Published by Nicholas McCullum on May 17th, 2017
Business Development Companies – or BDCs, for short – can be a great source of current yield for income investors.
With that said, BDCs are often ignored by investors because of their small size and confusion about the tax implications of their distributions.
BDCs cause a bit more work come tax time. Their distributions are a mix of return of capital, capital gains, qualified dividends, and non-qualified dividends. Even after accounting for this, BDCs can be a great source of income for retirees and other income-oriented investors.
Main Street Capital Corporation (MAIN) is a fine example of this. This BDC has a current dividend yield of 6.2% – which makes it a member of the exclusive list of stocks with 5%+ dividend yields.
Better yet, Main Street Capital Corporation pays monthly dividends (instead of quarterly like most investment vehicles). There are very few companies that pay monthly dividends, and MAIN is one of them.
Main Street Capital Corporation’s high dividend yield and monthly payments make it a solid choice for income investors at the security level. But what about the strength of the underlying business?
Fortunately for investors, the Main Street Capital Corporation business appears to be thriving.
This article will discuss the investment prospects of Main Street Capital Corporation in detail.
Main Street Capital Corporation operates as a debt and equity investor for lower middle market companies (those with $5-$50 million of annual revenues) seeking to transform their capital structures.
The BDC has the capability to invest in both debt and equity, which gives it a significant advantage over companies who invest in private debt or private equity alone (but not both).
Main Street Capital Corporation also invests in the private debt of middle market companies (not lower middle market companies) and has a budding asset management advisory business.
Source: Main Street Capital Corporation Investor Presentation, slide 4
The BDC’s corporate structure is rather simple.
Main Street Capital Corporation (owned by public investors like you and I) operates three funds:
- The Main Street Mezzanine Fund
- The Main Street Capital II Fund
- The Main Street Capital III Fund
Since Main Street Capital Corporation is the operator of its own investment funds, management fees are kept to a minimum, which gives it a cost-based competitive advantage over its competitors who outsource their fund management.
Source: Main Street Capital Corporation Investor Presentation, slide 16
Main Street Capital Corporation’s holdings are highly diversified by both transaction type and geography.
By transaction type, the BDC acquires most of its deals via recapitalization and leveraged buyouts.
By geography, the southwest United States has a 29% weight in the portfolio, the largest of any geography reported by Main Street Capital Corporation. This makes sense because this business development company is headquartered in Houston, Texas. The Central United States has a similar weighting (24%) while other regions are under-represented in comparison.
Source: Main Street Capital Corporation Investor Presentation, slide 23
Main Street Capital Corporation also has a very high degree of diversification by industry. The largest industry representation in the BDC’s investment portfolio comes from Energy Equipment & Services at 8%, closely followed by Hotels, Restaurants & Leisure at 7%.
Source: Main Street Capital Corporation Investor Presentation, slide 22
Main Street Capital Corporation’s growth prospects come from its unique strategy to driving investment returns.
Investors who own MAIN are rewarded in three ways. First, the BDC sustains its high monthly dividend and grows it over time.
Secondly, the BDC regularly pays supplemental dividends to further reward its investors. Right now, MAIN shareholders receive an extra $0.09 per share during two months of the year (June and December).
Lastly, Main Street Capital Corporation uses its superior investment returns to grow its net asset value over time, which creates capital gains at the security level for the company’s shareholders.
Source: Main Street Capital Corporation Investor Presentation, slide 7
At the business level, Main Street Capital Corporation’s growth will be driven by its expertise in the lower middle market segment of the economy.
Historically, the BDC’s focus in this area has driven strong net asset value (NAV) growth and has generated sufficient distributable net investment income (DNII) to avoid paying return of capital distributions – which some investors consider to be unfavorable from a taxation perspective.
Details about the fundamental growth of Main Street Capital Corporation since the company’s 2007 IPO can be seen below.
Source: Main Street Capital Corporation Investor Presentation, slide 8
A major catalyst for Main Street Capital Corporation is the growth of its new asset management business.
In May of 2012, the BDC’s asset management business was born when MAIN entered into an advisory agreement with the investment advisor to HMS Income Fund – another business development company that is not publicly-traded.
For Main Street Capital Corporation, this is beneficial in two ways.
First, the BDC receives a substantial boost in revenues. MAIN receives 50% of the investment advisor’s base management fee and incentive fees.
Secondly, Main Street Capital Corporation does not see a material increase in its operational costs by taking on outside clients. Increasing revenues while holding expenses fixed will result in higher net income and stronger shareholder returns.
Source: Main Street Capital Corporation Investor Presentation, slide 14
To conclude, Main Street Capital Corporation has expertise in the lower middle market of its industry and has a budding asset management business that enables it to have strong operational leverage.
These factors will drive the BDC’s growth for the foreseeable future.
Competitive Advantage, Risks, and Recession Resiliency
As an investment manager, Main Street Capital Corporation’s main competitive advantage comes from the talent it employs to source and fund deals.
The BDC’s track record suggests that its talent base has been strong over time. Investors might wonder – how robust is MAIN’s talent base today?
Fortunately, the company’s senior management team has been largely unchanged since inception. The company’s CEO, Vince Foster, has been in place since the 2007 IPO and worked for the predecessor of Main Street Capital Corporation previously.
A similar level of longevity is seen across MAIN’s senior executive team, outlined below.
Source: Main Street Capital Corporation Investor Presentation, slide 17
Main Street Capital Corporation also has a cost-based competitive advantage.
As an internally-managed private investor, MAIN generates substantially lower operating expenses than its externally-managed counterparts, which helps improve net income.
Source: Main Street Capital Corporation Investor Presentation, slide 36
As mentioned, Main Street Capital Corporation also has a durable competitive advantage due to its unique expertise in the lower middle market private debt & equity segment.
Lower middle market companies are broadly defined as those with between $5 million and $50 million of annual revenues. This segment is generally too small for commercial banks to lend to, but too large for the small business representatives of retail banks to lend to.
Main Street Capital Corporation fills this gap. By putting money to work in this unloved group of private companies, MAIN can realize outsized returns compared to its larger commercial bank counterparts.
Source: Main Street Capital Corporation Investor Presentation, slide 10
The lack of competition in the lower middle market means that Main Street Capital Corporation can often invest at valuations unheard of in the public markets (4.5x-6.5x EBITDA is cited by MAIN on their Investor Relations page).
Finance companies and asset managers are often vulnerable to recessions since investors will pull their money to cut losses when financial markets are in distress.
With that said, MAIN invests in private deals and lacks the same type of liquidity as, say, a mutual fund. Thus, Main Street Capital Corporation is expected to be moderately recession resilient.
The first piece of evidence for that claim can be found by looking at the company’s performance during the 2007-2009 financial crisis. Although fresh off its IPO at the time, Main Street Capital Corporation performed well during this difficult operational period, pulling ahead of the S&P 500 and its peer group.
Source: Main Street Capital Corporation Investor Presentation, slide 46
During the next recession, MAIN will benefit from its conservative capital structure.
The company has a well-laddered debt maturity profile, with its largest upcoming obligation being a $288 million credit facility due in 2021.
Investors should also note that the company has no debt maturing in 2017 or 2018, giving the company flexibility in the near-term.
More details about Main Street Capital Corporation’s debt maturity profile can be seen below.
Source: Main Street Capital Corporation Investor Presentation, slide 43
Since Main Street Capital Corporation is in the business of investing in debt securities, investors should rightly be concerned about the effect of rising interest rates on this business development company.
Normally, as interest rates rise, the value of debt securities falls proportionately.
However, Main Street Capital Corporation will actually benefit if interest rates rise.
This is because most of MAIN’s outstanding debt is fixed rate (limiting the increase in interest expense), while most of its debt investments are floating-rate (which means more upside if interest rates rise). The spread between MAIN’s investment income and its capital cost will widen with increasing rates, boosting the bottom line and its shareholder returns.
More details about the effect of rising interest rates on Main Street Capital Corporation can be seen below.
Source: Main Street Capital Corporation Investor Presentation, slide 44
All said, Main Street Capital Corporation appears fairly recession-resistant and insulated from the adverse effects of rising interest rates.
Valuation & Expected Total Returns
Future expected returns for the shareholders of Main Street Capital Corporation will be composed of valuation changes, growth in net asset value per share, and dividend payments.
Valuing business development companies is different than valuing conventional corporations because of their use of non-conventional financial metrics like distributable net investment income per share and net asset value.
The easiest way to get a sense of the valuation of a BDC is to compare its current dividend yield to its historical dividend yield. If the current dividend yield is higher than usual, the BDC is undervalued; conversely, if the current dividend yield is lower than usual, the BDC is overvalued.
Main Street Capital Corporation currently pays a monthly dividend of $0.185 per share (or $0.555 per quarter), which yields 5.7% on the company’s current stock price of $38.57.
Recall that Main Street Capital Corporation also pays supplemental dividends. Right now, the BDC is paying a higher dividend of $0.275 twice per year, giving investors an extra $0.18 of annual dividend income per share.
Taking supplemental dividends into account, and Main Street Capital Corporation’s current dividend yield is 6.2%.
The following diagram compares the company’s current dividend yield to its historical dividend yield.
Main Street Capital Corporation is trading roughly in-line with its valuation in recent years based on valuation. By this metric, the company is likely trading around fair value and valuation changes should not materially effect future total returns.
The remainder of the BDC’s returns will be composed of dividend payments and NAV growth. We’ve seen that MAIN’s current dividend yield is 6.2%. So how quickly will the company compound its net asset value?
At the end of the first quarter, Main Street Capital Corporation reported a net asset value of $22.44 per share. At the end of 2007 (its first year as a publicly-traded company), the BDC reported NAV per share of $12.85. The annual growth required to bridge the gap between these two figures is 5.7%.
Over full economic cycles, I expect Main Street Capital Corporation to continue this mid-single-digit pace of NAV growth.
So the BDC’s shareholder returns will be composed of:
- 6.2% dividend yield (including supplemental dividends)
- 4%-6% NAV growth
For total shareholder returns of 10.2%-12.2% before the effect of any potential valuation changes.
As a business development company, Main Street Capital Corporation’s distributions are not treated the same way as regular corporate dividends when it comes to tax reason.
Much like REITs, business development companies must pay out 90%+ of their income as distributions. Additionally, business development companies must derive 90% of their gross income from interest, dividends, or capital gains on securities.
This means that BDCs often have superior yields to their corporation cousins. However, BDC distributions can be taxed higher than corporate dividends. This is because BDCs pay their distributions as a mix of:
- Ordinary income & non-qualified dividends
- Qualified dividends
- Return of capital
- Capital gains
The mix of these four income types will be different for every BDC. Further, each particular BDC will have a different distribution mix from year-to-year. BDCs send a tax breakdown of their distributions to their shareholders in a Form 1099.
To get a sense of the distribution breakdown of Main Street Capital Corporation in recent times, consider the following table sourced from their most recent 1099.
Please keep in mind that – as always – past performance is no guarantee of future results. Thus, the future tax implications of Main Street Capital Corporation’s dividends may be materially different than the income distribution shown in the table above.
Although Main Street Capital Corporation is off-the-radar for most dividend growth investors, this BDC has a strong history of delivering outsized shareholder returns.
The firm’s strong track record of superior investment management and expertise in the lower middle market segment give it a strong competitive advantage in the private equity and debt industry.
Further, Main Street Capital Corporation is exceptionally shareholder-friendly. The stock’s high yield and monthly dividend payments are ideal for income investors.
With all this in mind, Main Street Capital Corporation has the potential to be a worthwhile investment for investors that are unafraid of some extra work come tax time.