Main Street Capital (NYSE:MAIN) has trumped the returns of its peers by keeping costs low and losses minimal. Over its history, the company has managed to generate realized gains in excess of losses -- what some call "negative" credit losses -- by making smart investment decisions.

But its history extends over an excellent period to be a lender. As signs of credit weakness emerge in the middle market, investors will want to keep their eyes on a few of its investments when it reports earnings on August 7.

Main Street's problem portfolio companies
Main Street Capital reported having five investments on non-accrual as of March 31. By definition, non-accrual investments are seriously troubled. Main Street puts a company on non-accrual status when "a loan or debt security becomes 90 days or more past due, and if Main Street does not otherwise expect the debtor to be able to service all of its debts or other obligations."

In other words, the interest payments are in serious doubt, and thus Main Street Capital doesn't accrue interest or dividends into its earnings. Generally, non-accruals usually result in some kind of capital loss. As of March, 1.2% and 3.9% of its investments at fair value and cost were on non-accrual, foreshadowing future realized losses from these investments.

When Main Street Capital reports earnings for the period ended June 30, I'll be paying close attention to its previously identified non-accrual assets in addition to some new companies that may find themselves on the problem list.

Developments with old non-accruals
Three of the five non-accruals disclosed in previous reports have experienced significant new developments in the current quarter. I've compiled the investments and their costs, fair values, and developments in the table below.

Investment

Cost and Fair Value

Developments

Quality Lease and Rental Holdings

Cost: $38.88 million

Fair value: $11.31 million

Liquidated in Chapter 11 bankruptcy on June 8, per Bloomberg.

FC Operating

Cost: $5.34 million

Fair value: $3.22 million

Filed Chapter 11; creditors will vote on how to proceed on August 7.

Modern VideoFilm

Cost: $6.28 million

Fair value: $2.04 million

Its assets were sold to Point 360 in exchange for stock on July 9.

Sources: Cost and fair values from Main Street Capital's 10-Q for the period ended March 31, 2015.

Given that the previously identified non-accruals compromise only 1.2% of assets at fair value, I'm not particularly concerned about their impact to the portfolio this quarter. Held at an average of 31% of cost, the five non-accrual investments have already experienced the worst of potential writedowns in prior quarters.

New troublemakers
A handful of investments were marked at significant discounts to Main Street Capital's cost basis but were not categorized as non-accrual assets as of March 31.

I compiled a list of these companies (excluding oil firms, which I'll get to later) for which I could find records of new developments since the end of the first quarter. These investments deserve additional scrutiny when Main Street reports its second-quarter earnings.

Portfolio Company

Cost and Fair Value

Developments

Anchor Hocking

Cost: $10.89 million

Fair value: $5.85 million

Filed for Chapter 11; secured lenders will own 96% of the common stock.

CGSC of Delaware

Cost: $2 million

Fair value: $1.74 million

Moody's put its ratings on review for a downgrade on July 1 given falling earnings.

Guitar Center

Cost: $8.54 million

Fair value: $7.85 million

Opinion piece notes reduction to salesperson commissions. Credit stress evident by the difference between cost and fair value as of March 31. After tanking to start Q1, its bonds have slowly recovered in 2015.

iEnergizer Limited

Cost: $9.62 million

Fair value: $9 million

Its CFO resigned as the company reported that its pre-tax profit dropped by more than half from the prior year.

Targus Group

Cost: $4.24 million

Fair value: $3.43 million

Company was downgraded in February 2015 by Moody's. Another lender, Prospect Capital, revealed that the company was now paying 2% default interest on its first lien term loan in its filings for the period-ended March 31.

Sources: Fair values and costs from Main Street Capital's 10-Q for the period ended March 31, 2015. Developments cited with links.

In all, these investments made up $27.88 million at fair value as of March 31, 2015, or roughly 1.5% of Main Street Capital's total assets.

What's going on in the oil patch?
One last area of concern is in Main Street Capital's oil investments, which I haven't included in the potential problem areas above. The company reported that oil and gas and broader energy investments made up 8.5% of its investments at fair value as of March 31.

Handicapping potential losses from the oil industry is difficult given oil prices are in constant flux and its investments have hedged some of their exposure for the time being. (On the fourth quarter 2014 conference call, Main Street Capital executives noted that they felt fine for 2015, but most of their portfolio company's hedges would expire in 2016.)

Furthermore, the underlying assets behind each portfolio company may be profitable if not for the latter's financial leverage, a matter previously discussed on prior conference calls.  

A turn in the credit cycle?
Many believe we're now somewhere in the late stages of the credit cycle where too much capital is chasing too few good deals. In recent quarters, a number of BDCs have shown an increase in non-accruals after years of relatively benign credit metrics -- many BDCs had non-accrual rates at or below 1% of total assets for years following the financial crisis.

Today, things seem to be changing. Several management teams have opined that credit performance has nowhere to go but down. Most notably, Golub Capital executives laid the claim that the "everybody is a genius" part of the cycle was over in the first quarter of 2015. They would probably know -- Golub is one of the biggest middle-market lenders.

If there's some consolation for Main Street Capital, it's that a frothy environment may provide for some money-making exits. Last quarter, its lower middle market portfolio was written up broadly, with Main Street CEO Vince Foster saying that they're seeing purchase price multiples for smaller companies that are higher than they've ever seen before.

Gains from its lower middle market equity investments could help offset any future losses from its middle market debt investments. But going forward, it'll be more important than ever to pick apart BDC portfolios with a fine-tooth comb. It's becoming more and more clear that the easy money is gone.

 

Jordan Wathen has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.