Main Street Capital: Premium Fears Overblown (NYSE:MAIN)

My initial bullish thesis on Main Street Capital (NYSE:MAIN) was issued in April 2024, when MAIN was at a significant premium to its NAV.

Why it’s important to mention the premium look at NAV? Well, because if we look at most of the recent bearish or conservative articles on MAIN, the common denominator justifying why analysis does not recommend going long is the presence of a sizeable premium to NAV.

The argument is that the multiple will make it very difficult for MAIN to provide value in the form of additional price appreciation. It would also, by definition, result in negative alpha compared to other BDCs that do not have this specific valuation headwind.

However, I just don’t buy that, especially given the prevailing market context, where defense became even more important.

Additionally, if we look at the chart below, which shows total return performance since I published my original thesis on MAIN, we can see that BDC has clearly outperformed the broader BDC market. This was despite the aforementioned premium to NAV, which at the time was 167%.

In fact, what we have to keep in mind that the premium for MAIN has always been there (at least since 2009). Theoretically, we could have had a similar opportunity to argue back in 2009 that due to abnormal values, investors should avoid investing in MAIN.

The result would have been the following…

Namely, these investors would have incurred a massive opportunity cost if they didn’t go long.

Now that we’ve covered the premium concerns, let me explain why, after seeing the Q2, 2024 results, I still remain bullish on MAIN.

Revision of the thesis

Q2 2024 results were again strong with total investment income up 3.6% over Q2 2023, which is not that common in the BDC space for larger players to post positive investment income results , while there are some clear pressures. on the M&A and yield front.

Measured quarterly, the result is still up 0.4%, which is certainly a significant positive given the overall dynamics of the BDC market.

Importantly, MAIN was able to increase its NPV per share by $0.26 from the previous quarter and by $2.11 or 7.6% from the same period last year. There are several reasons behind this move, but the main two are: 1) conservative dividend coverage, which allows MAIN to keep some of its cash generation on the books, and 2) increased realized and unrealized capital positions.

Similarly, there was no significant difficulty on the non-accrual side, as the second quarter ended with only 1.2% of the total fair value of the portfolio tied to significantly underperforming/non-accrual positions.

In view of such strong and stable performance, MAIN has decided to distribute an additional dividend of $0.30 per share, which translates into the 12th consecutive quarterly additional dividend in combination with the steadily increasing basic dividend, which has now reached $0.245 per share.

On a going forward basis, I expect MAIN to remain in a position to deliver sustainable returns for its investors.

A major favorable factor for this assumption (besides the built-in defense at the portfolio company level) is MAIN’s conservative leverage profile, where in Q2, 2024, debt to equity was 85% (ie, well below the sector average of 116%) ). . Having such low leverage not only helps keep the effects of potential defaults small, but also provides management with ample financial capacity to allow the portfolio to grow in a sustainable manner.

As board member and chief executive Dwayne Hyzak indicated on the recent earnings call, the deal outlook for MAIN looks very strong, which fits well with conservative leverage levels today:

We are pleased that we continue to see increased interest from potential buyers in several of our lower middle market portfolio companies, which could lead to favorable performance over the next several quarters, which we believe highlights the strength and quality of our companies from the portfolio.

Statistics from Q2, 2024 already provide some evidence of this. For example, MAIN completed $324 million in total private loan investments, which, after adjusting for repayment activity, resulted in an increase in portfolio size of approximately $225 million.

Key risk

The key risk, which I see in the MAIN context, is future interest rate cuts, which will push portfolio yields down, thereby reducing the return on capital margins currently enjoyed by BDC.

However, here are three simple mitigating factors that, in my opinion, collectively neutralize this risk:

1. As MAIN has a significant portion of its portfolio invested in equity positions, the reduction in interest rates will by definition increase equity valuations and facilitate a more liquid environment in which to make successful exits.
2. Lower borrowing costs will strengthen the level of interest and debt coverage of MAIN’s portfolio companies, thus reducing the likelihood of suffering from high defaults.
3. With the deal market outlook looking solid, it seems highly likely that MAIN will be able to expand its portfolio base, especially given that it has such a conservative balance sheet. This should increase the level of total investment income and help offset the pressures from the spread tightening.

The bottom line

In my humble opinion, the argument that MAIN has a significant premium to NAV and therefore investors should somehow avoid investing in this BDC is simply not valid.

Historical data, current financial performance and existing fundamentals relative to other peers and prevailing market conditions make a strong case for actually going long MAIN.

As a result of the above, I remain bullish on Main Street Capital.