AlexLMX
Investment Thesis
Main Street Capital (NYSE:MAIN) presents an intriguing anomaly within the Business Development Company ‘BDC’ sector, especially when viewed through its Price-to-Book ‘P/B’ ratio or NAV/share. Unlike most BDCs, which typically trade at a discount to NAV, MAIN consistently trades at a significant premium. This phenomenon is not a product of superior performance metrics of management investment skills. Instead, it is a by-product of a self-reinforcing speculative cycle, with MAIN outperforming due to its ability to raise equity at a premium to NAV and investors willing to buy shares above NAV due to MAIN’s outperformance.
Market Exuberance
The willingness of investors to pay more than the company’s book value allows MAIN to cover its losses in a way that is not feasible for most of its peers. BDC companies often face difficulties maintaining their book values over time due to the regulatory mandates that require them to distribute most of their income. This leaves little room for retaining earnings to cushion against bad debt write-offs. Earnings retention to compensate for bad debt is a fundamental concept in finance. It allows banks and credit card companies to maintain their capital despite loan defaults. Due to distribution requirements, BDCs don’t have this option.
Contrary to common perception, capital losses do not lower distribution requirements. Ordinary income from interest (and dividends) is separate from capital gains/losses when it comes to distribution laws. Even if MAIN edges on the verge of bankruptcy, it must distribute every single dollar of income to its shareholders. This makes it challenging for MAIN to retain earnings to compensate for capital losses.
Since bad debt write-offs are inevitable, BDCs continuously raise fresh equity capital via a combination of equity and debt, but eventually, most BDCs see a decrease in NAV/share. A prior article noted that nearly 80% of BDCs lose NAV/share value after inception.
In our view, the ideal BDC is self-preserving, where capital gains counterbalance losses. Looking at MAIN’s financials over the past decade, we notice a net realized loss of $160 million, a pretty large figure for its size. Moreover, this number only partially captures the extent of its mediocre investment apparatus. MAIN has a different strategy for dealing with its underperforming loans. Latest figures show that 3.1% of its portfolio, equivalent to $120 million, is non-performing. Instead of offloading these assets, as is common practice among BDCs, MAIN chooses to hold on to them. So, these assets don’t find their way to realized loss accounts and remain under an opaque unrealized gain/loss balance whose value is largely influenced by subjective fair value estimates.
Given this performance, we don’t see that MAIN stands out in a way that would justify its share price premium over NAV. It seems that MAIN’s elevated market valuation is more a product of a self-feeding cycle, raising questions about the sustainability of this premium. NAV/share is growing because of accretive equity raises, while accretive equity raises exist because of investors’ expectations that NAV/share will continue to increase.
Main Street Capital
2024 Performance
As long as investors are willing to pay a premium for MAIN shares, the impact of capital losses is less of a concern, but we acknowledge that this is not a sustainable business model. MAIN’s new equity offerings not only provide capital for growth but also cover losses. Net Investment Income ‘NII’ per share is increasing, and by extension, so is the dividend per share. Recently, MAIN released Q4 preliminary results, showing increased ROE and record NII despite near-record realized losses in 2023, which stood at more than $100 million.
In recent quarters, MAIN has accelerated its issuance of common shares, raising $81 million in Q3 2023 alone, as shown in the chart below. With authorized shares nearly double those issued, it is quite possible that MAIN raised more equity in Q4, but we’ll have to wait and see to be certain when the company releases Q4 results on February 22, 2023. Certainly, with a Price to NAV premium of nearly 50%, new equity issuance is accretive.
The question of whether MAIN’s self-reinforcing cycle is poised to burst in 2024 will depend on market sentiment. The Fed’s rate cuts will likely coincide with softening macroeconomic conditions, potentially impacting MAIN’s valuation. But our base-case scenario is that MAIN’s NII and dividend per share will continue to appreciate as the company continues to raise equity above NAV. Our ‘Hold’ rating mirrors the absence of solid fundamentals behind its performance rather than short-term worries that the self-feeding cycle will break. For the better half of the past decade, MAIN traded at a premium to NAV of roughly 50%, and we don’t expect this to break in 2024. We believe management will continue exploiting the market’s optimism by issuing accretive new equity.
Dividend
One would expect dividends from BDCs to be consistent, reflecting a loan portfolio’s steady income. Typically, special dividends would be reserved for intermitted net capital gains. However, MAIN has been issuing special dividends regularly. These dividends imply a special favorable event, but in reality, it is simply because MAIN’s regular dividend falls short of minimum regulatory requirements.
Based on Q4 2023 results, we estimate MAIN’s ordinary income (net investment income) run rate to be $90 million per quarter ($360 annually). Based on these estimates, we anticipate that in 2024, MAIN will distribute at least $3.9 per share in annual dividends to meet the 90% distribution mandate, resulting in an 8.7% forward yield, surpassing the 6.5% yield suggested by its regular dividend. Whether MAIN distributes the $3.9 dividend as a regular or special dividend is yet to be seen, but it hardly matters.
Summary
MAIN’s ability to consistently raise equity above NAV, despite its mediocre investment strategy, mirrors a sentiment-based, self-reinforcing cycle that helped the company grow. This cycle, fueled by investors’ optimism, allows MAIN to capitalize on its premium valuation, turning a lukewarm investment strategy into a growth engine. Going into 2024, we don’t see a significant threat to this self-fulfilling cycle of equity capital raise, but the Fed’s rate hikes will likely be accompanied by macroeconomic softness.
We expect dividends and NII per share to grow in 2024. Total dividends, which encompasses regular and special distribution, will likely approach the 9% annual yield mark. The company remains in a favorable position compared to peers, but the unsustainability of its business model renders it a ‘Hold’ in our view.
