Earnings Call Transcript - MAIN Q1 2020

Operator, Operator

Greetings and welcome to the Main Street Capital Corporation First Quarter Earnings Conference Call. It is now my pleasure to introduce your host, Zach Vaughan with Dennard Lascar Investor Relations. Thank you, you may begin.

Zach Vaughan, Investor Relations

Thank you, operator, and good morning, everyone. Thank you for joining us for Main Street Capital Corporation's first quarter 2019 earnings conference call. Main Street issued a press release yesterday afternoon that details the company's fourth quarter financial and operating results. This document is available on the Investor Relations section of the company's website at mainstcapital.com. A replay of today's call will be available beginning an hour after the completion of the call and will remain available until May 15. Information on how to access the replay was included in yesterday's release. We also advise you that this conference call is being broadcast live through the Internet and can be accessed on the company's home page. Please note that information reported on this call speaks only as of today, May 08, 2020, and therefore, you are advised that time-sensitive information may no longer be accurate at the time of any replay listening or transcript reading. Today's call will contain forward-looking statements. Many of these forward-looking statements can be identified by the use of words such as anticipates, believes, expects, intends, will, should, may, or similar expressions. These statements are based on management's estimates, assumptions, and projections as of the date of this call, and there are no guarantees of future performance. Actual results may differ materially from the results expressed or implied in these statements as a result of risks, uncertainties, and other factors, including, but not limited to, the factors set forth in the company's filings with the Securities and Exchange Commission, which can be found on the company's website or at sec.gov. Main Street assumes no obligation to update any of these statements unless required by law. During today's call, management will discuss non-GAAP financial measures, including distributable net investment income. Please refer to yesterday's press release for a reconciliation of these measures to the most directly comparable GAAP financial measures. Certain information discussed on this call, including information related to portfolio companies, was derived from third-party sources and has not been independently verified. And now I'll turn the call over to Main Street's CEO, Dwayne Hyzak.

Dwayne Hyzak, CEO

Thanks, Zach. Good morning, everyone, and thank you for joining us today. With me on the call to share their insights are David Magdol, our President and Chief Investment Officer, and Brent Smith, our CFO. For the Q&A segment later, we also have Vince Foster, our Executive Chairman, and Nick Meserve, our Managing Director and Head of our Middle Market Investment Group. Considering the significant and unprecedented impacts on our society and economy in recent months, today's call will differ from our usual format as we will discuss the effects of COVID-19 on our business, our portfolio companies, and our collective responses. I’ll begin with comments about the impact of COVID-19, followed by our overall performance and results in the first quarter, dividend announcements and future plans, our investment activities and current investment pipeline, and our investment portfolio. I will end with remarks on recent share purchases by our senior management team and Board of Directors. After my comments, David and Brent will elaborate on our investment strategy and provide more details regarding our investment portfolio and financial results, after which we will welcome your questions. We want to express that everyone at Main Street hopes you and your loved ones are safe and healthy. We understand that the last few months have been quite challenging for all, with significant uncertainty looming over the near-term future. Our thoughts are with those most adversely affected by the COVID-19 pandemic, and we are sincerely grateful to those who have put their personal safety on the line for the well-being of others, helping us navigate through these tough times. As we’ve communicated in our press releases in March and April, we have prioritized the health and safety of our employees amid the COVID-19 impacts. Our team at Main Street is vital to our past and future success in delivering top industry returns for our shareholders. We are fortunate that our employees have remained safe and healthy during these last months. We initiated remote working arrangements in mid-March and have effectively sustained our operational capabilities during the pandemic. We appreciate our employees' efforts, and their strength gives us confidence for the future. Long-term investors and followers of Main Street are familiar with our focus on the lower middle market strategy and its associated benefits. We believe this strategy stands out among investment firms and is a key driver of our value creation for shareholders. One of the fortunate elements of our Milwaukee strategy is the quality of management teams in our portfolio companies and our strong alignment of interest with these individuals. In our investment underwriting process, we place significant emphasis on assessing these individuals as our long-term partners more than any other aspect of due diligence. We consistently aim to align our interests through typical investment structures, and we believe this alignment is a notable strength and source of value for us and our investors. Over the past few months, our Main Street investment teams have been actively collaborating with our portfolio companies, and the strength of their management teams has never been more apparent. We deeply value the diligent efforts and proactive measures taken by our portfolio companies, and our confidence in our core principles of selecting the right partners and ensuring strong alignment of interest is stronger than ever. Regarding our first quarter results, the unprecedented effects of COVID-19 have presented significant challenges. Our results reflect a negative impact due to adverse economic conditions, particularly the unrealized depreciation in our investment portfolio. Our strategy of maintaining a conservative capital structure and substantial liquidity has helped us navigate these challenges, support our existing portfolio companies, and pursue new investment opportunities selectively. We believe that our diversified and mature investment portfolio will be advantageous as we work through the current landscape. Dave and Brent will elaborate on these aspects shortly. Despite the tough first quarter, our diversified investment portfolio, coupled with the advantages of our differentiated strategy, alignment with our lower middle market management teams, efficient operating structure, and strong liquidity position, positions us well to handle current market conditions and achieve favorable outcomes for all stakeholders. We remain committed to maintaining stable dividend payments. This week, our Board declared our third-quarter regular monthly dividends of $0.205 per share to be paid in July, August, and September, consistent with second-quarter dividends. Due to the challenges presented by COVID-19, we have decided to suspend our semiannual supplemental dividend indefinitely to prioritize a conservative dividend approach and preserve liquidity for new investments. We believe this decision is wise and serves the best interests of all stakeholders while supporting our commitment to stable monthly dividend payments. Regarding our investment activities in the first quarter, we completed $66 million in lower middle market investments, including two new companies. Currently, influenced by COVID-19, I would categorize our lower market investment pipeline as below average. Nonetheless, we remain active, evidenced by our recent $49 million investment announced in late April. We have several new investment opportunities in the pipeline and expect to continue executing new investments soon. Based on historical experiences over the past two decades as an industry leader for lower market companies, we anticipate a substantial increase in lower middle market opportunities as the economy recovers. In this current environment, maintaining a disciplined and selective investment approach is crucial, and we remain confident in our ability to originate new investments consistent with our historical profile. In the first quarter, we also focused our non-lower middle market investment portfolio growth on our private loan portfolio, which grew modestly, while our middle market portfolio decreased by over $30 million. I would describe our private loan investment pipeline as slightly below average but expanding, given the reduction in competitors with access to capital. Regarding the performance of our investment portfolio during the quarter, I'm pleased to report that most of our lower middle market companies were deemed essential or critical and maintained operations through remote arrangements. This allowed them to navigate the challenges posed by various mandates effectively. In conclusion, our office rent director group has maintained a positive view of the Main Street platform, and they continued to buy our shares, investing approximately $1.1 million in the first quarter, with significant purchases by our executive and senior management team and our board in March when our stock faced the greatest downturn due to COVID-19. Collectively, our director group owns Main Street shares valued at approximately $68 million at the end of the quarter, with the figure rising to over $80 million today. I will now hand the call over to David.

David Magdol, President and Chief Investment Officer

Thanks Dwayne and good morning, everyone. As Dwayne highlighted in his remarks, this is a challenging quarter for Main Street as we enter portfolio company partners prepared for and respond to the sudden and unexpected negative impact created by COVID-19. Despite this negative impact, our intentional and purposeful diversified investment strategy has served us well during this time. It has been the cornerstone of our philosophy over our nearly 13 years as a public company and the benefit of our permanent capital structure. We believe our diversification by issuer, industry, market vintage, and geography provides our shareholders attractive structural benefits. Some of these benefits come from our ability to be a long-term permanent capital provider, as is evident by the fact that 22 of our lower middle market companies have been in our portfolio for longer than eight years, including 12 relationships lasting longer than a decade. Our long-term holding period results in a very conservative capitalization for the vast majority of our lower middle market companies, and we benefit from strong relationships with the management teams of our portfolio of companies where oftentimes we are minority equity investors. As of March 31, our investment portfolio had investments in 193 portfolio companies spanning across more than 40 industries. Our largest portfolio company represented approximately 3% of our total investment portfolio fair value at quarter end and 4.4% of our total investment income for the last 12 months. Most notably, the majority of our portfolio investments represented less than 1% of our assets and our income. Main Street's overall conservative capitalization allowed us to focus on our portfolio company needs instead of having to specifically turn our attention to our own capital structure during this time of market dislocation. Since early March, we've been working very closely with our lower middle market portfolio companies in assessing and responding to the rapidly challenging market conditions resulting from COVID-19. Our strong alignment of interest by being significant equity investors alongside a lower middle market portfolio of company executives proves powerful as we and our portfolio company partners work tirelessly to support our portfolio company interests. We've been extremely impressed with the proactive and responsive nature of our portfolio company executives and are grateful for their partnership. We are highly confident that their actions are the direct result of our portfolio company managers being material equity owners of their respective company as opposed to just being salaried employees. In many instances, the management teams voluntarily reduced their compensation, made tough operating decisions including furloughing long-term employees, and several of our portfolio company managers offered to put in their own equity capital to support their businesses. These actions give us an extremely high level of respect for these executives and significant comfort that their decisions are in the best interest of their companies. Over 90% of our lower middle market investments were either deemed essential businesses or were able to continue to operate on a full or limited basis during these uncertain times, which we expect will mitigate some of the detriment of these businesses that would have otherwise incurred. During the first quarter, the contributions from our lower middle market portfolio continue to be well diversified with 98% of our debt investments in this segment of our business representing first lien debt positions and 40 of our 70 lower middle market companies with equity investments maintaining unrealized appreciation at quarter end. 62% of our companies that are pass-through entities for tax purposes contributed to our dividend income in the last 12 months. We believe that our investment philosophy investing in both the first lien debt investments as well as the equity securities of our lower middle market portfolio companies provides an attractive financing option for our partners and provides a very desirable investment structure for us when compared to other models or strategies available in the market. During the first quarter, we continued to take advantage of our liquidity and capital structure to make attractive strategic investments focused on our lower middle market and private loan portfolios. Our investment activities in the first quarter included total investments in our lower middle market portfolio of approximately $66 million, including investments totaling $56 million in two new lower middle market portfolio companies, which after aggregate repayments on debt investments and return of invested equity capital resulted in a net decrease in our lower middle market portfolio of approximately $9.4 million. Total investment in our private loan portfolio was approximately $66 million, including $41 million of new and $25 million of follow-on investments, which after aggregate repayments resulted in a net increase in our private loan portfolio of $4.4 million and we had a net decrease in our middle market portfolio of approximately $32 million. Our lower middle market portfolio included investments in 70 companies representing approximately $1.2 billion of fair value, which is over 18% above our cost basis. The fair value of our lower middle market portfolio company equity investments was approximately 162% of the cost of such equity investments with most of these investments capitalized with conservative leverage ratios. In our private loan portfolio, we had investments in 63 company representing approximately $629 million of fair value and in our middle market portfolio, we had investments in 48 companies representing approximately $418 million fair value. Our total investment portfolio at fair value at quarter end was approximately 99% of the related cost basis and we had 10 investments on non-accrual status which comprised approximately 1.3% of the total investment portfolio's fair value and 5.3% of cost. Turning to the outlook for the remainder of 2020, we intend to focus our efforts on continuing to support our existing investments while thoughtfully investing capital primarily in new lower middle market opportunities. As a matter of historical context, some of our most successful lower middle market investments were initiated in the wake of the 2002 to 2004 recession and the 2008 and 2009 financial crisis. During these uncertain times, Main Street's unique and differentiated lower middle market strategy provides a particularly attractive value proposition to our perspective portfolio company partners. Our ability to provide flexible debt and long-term equity solutions are always a key differentiator for us, but the current environment is a particularly good time for us to put new money to work in our core market comprised predominantly of privately owned closely held businesses that had a specific reason to transact. As other lenders struggled with capital availability and private equity investors acted overly opportunistic in this environment, they tend to be unresponsive to the marketplace. This dynamic can provide an environment for our type of solution to particularly thrive as an attractive alternative. Our investment committee has worked together for nearly 20 years in more prolific times and in times of market dislocation, and we're excited for the opportunity to create significant shareholder value in 2020 and 2021. To that end, we continue to see attractive new lower middle market investment opportunities and we are cautiously optimistic that we will be able to prudently deploy capital with attractive risk-adjusted return profiles during the remainder of 2020. As I've mentioned in the past, we continue to deemphasize new investment activity in our middle market segment of our investment portfolio in favor of private loan opportunities, but we intend to opportunistically put capital to work in a select number of attractive private loan and middle market names as opportunities present themselves as other debt investors are forced by lenders to seek liquidity from their portfolios and sell existing investments at attractive discounts to par. Since the first quarter, we've selectively closed investments that fit that criteria. These investments when purchased at attractive prices should provide above-average investment returns in future quarters as they approach maturity. Finally, during these times of market volatility, we are also grateful for the deep relationships that we've built over time with so many referral sources over the past 20 years, which we believe will serve us particularly well in finding attractive risk-adjusted return opportunities as the year progresses. With that, I'll turn the call over to Brent to cover our financial results, capital structure, and liquidity position.

Brent Smith, CFO

Thanks David. Our total investment income in the first quarter decreased over the same period in 2019 to a total of $56.2 million, primarily driven by a decrease in dividend income and interest income as both areas were negatively impacted by COVID-19. The change in total investment income is after an increase of $2.4 million related to higher levels of accelerated income for certain debt investments when compared to the first quarter of last year. Our operating expenses excluding non-cash share-based compensation expense decreased by $2.8 million over the same period the prior year to a total of $16.8 million, primarily related to a decrease in cash incentive compensation levels and a decrease of deferred compensation expense due to the decline in fair value of our deferred compensation plan assets. The ratio of our total operating expenses excluding interest expense as a percentage of average total assets was 1.1% for the first quarter on an annualized basis. This low-cost percentage highlights our unique internally managed structure and alignment with our stakeholders. Our ability to leverage our efficient operating structure during this challenging environment offset a significant portion of the decline in investment income, resulting in distributable net investment income of $39.4 million or $0.61 per share. The activities of our external investment manager benefited our net investment income by approximately $2.3 million through the allocation of $1.6 million of operating expenses for services we provided to it and $0.7 million of dividend income. We recorded a net realized loss of $22.4 million during the first quarter, primarily relating to realized losses from the exit of a lower middle market investment and the partial exit of two other lower middle market investments. We recorded net annualized depreciation on our investment portfolio of $211.6 million, primarily resulting from the impact of COVID-19. The net unrealized appreciation includes $72.2 million of net appreciation relating to our middle market portfolio, $68.4 million of net depreciation on our private loan portfolio, $45.6 million of net depreciation on our lower middle market portfolio, $12.9 million of depreciation relating to our external investment manager, and $11.3 million of net depreciation on our other portfolio. Our operating results for the first quarter resulted in a net decrease in net assets of $171.4 million or $2.66 per share. Our overall capitalization and current liquidity remained strong as our total liquidity is approximately $500 million. Early during the quarter and prior to the impacts of COVID-19, we raised approximately $4 million in net proceeds under our ATM equity issuance program. Moving forward, we expect to be active under the program at conservative levels as we continue to believe that funding our new lower middle market equity investments with permanent capital is appropriate and we believe our ability to continue to raise equity is another differentiating factor for Main Street. Overall, we feel that our conservative leverage, continued access to capital, and strong liquidity have us well positioned to not only continue to successfully navigate through this challenging strategy but to also be opportunistic in terms of investment opportunities in the market. As we look forward to the second quarter, due to the ongoing impact of COVID-19, a significant amount of uncertainty exists in relation to the overall economy and the operating results of our portfolio of companies. As a result, there's an increased level of uncertainty related to our expected operating results. Therefore, we are not providing our typical guidance for distributable net investment income for the second quarter. However, and as we previously mentioned in our press release in mid-April, we do expect that our distributable net investment income will be below our monthly dividends for the second quarter. Specifically, we expect a decline in the dividend income from equity investments, as the cash flows of some of our portfolio companies have been negatively impacted to varying degrees, and in general, our portfolio companies are appropriately taking a conservative approach in managing their overall liquidity during this period of uncertainty. In addition, we expect a decrease in our interest income primarily due to the decline in LIBOR rates that occurred during the first quarter and a decrease in our fee income due to our decreased origination activity during the pandemic as we continue to manage our capital and liquidity in a very conservative manner. With that, I'll now turn the call back over to the operator so we can take any questions.

Operator, Operator

Our first question is from Matt Tjaden with Raymond James.

Matt Tjaden, Analyst

First question I guess kind of been broad strokes were there any industries in the quarter or post quarter end that were more hit by COVID and the pandemic effects than was expected beyond kind of the usual suspects like leisure, retail, or restaurants and so forth?

Dwayne Hyzak, CEO

I would say that no huge surprises outside of the industries that you referenced that you would expect would have been significantly impacted. I would say that if you look for outliers, it would be more geographic where you had stronger shelter-in-place or stay-at-home mandates that require companies to shut down either totally or to a greater extent. So that would have been the outlier. Outside of that, I would say it would be the industry that you expected to be impacted.

Matt Tjaden, Analyst

What about in terms of can you give any scale as to whether or not there were any amendment relief requested in the quarter or post quarter end and whether or not that has accelerated through the first month of the quarter?

Dwayne Hyzak, CEO

I would say there has been some activity there, and I would say most of the activity has been around deferrals on a temporary basis for either interest or some type of principal repayment. I would say our approach, which is consistent with what I think you would have always been is fair to request there. We're looking for the company and its equity investors to do something in tandem with this or as part of that request they've got to do something whether that cost-cutting internally at the company if they're owners of the business or to the private equity group in our private loan or middle market portfolio is making some other concession to go along with that request.

Matt Tjaden, Analyst

My apologies. Last question just briefly on the LMM portfolio, could you give any scale as to whether or not companies have been applying for the Paycheck Protection Program and if so, how many have applied and kind of what the receivable rate has been on such, thank you?

Dwayne Hyzak, CEO

So I would rather say on this, the PPP loan program, yes, I think given our primary focus on the lower middle market and the profiles of these companies—representing the size and scale of the companies both from an EBITDA and revenue standpoint, and from an employee standpoint—it's safe to assume that a significant number of our companies would be eligible for the PPP loan program. I would also say, I would also remind people that we are typically the minority equity investor in most of our lower middle market companies and in these situations it's not another institutional investor, another private equity group that’s the majority owner. It's typically going to be individuals and most commonly the individuals that are on the management team. So for these companies when you look at their application for the PPP loans, ultimately it's not solely our decision on whether they decide to access the loans and I would also say that in these companies' cases, clearly they've been impacted by COVID-19 and I think in situations where the companies have been more significantly impacted, these PPP loans are a very positive source of liquidity to help those companies through the issues associated with the pandemic. The other thing that I think we would point out is that PPP loans are just part of the stimulus opportunities that are out there and I would say that the vast majority of our companies are not just in the lower middle market but also in the private loan and middle market portfolios. We believe that they should be and we believe that they are actively evaluating all these programs including some of the programs under the payroll tax areas we can either use the credits or look for deferrals. There are also a number of state and local opportunities that our companies are exploring, and then you also have a reinstatement of the tax net operating loss carryback that can provide significant benefits to our company. So we expect they are acting on all these opportunities and when we can, we're helping them evaluate the opportunities.

Operator, Operator

Our next question is from Kenneth Lee with RBC Capital Markets.

Kenneth Lee, Analyst

Just one on the valuation process, presumably most of the net unrealized losses in the quarter were driven by widening credit spreads, but just wondering if you could just frame out for us how much of any of the idiosyncratic COVID-19 related adjustments were factored into the valuation, thank you?

Dwayne Hyzak, CEO

I would say as part of our valuation process, we definitely would have been looking at the impacts of COVID across the portfolio both in the lower middle market and our private loan middle market portfolios, and I think that as you would probably expect, the impact of COVID-19 was very significant and that's reflected in the metrics that we have in our earnings release and our 10-Q you will be able to see the detailed portfolio. I think the impact of credit spreads was most impactful on the middle market and private loan portfolios and specifically in the private loan portfolio we think there's a significant portion of net unrealized appreciation that as spreads recover—and we've already seen some recovery here in the first part of the second quarter—we should see some of that depreciation come back to us in terms of flipping back into unrealized appreciation.

Kenneth Lee, Analyst

And then one follow-up if I may, just given the uncertainty, the economic uncertainty wondering if you could just give us any kind of thought on potential trends for dividend income that you could be receiving from your LMM portfolio within the near-term, thanks.

Dwayne Hyzak, CEO

I would say it's probably not a surprise to anybody given the impacts of COVID-19, all companies—including the companies in our lower middle market portfolio—have taken a very hard look at liquidity and they're making sure that they've got a capital structure and liquidity position that is conservative enough to withstand or work through the challenges associated with COVID-19. So when you look at our lower middle market companies, and I think if you look at our first quarter results, you would have seen that impact coming through in the dividend income that we received from our portfolio companies and I think we expect that you'll continue to see that for the second and third quarters, and the long-term results will be really dictated by how long this COVID-19 pandemic lasts and how long these shelter-in-place and stay-at-home mandates last.

Operator, Operator

Our next question is from Michael Ramirez with SunTrust.

Michael Ramirez, Analyst

I apologize if I missed this or it was discussed earlier, just curious how much of your interest income collected during the quarter was classified as PIK and how does that compare to last quarter?

Brent Smith, CFO

I think interest was around 2% this quarter and it increased by about not quite a percent during the quarter as we agreed to work with some of our companies to let them switch to PIK for a certain period of time as we work through this pandemic.

Michael Ramirez, Analyst

So that I believe last quarter is about 2% so relatively flat I believe.

Brent Smith, CFO

Yeah, I think it was around—it was like 1.8%, I believe last quarter. I believe it might be close to 2.5% this quarter. So it wasn't a huge jump overall percent.

Michael Ramirez, Analyst

Follow-up if I may, so it's quite understandable that you're not going to provide your usual guidance, but thanks for the color regarding the dividend, interest income, and fees. Just curious maybe more of a high level with the uncertainty of portfolio future prospects and ability to pay interest income and dividend and fees you could collect on your origination, what are your thoughts about sort of temporarily moving toward a variable dividend policy?

Brent Smith, CFO

Mike, I think if you look at our actions over the last month or so, we've taken steps to not recommend our board that we continue to pay the semiannual supplemental. I think with that action and our current position across the portfolio and our spillover income position, I think at least for the next couple of quarters, we feel really good about our ability to maintain a stable monthly dividend. That's our plan and our intent. I think again if the COVID-19 pandemic issues last longer, we'll obviously have to reevaluate that over the next couple of quarters, but I think given everything that we're looking at today across all factors, we feel pretty good about that monthly dividend and that's what we're trying to communicate in our previous comments.

Michael Ramirez, Analyst

Okay. That's helpful and I think that's all for me. Thanks guys.

Operator, Operator

Thank you. This concludes the question-and-answer session. I will turn the floor back to management for closing remarks.

David Magdol, President and Chief Investment Officer

We thank everyone for joining us again for our conference call. We look forward to talking again in a few months here and we hope everyone remains as safe and healthy as possible. Thank you.

Operator, Operator

Ladies and gentlemen, thank you for your participation. This concludes today's teleconference. You may disconnect your lines and have a great day.