Main Street Capital: Bull vs. Bear

Markets are forward-looking, and generally pretty efficient, but that doesn't mean they're always right at any given time. Shares of Main Street Capital Corporation (MAIN 0.67%) have been on a tear this year, rising nearly 10% in a year in which a popular business development company (BDC) index fund is down roughly 2%.

Is Main Street Capital's rise indicative of good things to come, or is the market simply too comfortable paying a premium for one of the most beloved BDCs? I'll lay out the bull and bear case for Main Street Capital with the goal of hitting the topics that are most important for its shareholders.

There are compelling bull and bear arguments for Main Street Capital. Image source: Getty Images.

Bull: Main Street Capital's low expenses are an advantage

Main Street Capital benefits from lower expenses, thanks to a lean internally managed structure that holds down costs as a percentage of assets under management. In the most recent six-month period, Main Street Capital's all-in expense burden tallied to just 1.6% of average assets, far less than the typical BDC.

BDCs are generally externally managed, which results in very few economies of scale. An externally managed BDC typically pays a base management fee of 1.5% to 2% of assets plus an incentive fee equal to 20% of returns. Comparatively, Main Street Capital's expenses are the equivalent to a management fee equal to 1.6% of assets with no incentive fee, making it easily one of the most efficient operators in the BDC industry.

Lean operating costs mean that Main Street Capital can make more underwriting errors than the average BDC and still eke out industry-leading returns, all else equal. Low operating costs also serve as a very good sign that management cares about shareholder returns in an industry that isn't known for being shareholder-friendly. 

Bear: Low operating costs are priced in

Main Street Capital's low operating costs are well known, resulting in a valuation that vastly exceeds the industry average. Main Street Capital shares currently trade at a 78% premium to book in an industry where the median trades at close to a 10% discount to book.

Main Street Capital trades at a similarly outsize multiple of net investment income (NII). The company is on track to generate $2.30 of net investment income per share this year, thus meaning it trades at more than 17 times earnings before capital gains and losses. Shares offer a meager NII yield of just 5.7%, in line with the 5.7% yield of junk bonds (BofA Merrill Lynch US High Yield Effective Yield Index).

The high valuation results in a regular dividend yield that doesn't adequately compensate investors for risk. It's difficult to explain why Main Street Capital (which is itself a portfolio of low-quality debt and equity investments with leverage on top) should trade at an NII yield equal to the effective yield on an unlevered index of junk-rated credits.

Bull: Higher interest rates will lead to dividend growth

Main Street Capital's middle-market investment portfolio contains floating-rate loans that should generate more interest income as interest rates rise. This should help preserve and grow Main Street Capital's dividend over time. 

Image source: author.

Using end-of-period share counts, each 25 basis point increase in the base rate (LIBOR, typically) would lift net investment income by $0.032 per share on an annual basis. Over time, rising rates should buoy Main Street Capital's earnings, providing an easy "lever" for growth in operating income that can support dividend growth.

Main Street Capital's mostly fixed-cost operating structure ensures that the benefits of rising rates will flow to shareholders. In contrast, externally managed BDCs have variable expenses (incentive fees), which send 20% of the benefit of rising rates to their managers. For this reason, Main Street Capital shareholders can be certain that increased earnings from rising rates will flow into their pockets.

Bear: Rising rates could rattle its core portfolio

Main Street Capital's "secret sauce" is its lower middle market investments in tiny companies across the United States. These companies are more exposed to the ups and downs of the economy as a whole, given that they are small, and generally lack access to attractive financing sources, particularly in recessions.

Main Street Capital disclosed in its quarterly report that its average lower middle market investment generated EBITDA of $4.8 million per year. To put that in perspective, consider that the average Costco store generated a similar amount of EBITDA in just eight months in 2016. Main Street Capital's lower middle market companies are very, very small, but its investments in these companies make up approximately 43% of Main Street Capital's total assets.

Should higher interest rates act as a drag on economic growth, it will be Main Street Capital's tiny lower middle market companies that feel the brunt of the impact. Given Main Street Capital's outsize exposure to these smaller companies, capital losses from this group could easily exceed the incremental earnings it stands to generate from rising rates on its true middle market loan portfolio.

Bull: Main Street Capital's underwriting is excellent

Main Street Capital's balance sheet reflects its best-of-breed underwriting abilities. Since inception, the company has generated net realized and unrealized gains of roughly $161 million, reflecting its ability to earn more from its winning investments than it gives up from its losers. In contrast, the vast majority of BDCs produce net losses from their underwriting, as winners fail to paper over the losers.

Main Street Capital's gains are a function of its process. Because it invests in both the debt and equity of lower-middle-market companies, it can win in two ways: from capital gains as its portfolio companies' earnings grow, and from capital gains when its portfolio companies pay down their borrowings. When a company pays down debt, the equity value of the company increases. Main Street Capital historically aims to own about a third of its portfolio companies, thus it stands to directly benefit as its loans are paid down.

Main Street Capital should be able to grow net asset value (book value) over time by producing gains in excess of losses, driving increased dividends on a per-share basis. Investors now have nearly a full decade of historical performance on which to judge the quality of the company's underwriting, justifying its premium valuation relative to peers.

Bear: Main Street's underwriting is a function of timing

When Main Street Capital went public in October 2007, its portfolio included many winning legacy investments that were already marked at substantial premiums to cost. These companies largely sailed through the financial crisis, given that many had deleveraged either through growth, debt reduction, or a combination of both in the years leading up to the downturn.

Although Main Street Capital has made a number of winning investments, the vast majority are concentrated in a cohort of its earliest investments. More than $94 million of unrealized gains on Main Street Capital's balance sheet come from just four portfolio companies it originally invested in before 2011.

Data sources: SEC filings, Main Street Capital website.

Notably, Main Street Capital is slowly monetizing its early winners. It recently exited Compact Power Equipment and Indianapolis Aviation Partners at realized gains, companies that entered its portfolio in 2009. As time goes on, Main Street Capital won't be able to rely on its most timely investments to drive realized gains in its portfolio.

Bears can concede that Main Street Capital's earliest lower-middle-market investments have proved extraordinary. The question is whether those results can be duplicated. Main Street Capital is more than 20 times times larger by assets today than it was during the quarter immediately before its IPO, and true bargains are few and far between compared with the deals Main Street Capital saw in the years immediately following the financial crisis. For this reason, Main Street's future underwriting results are unlikely to look anything like the past.