net investment income. Please refer to yesterday's press release for a reconciliation of these measures to the most directly comparable GAAP financial measures. Certain information discussed on this call, including information related to portfolio companies, was derived from third-party sources and has not been independently verified.

And now I'll turn the call over to Main Street's CEO, Dwayne Hyzak.

Dwayne Hyzak -- Chief Executive Officer

Thanks, Zach. Good morning, everyone and thank you for joining us. We appreciate you taking the time to join us and we hope that everyone is doing well and staying healthy and safe. Joining me today with prepared comments are David Magdol, our president and chief investment officer; and Jesse Morris, our executive vice president and chief operating officer.

Also joining us for the Q&A portion of our call are Vince Foster, our executive chairman; Nick Meserve, our managing director and head of our private credit, formerly middle market investment group; and Brent Smith, our CFO. On today's call, I will provide my normal updates regarding our performance in the quarter, while also providing updates on our asset management activities, our investment activities and current investment pipeline, our recent dividend increase and our expectations for dividends going forward and several other updates. Following my comments, David and Jesse will provide additional comments on our investment strategy, investment portfolio, financial results and future expectations, after which we'll be happy to take your questions. We are pleased with our second-quarter results, which we believe demonstrate the strength and momentum of our Main Street platform and the quality and strong performance of our diversified group of portfolio companies.

The quarter represented our third consecutive quarter of sequential growth in total investment income, with the total investment income for the quarter, representing a significant increase from our pre-pandemic levels and with all components of income above their pre-pandemic levels. Our performance resulted in distributable net investment income, or DNII, well in excess of our monthly dividends paid to shareholders during the quarter and significantly higher than last year, along with continued improvement in our net asset value per share. Our results also included a net increase in net assets from operations of $1.39 per share and an annualized return on equity for the quarter over 24%, both of which are Main Street records. As we look forward to the second half of the year, we are excited about our investment activity since quarter end and the size and quality of our current investment pipeline in both our lower middle market and private loan investment strategies and believe we are very well positioned to continue to execute on these attractive investment opportunities due to our conservative capital structure and significant liquidity position.

The operating performance across most of our portfolio companies continued to improve during the quarter, resulting in over $35 million of net appreciation in our lower middle market investment portfolio and a 3.4% increase in our net asset value or NAV per share in the quarter. The strong performance of our portfolio companies, combined with ongoing organic and acquisition growth activities at several of our high-performing portfolio companies, provides us optimism about our ability to generate incremental fair value improvement and NAV per share increases over the next few quarters. We also made continued progress in our asset management business during the quarter. This includes progress at MSC Income Fund, the non-traded BDC we advised through our external investment manager, which increased its investment portfolio by over 14% during the second quarter and paid an increased dividend to the fund's shareholders in July.

We remain excited about our plans for the fund as we continue to execute on our investment strategies and other strategic initiatives and we are optimistic with our outlook for the future performance of this fund. At MS Private Loan Fund I, our new privately held fund that we launched a few quarters ago, we accepted significantly increased capital commitments from investors and continue to grow its investment portfolio through its coinvestment activities with Main Street and MSC Income Fund in our private loan investment strategy. The growth of our asset management business has been significantly beneficial to our ability to execute our private loan strategy and we expect these benefits to increase in the future. We remain excited about our strategy for growing our asset management business within our internally managed structure and increasing the contributions from this unique benefit to our Main Street shareholders.

Based upon our results for the second quarter and the positive developments at our existing portfolio companies, combined with our favorable outlook in each of our core investment strategies and for our growing asset management business and the benefits of our efficient operating structure and strong liquidity position, earlier this week, our board declared an increase to our monthly dividends for the fourth quarter to $0.21 per share payable in each of October, November and December, representing a 2.4% increase from our monthly dividends for the third quarter. We are also confident that we will be in a position to generate DNII at levels sufficient to provide continued coverage of our monthly dividends and increased future dividends in 2022, consistent with our long-term historical practices. Now, turning to some additional details on our investment activities in the second quarter and our current investment pipeline. We completed lower middle market investments of $26 million in the quarter.

As of today, I would characterize our lower middle market investment pipeline as well above average. We remain very active in our lower middle-market strategy and we are excited about the investment opportunities in the current pipeline. Consistent with our activities since the beginning of the pandemic, our recent investments and the current pipeline includes several follow-on investments in existing portfolio companies, as we and our companies actively look to execute on various growth opportunities. We view these follow-on investment opportunities as very attractive as they allow us to make follow-on investments in some of our top-performing companies and management teams and provide the opportunity for meaningful equity value creation through these accretive acquisitions and continued fair value appreciation on these investments going forward.

As we noted in our comments last quarter, we believe that several factors are driving the significant increase in activity in our current pipeline. These factors include an increased focus on financial and estate planning priorities by many entrepreneur owners after the difficult environment experienced broadly across the economy since early 2020 combined with significant uncertainty and concern regarding increasing future tax rates, particularly taxes on capital gains. Consistent with our historical experiences over the last two decades as the industry-leading partner for lower middle market companies and their management teams, we believe that our unique combined debt and equity investment offering and our ability to be a long term to permanent partner for the companies we invest in, positions us to be a favorite investment partner for these business owners. We expect that this position will continue to result in attractive new lower middle market originations for our Main Street platform through the end of the year.

Due to the strength and quality of our lower middle market portfolio companies, we have also experienced robust interest in a number of these portfolio companies, which could result in a few additional exits and significant realized gains and additional fair value appreciation over the balance of the year. During the second quarter, we also continued the successful focus of our investments in our private loan strategy, resulting in new investments totaling approximately $200 million and representing a record level of originations for this strategy. As of today, I would characterize our private loan investment pipeline as above average. With that, I will turn the call over to David.

David Magdol -- President and Chief Investment Officer

Thanks, Dwayne and good morning, everyone. As Dwayne highlighted in his remarks, we believe our second-quarter financial results demonstrate the strength of Main Street's platform, our differentiated investment approach and our unique internally managed operating model. We are excited that our investment income generated during the quarter was at an all-time high. We're also pleased to report that the overall operating performance for the majority of our portfolio companies was strong in the quarter and resulted in both significant increases in our NAV per share as well as the achievement of several significant positive milestones in our lower middle-market strategy.

As we've discussed in the past, the primary driver of our long-term success has been and continues to be our focus on the underserved lower middle market and specifically, our strategy of investing in both the debt and equity in lower middle market companies and partnership alongside strong existing management teams. Our equity investments closely align our interest with our portfolio company management teams and allow us to share in the equity upside on a current basis through dividend income and on a long-term basis through the equity appreciation as our companies grow and perform. These equity investments support growth in Main Street's realized income through the dividend income we received and the periodic realized gains upon the exit of those businesses. This quarter, our lower middle market portfolio companies generated the highest level of dividend income in our firm's history, which we view as an important milestone and continued validation of our unique lower middle market investment strategy.

In addition to the benefit we received from the dividends paid from our lower middle market portfolio companies, Main Street also significantly benefits from both the unrealized and realized equity appreciation as the portfolio of companies we invest in both deleverage and grow over time. We achieved another meaningful milestone in the second quarter as our lower middle market investments achieved the greatest level of quarterly fair value appreciation in our history. Our lower middle market investments were the primary driver behind our significant pre-tax net unrealized depreciation this quarter of over $0.50 per share. Additionally, in the second quarter, we had a good example of the value creation we can achieve with our lower middle market equity investments as we fully exited our ownership position in American Trailer Rental Group or ATRG, which represented a $17 million realized gain.

As is typical with many of our lower middle market investments, we initially made a minority equity and debt investment in ATRG in 2017 to support a change of control transaction and growth capital financing. The company utilized additional debt and equity provided by Main Street to grow as it executed on multiple accretive acquisitions and fleet expansion opportunities. On our equity investment, ATRG represented a total internal rate of return of 61% and a three times money invested. On a cumulative basis, including our debt and equity investments, ATRG represented a 28% internal rate of return or a 1.7 times money invested.

Realized gains like this provide an offset against the inevitable credit losses that will be experienced when investing in non-investment grade debt as we do for the vast majority of the investments in our portfolio. Now, turning to the overall composition and results from our investment portfolio, consistent with prior quarters, the contributions from our lower middle market portfolio continued to be well diversified with over 60% of our lower middle market companies with equity investments having appreciation at quarter end and with over 60% of those companies that are flow-through entities for tax purposes contributing to our dividend income over the last 12 months. In addition, we also have several equity investments in nonflow-through entities, which have contributed to our dividend income over the last 12 months. Our investment activity in the second quarter included total investments in our lower middle market portfolio of approximately $26 million, which after aggregate repayments on debt investments and return of invested equity capital from a combination of the successful exit of our investments in ATRG and other repayment activity resulting from the strong performance of our portfolio companies resulted in a net decrease in our lower middle market portfolio of approximately $37 million.

Since the end of the second quarter, we have subsequently made investments totaling in excess of $50 million in the lower middle market. And as Dwayne mentioned, our current pipeline of new and add-on investment opportunities remains very strong. We also made $198 million in total private loan investments, which after aggregate repayments of debt resulted in a net increase in our private loan portfolio of approximately $105 million. Finally, we had a net increase in our middle market portfolio of approximately $17 million.

We are excited with the pace of new and follow-on private loan investment opportunities that our private credit investment team has been able to achieve. The growth in our private loan portfolio is consistent with our stated strategic goal over the last few years to continue to grow the private loan portfolio as a greater proportion of our overall portfolio and the results of our private credit team had in the quarter are further evidence of the successful execution of this strategy. As of June 30, we had investments in 177 portfolio companies spanning across over 50 industries. Our largest portfolio company represented approximately 2.7% of our total investment portfolio fair value at quarter end and 3.2% of our total investment income for the last 12 months.

The vast majority of our portfolio investments represented less than 1% of our assets and our income. At quarter end, our lower middle market portfolio included investments in 69 companies, representing over $1.3 billion of fair value, which is over 20% above our cost basis. Our private loan portfolio included total investments in 69 unique companies, representing approximately $863 million of fair value and our middle market portfolio had investments in 39 companies, representing approximately $434 million of fair value. The total investment portfolio at fair value at quarter end was approximately 109% of the related cost basis.

In summary, Main Street's investment portfolio continues to perform at a high level, which we believe will allow us to deliver on our stated goals of creating significant shareholder value through achieving increasing NAV appreciation and dividends paid to our shareholders. With that, I will turn the call over to Jesse to cover our financial results, capital structure and liquidity position.

Jesse Morris -- Executive Vice President and Chief Operating Officer

Thank you, David. Turning to a summary of our financial results. Our total investment income in the second quarter increased by $15.3 million over the same period in 2020 to a total of $67.3 million, driven by increases in both interest and dividend income. Of particular note, dividend income increased by $10.8 million, which more than doubled the level of dividends a year ago and included a net increase of $2.6 million that is generally considered less consistent or nonrecurring.

This increase in investment income is further evidence of the strength of our underlying portfolio companies and their management teams and Main Street's continued success in deploying capital to support our portfolio company's growth initiatives and execute new platform investments that Dwayne and David discussed in their earlier remarks. Our operating expenses, excluding non-cash share-based compensation expense, increased by $4.2 million over the same period of the prior year, primarily driven by increases in compensation expense and interest expense in the quarter. The increase in compensation expense is primarily due to higher levels of incentive compensation accruals, which is directly related to the improved performance and an investment in additional personnel to grow our investment team. Despite these compensation expense increases, the ratio of our total operating expenses, excluding interest expense, as a percentage of our average total assets, was 1.4% for the second quarter on an annualized basis and for the trailing 12 months, which continues to be among the lowest in our industry.

The activities of our external investment manager benefited our net investment income by approximately $3.8 million during the second quarter through the allocation of $2.6 million of operating expenses for services we provided to it and $1.2 million of dividend income, an increase of 75% from prior year. As a reminder, in October of 2020, Main Street took over the sole advisor responsibilities of the HMS Income Fund, which has since been renamed the MSC Income Fund. This change has resulted in a significant increase from prior year and the benefits from the external investment manager. Net investment income increased by $11.1 million in the second quarter of 2021 over the same period last year, an increase of 35%, which outpaced the rate of growth of our total investment income of 29%.

For the first six months of the year, net investment income, as a percentage of total investment income, was 63.1%, an improvement of approximately 100 basis points over the full fiscal year of 2020, which demonstrates the improving operating leverage underlying Main Street's overall results. We recorded a net realized gain of $18 million during the second quarter, resulting from net gains realized from the exit of two lower middle market investments, a realized gain from the partial exit of a middle market investment and a realized loss from the full exit of a middle market investment. We recorded net unrealized appreciation on the investment portfolio of $49.1 million during the second quarter, which included net appreciation of $36.4 million on our lower middle market portfolio, $5.2 million in our private loan portfolio and $5.1 million in our other portfolio, which was partially offset by $2.2 million of net depreciation in our middle market portfolio. In addition, our external investment manager also reflected appreciation of $4.5 million, driven by increased assets of the funds managed.

Our operating results for the second quarter resulted in an increase in net assets of $95.1 million and an increase in net asset value or NAV per share of $0.77 to end the quarter with an NAV of $23.42 per share. We ended the second quarter with nine investments on non-accrual status, comprising approximately 1.2% of the total investment portfolio at fair value and approximately 3.9% at cost. Our overall capitalization and liquidity remained very strong as our total liquidity is currently in excess of $750 million. We were very pleased to have further enhanced our capital structure by extending our revolving credit facility in April with an increase in total commitments to $855 million.

We continue to believe that our conservative leverage, strong liquidity and continued access to capital are significant strengths that have us well positioned for the future. Coming back to our operating results. A key measure of our performance is DNII or distributable net income per share. DNII per share for the second quarter was $0.60 per share, a $0.14 or 27% increase over the same period last year and a 6% increase over the first quarter of 2021.

This quarter also marks the third consecutive quarter that our DNII per share has exceeded the dividends per share paid to our shareholders. And as Dwayne noted, earlier this week, our board of directors declared an increase in our quarterly dividend to $0.63 per share for the fourth quarter. As we look forward, we expect that we will generate DNII per share of roughly $0.65 per share in the third quarter. Based upon our current expectations of visibility, we believe that there is opportunity for additional upside to DNII in the third quarter and we expect continued strong performance in the fourth quarter.

With that, I will now turn the call back over to the operator so we can take any questions.

Questions & Answers:


[Operator instructions] Our first question is from Kenneth Lee of RBC Capital Markets. Please state your question.

Kenneth Lee -- RBC Capital Markets -- Analyst

Hi. Thanks for taking my question. I just want to talk about the topic of the distributable net investment income, the DNII. It sounds like it's on that sustainable path of improvement, but I just want to double check and also get a little bit more detail on what could potentially drive that upside to DNII in the third quarter? Thanks.

Dwayne Hyzak -- Chief Executive Officer

Sure. Thanks, Ken. I do think we feel good about where DNII sits today and as we look forward to the next couple of quarters, which is why Jesse and his comments gave the guidance that we feel good about $0.65 with some potential for upside. I think when you look at the upside, it will be driven by the pace of new investment activity, how many of the new lower middle market transactions we have in our pipeline, how many of those can we get closed between now and the end of the quarter as well as just the quarter-to-quarter volatility we talked about in the past that we continue to see in the dividend income from certain of our lower middle market companies, how much of that dividend income ends up coming in before 930.

So those will be the two big drivers that could lead to some upside to that $0.65 number.

Kenneth Lee -- RBC Capital Markets -- Analyst

Got you. Very helpful. And just one other question. Within the lower middle markets segment, you talked about seeing a lot of volumes for follow-on investments.

Just wanted to get a little bit more detail around what's driving that elevated activity? Thanks.

Dwayne Hyzak -- Chief Executive Officer

Sure, Ken. So I think we mentioned over the last year kind of since the beginning of the pandemic, certain of our companies, particularly the companies that were performing better throughout the last 12 to 18 months. One of the things that they started to embrace more than our companies had embraced historically was growth through acquisition. So as we've looked at those companies and have been supporting them through those acquisition growth alternatives or activities they've been going through, we're finally starting to see some of those activities pay dividends through transactions that have either closed here recently or that we're hopeful will close over the next couple of months.

Kenneth Lee -- RBC Capital Markets -- Analyst

Great. Very helpful. Thanks again.

Dwayne Hyzak -- Chief Executive Officer

Thank you.


[Operator instructions] Our next question is from Robert Dodd of Raymond James. Please state your question.

Robert Dodd -- Raymond James -- Analyst

Hi, guys. Dwayne, on the pipeline for lower middle market, I mean, you said well above average. I mean I've heard a lot of above averages in the past, a lot of averages. I don't recall hearing -- in the call hearing a well above average at least for a long time.

I mean -- so where would you characterize the portfolio, not just relative to averages but relative to, say, historic highs in terms of potential for activity? It sounds very optimistic on that front right now.

Dwayne Hyzak -- Chief Executive Officer

Yeah, Robert, I think David touched in his comments on the actual closings we've had today, which is right at $50 million. So when you put that together with the current pipeline, historically, I think we've guided to an annual origination amount for Main Street in the lower middle market kind of in the $225 million range. So if you take that and you separate it out or look at it on a quarterly basis, you're looking at just under $70 million a quarter. If I was to look at the current quarter with the $50 million that we've already closed, I think you have potential upside for one and a half to two times that number for the third quarter, if everything was to go the way that we want it to.

But at the same time, I'll give you a caveat that we don't control the timing of closing of these transactions exclusively. There is the seller and other parties involved. So things have to go well for us to hit that upside number.

Robert Dodd -- Raymond James -- Analyst

Understood. And on that, I mean, what's the -- can you break down kind of the drivers? Obviously, there's potential for tax changes. There's -- last year was very slow for obvious reasons. I mean, is it just the confluence of both those two factors driving that? Or is there something else that's driving the pipeline? I don't want to be just talking about Q3 because things can spill to Q4, but it doesn't really matter that much in the long term.

So any kind of color you can give on kind of what the factors are that are driving that right now?

Dwayne Hyzak -- Chief Executive Officer

So we do think, Robert, that tax is a big driver. When you look at the potential for a significant increase in capital gains tax rates, the seller, as he or she should be as focused on the net after tax amount. So if you see a significant increase in tax rates, that could be a big motivator to transact in the current year before year-end. So I do think we're seeing a healthy amount of activity from that potential change or the uncertainty around it.

I also think, as we've touched on, we are seeing the benefits of the focus on acquisition growth of some of our companies. We're seeing that come through the pipeline as well. So we're very excited about that because if we have the opportunity to put additional capital into our best companies and our best management teams, we love doing that. We're seeing that through these follow-on acquisition financing opportunities.

David Magdol -- President and Chief Investment Officer

I'd just add one last thing, Robert. Last year with COVID and all, there were a number of transactions that were pulled from the market and came back to the market, which really helps us as far as the number of transactions we're seeing come through our pipeline.

Robert Dodd -- Raymond James -- Analyst

Got it. Appreciate that. And then one last one, if I can. On the asset management business that, as you said, performing well, what are -- the bulk of that today, obviously, is MSC and that's not in fundraising mode obviously.

It's in growing by relevering up, etc., but not fundraising. What are your expectations or maybe that's overstating it, but hopes maybe, aspirations about fundraising and additional capital that can be raised to be managed by the asset management business, which obviously accrues earnings to the BDC shareholders?

Dwayne Hyzak -- Chief Executive Officer

Yeah, Robert. So if you look at the two primary drivers for our asset management business, obviously, MSC Income Fund is by far the largest. And to your point, they are not and have not for quite a while been raising equity. We do think their balance sheet leaves an opportunity for additional leverage or debt capital.

So you've seen them grow through the use of debt capital and leverage. And I think we continue to see an opportunity for additional growth there for the fund through the use of additional leverage. I think that's one area for potential growth on the MSC Income Fund side. And then on the private loan fund side, that really has not been a significant contributor to the asset management business today.

But we do remain optimistic about the pace of fundraising activity that we've seen as well as the opportunity for once we get through the fundraising process and have completed the equity raising to come back and put some debt capital leverage on top of that, that equity. So we think those two factors give us quite a bit of tailwinds behind us on the asset management business, that should be a really big positive for Main Street over the next two to four quarters.

Robert Dodd -- Raymond James -- Analyst

Got it. Appreciate it. Thank you.

Dwayne Hyzak -- Chief Executive Officer

Thank you, Robert.


Ladies and gentlemen, we have reached the end of the question-and-answer session. I would now like to turn the floor back over to management for closing comments.

Dwayne Hyzak -- Chief Executive Officer

Thank you to everyone for joining us again this morning and we'll look forward to talking again in early November.


[Operator signoff]

Duration: 35 minutes

Call participants:

Zach Vaughan -- Investor Relations

Dwayne Hyzak -- Chief Executive Officer

David Magdol -- President and Chief Investment Officer

Jesse Morris -- Executive Vice President and Chief Operating Officer

Kenneth Lee -- RBC Capital Markets -- Analyst

Robert Dodd -- Raymond James -- Analyst

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