Main Street Capital Corporation (NYSE:MAIN) is an outlier in the BDC industry, due to its impressive historical returns, and its portfolio of much smaller, middle-market companies.
Main Street Capital is most active in the lower middle market. It's here you find the smallest of companies -- "mom and pops," if you will.
A story of two different worlds
Mom and pop shops aren't the kind of companies you'd find in the upper-middle market. The CFO of a lower middle market firm might just be CFO because he was in the family tree, not because his or her Ivy League pedigree. This is very different from the upper-middle market, where you have vetted C-level executives installed by private equity teams.
And I've long thought that the lower middle market would be more advantageous for similar reasons. Lower middle market companies aren't as "tuned in" to the finance world, and frankly, aren't as sophisticated as your average upper-middle market company.
On Main Street Capital's recent conference call, Vince Foster alluded that the lower middle market is as "backwards" as one might think, stating:
[W]hat we're seeing is our companies are more reluctant to sell than we are...[W]e're saying if you can go get 7 or 8 times we would be more inclined to do that, they don't want to and we tend to support them. It's kind of amazing that that's the case but that's just the way they happen to be."
BB&T Capital Markets analyst, Vernon Plack, then asked why the portfolio company wouldn't want to sell.
"Well I think they enjoy what they are doing. They are bullish about their prospects. They don't want to retire -- just a lot of more individual lifestyle reasons. It's certainly -- they are not necessarily acting in their financial best interest. They are taking more risk than they should but when we're sitting here we with triple our money in one of these companies, who are we to say go sell it?"
What's going on?
This conversation really highlights the difference between lower- and upper-middle market companies. Main Street Capital's lower middle market portfolio is often invested in small, family run companies.
Its portfolio companies often receive buyout offers at attractive prices. The companies pass up the offer, continuing to do business as they always had. Exits usually come with declining management health, or disinterest in the business, not financially opportune timing.
In the upper middle market, you'd see no such thing. An offer would be followed with rigorous financial analysis, investment bankers storming through the doors to do a deal, and a careful negotiation.
Patience creates opportunity
In working with lower-middle market companies, a business development company like Main Street Capital can extract additional liquidity premiums on their investments, as managers aren't career executives jumping from buyout to buyout. Portfolio companies are smaller, less sophisticated companies just looking to keep on going, and growing. Fewer investors are willing to invest in companies where their holding period is completely unknown.
The point is this: The lower middle market, which offers impressive 14% interest rates on debt investments, and has generated approximately $2.91 per share in unrealized appreciation, is a fine place for Main Street Capital do to business -- even if it isn't a fast-paced, high-finance world.