Description

Short MAIN, a wildly over-valued BDC with questionable fair value marks and poor credit underwriting. Downside of 30%-50%.    

I submit that MAIN is not the success story (retail) equity investors believe. In fact, despite one of the longest bull markets in history, MAIN has only generated net realized gains of $60mm since IPO in 2007. I believe MAIN is an attractive short due to its aggressively mis-marked/inflated investment portfolio which contains significant loss content and declining earnings power (asset sensitive) against an undeserved premium multiple (1.8x BV vs. peer avg. at 0.9x-1.0x w/ range of 0.7x-1.2x). 

MAIN investors do benefit from lower fees and fewer conflicts as a result of the internally managed corporate structure which differs from almost all of its peers. However, the benefit of lower expense is more than discounted into the current valuation. 

Tight dividend coverage which depends on equity income provides a further source of downside potential in an adverse macro environment, although I wouldn’t define the dividend as at-risk. Either through aggressive multiples or liberal reference earnings/EBITDA adjustments, MAIN somehow manages to avoid the volatility inherent to its portfolio companies. David Einhorn has discussed many of these BDC accounting issues in the past. Further, I do not believe that retail investors understand that MAIN’s primary source of book value growth has been issuing equity at a sharp premium to book value. The problem is if you raise the capital, you have to invest it and MAIN quite simply isn’t very good at that. MAIN’s NAV stood at $24.17 (aggressively marked) as of 6/30/19 while the stock has hit 52 weeks highs and recently topped $44. I don’t think the massive premium is justified. It is not as if MAIN’s assets are undervalued or there are some hidden assets. Quite the opposite. No peers I am aware of trade above 1.3x. Until recently, the vast majority of BDCs traded at discounts. MAIN’s ROE of 10%-11% is similar to other BDCs which are anchored to BV. Meanwhile, MAIN’s investment portfolio includes a large slug of equity and debt to inferior local/regional credits in the lower middle market. This huge P/BV premium is undeserved and downside of 30%-50% exists were MAIN to trade merely in-line with current best in class BDC peers. 

While some of the movement in the stock can be attributed to the impact of interest rates (MAIN and other BDCs are primarily yield vehicles for retail investors), the leveraged loan market is on borrowed time and I believe poised for a big correction in the next year or so. Many commentators have opined on the froth in the private loan market which greatly benefits from lack of public disclosure requirements and other legal protections offered by registered securities. Covenant-lite deals have become the norm and non-GAAP metrics have been routinely abused. CLOs, BDCs and similar vehicles have been buying up these loans hand-over-fist. Eventually, the correction is going to be brutal as excess liquidity reverses and sparks cascading losses. I won’t spend too much time here, but these issues are frequently discussed in Grant’s.  

I haven’t been involved in BDCs for years and originally came across MAIN when trying to figure out who in the world would loan money to AAC Holdings, a highly-levered company with significant accounting problems that I have been short (hat tip to roc924 for the excellent write-up). Investors should question the credit underwriting acumen of any firm that bought this debt over the past four years. There might be some collateral value in the real estate, but much less than AAC management suggests. MAIN and its related entities lent more than $30mm to AAC and recently added to their investment earlier this year. Even though AAC was downgraded, the stock is down 90%+ and the newest tranche priced at L+1100, MAIN was not forced to take a material write-down on the loans. This speaks to the risk-blind nature of the leveraged loan market, where pricing rarely properly discounts fundamental developments. As of 6/30/19, AAC’s term loan debt was held at 90%. AAC’s stock trades well below $1 ($15mm market cap vs. $350mm+ in debt) and is currently in default. The company has a going-concern warning in its filings. I believe it is just a matter of time until the company files for BK. Despite significant deterioration in the credit, the loan was held at 98% of par at year-end and a premium to par in 3Q18. If this investment is not on non-accrual, despite the debt being in default and issuing a going-concern warning, I wonder if it actually takes a BK filing for MAIN to stop accruing income from its troubled investments. 

The AAC investment isn’t a huge dollar amount but calls into question MAIN’s underwriting ability in a rare instance where investors can analyze the credit underlying the loan. The AAC loan is actually part of the portfolio where MAIN has less discretion over marks, so they do get some degree of latitude on where the loans were held. However, there is no reason why this investment should still be accruing. 

In MAIN’s “core competency” Lower Middle Market portfolio, investors in most cases have zero transparency into the business and there is no public marks available for the equity or debt securities. MAIN is particularly sensitive to valuation marks b/c a higher percentage of its portfolio is invested in smaller companies and in the equity slice of the capital stack. MAIN also has a percentage of investments that are considered controlled or affiliates. In many cases, the company invests in both the debt and equity of a portfolio company, taking a controlling stake in the equity. The “one stop shop” approach creates an odd dynamic where company is senior lender and controls equity. Have seen this in the past result in situations where the company impairs the junior debt but keeps senior debt at par or impairs the equity and keeps debt at/near par. Also have seen situations where equity value is protected uneconomically in order to avoid a write down, either debt is recapped to preserve equity value or equity sold with juicy debt terms. A ton of perverse incentives. Rife with conflicts and vulnerable to abuse and manipulation. 

I contend that the bulk of the mis-pricing/aggressive marks rest within MAIN’s Lower Middle Market portfolio. Furthermore, I believe there are also considerable losses within the Private Loan and Middle Market portfolios which will become realized losses in the next few quarters as these are more difficult for MAIN to obscure/delay reckoning. Part of what is driving this opportunity is the sloshing liquidity in the private credit market which makes MAIN’s more liquid debt portfolio appear healthier than it is, with AAC a case in point.  

The first bullet in MAIN’s summary fact sheet states... “Unique primary investment focus on LMM companies, which provides lower correlation to broader debt and equity markets.” Of course, they have a low correlation because MAIN doesn’t mark them appropriately. 

Background

Woodrow submitted MAIN as a short idea in November 2015, which I suggest reading since many of the same issues are still prevalent today. Woodrow’s write-up highlighted MAIN’s liberal use of mark-to-model (or mark-to-make believe) accounting, specifically as it related to Lower Middle Market energy equity investments which should have been marked substantially lower based on public comps. My analysis suggests this masquerade continues on a larger scale across MAIN’s book. The aggressive marks are nothing new in BDC land, but when you trade at such an exorbitant multiple of book value, it should matter even more. The aggressive marks are most prevalent in MAIN’s Lower Middle Market (“LMM”) equity portfolio. But as mentioned above, the failure to make timely impairments extends to debt investments in the Middle Market (“MM”) and Private Loan (“PL”) portfolios. For example, this quarter, investors were surprised to learn of a bankruptcy (in June) and write-down on MAIN’s debt investment in Joerns. Joerns debt was marked at 84% in Q1’19, 90% in Q4’18 and 93% in Q3’18 despite reports that Joerns was in default on covenants since 2018 and breached a major financial covenant in March 2019. As of Q2’19, the loan was held at 48% which compares to market participant quotes at the time of ~74%. A week later, quotes dropped to 35% and now sit at 37.5%. This should give some sort of indication regarding the accuracy of these market quotes.  

I believe MAIN’s investment in OMi Holdings (a crane manufacturer) provides valuable insight. This investment was highlighted at a recent investor day. In 2016, revenues declined ~30% and EBITDA declined almost 50% from 2015, yet the equity value only declined 4%. From 2015 to 2018, revenues are up 1% while EBITDA is down 15%, yet the equity value has appreciated by 20%. To give a sense for the quality of this business, since MAIN’s investment in 2008, EBITDA is up only marginally. Finally, although this investment is not in the energy sector, MAIN’s comments on the significant impact of oil/gas to financial results suggests this is a primary end-market. 

Another example is portfolio company Quality Lease Service, LLC (oil & gas) which quietly went through yet another restructuring in 2Q’19. A $10.4mm investment consisting of $6.4mm of zero coupon secured debt and $4.0mm of equity as of 1Q’19 was magically transformed into $10.6mm of equity as of 2Q’19 with no disclosure to investors. Apparently the debt service was too onerous? Similarly, MH Corbin was restructured in 1Q’19 and came off non-accrual at a higher value. While transparency is limited, I provide a non-exhaustive list of questionable marks in a section below. 

The risk/reward here is favorable because of the rosy valuation which discounts continued economic expansion, no trouble in the credit markets and continued use of MAIN’s extremely rich multiple to drive actual accretion. I believe investors can win here without widespread macro pain or weakness in the private loan market, but either would greatly enhance the return. This idea does not have an easily identifiable hard catalyst. As such, it should be sized appropriately. However, I believe once these mis-marks become evident through elevated losses, the stock will re-rate significantly lower as investors realize the use and abuse of fair value accounting. 

Is this a valuation short? Yes; to some degree, but I think there are a sufficient number of potential catalysts and further upside is constrained by predominant focus on fixed income and fact that BDCs are tethered to BV. 

MAIN is mispriced due to an ebullient leveraged loan market which has buoyed performance by keeping defaults lower than they should be. Zombie issuers can easily refinance and kick the can down the road. This idea would be a completely different risk/reward if MAIN were trading at discount to BV. This would also be a different story if new capital could be deployed in an accretive manner. It cannot due to the lack of scalability for lower middle market investments (extremely small check sizes) and nosebleed asset pricing. MAIN has proven its ability to quickly lose money in larger loan deals. 

Summary

-Market cap is $2.8 billion w/ ADV a little under 300k. 

-Based in Houston, Main Street IPO’d in 2007 at $15 per share.

-The company has been around since the 90s and helped found Quanta Services (ticker: PWR). 

-Short interest only 3.8% and borrow is cheap.

-Investments in 182 portfolio companies w/ 69 LMM, 62 PL and 51 MM. At fair value, LMM is about half of portfolio with MM and PL roughly an even split.

*LMM is $1,214 million at FV and $996mm at cost. 33%/67% equity/debt at cost. 

*MM is $520 million at FV and $562mm at cost. 4%/96% equity/debt at cost.

*PL is $594 million at FV and $630mm at cost. 7%/93% equity/debt at cost.

-Avg. Investment size of ~$12mm. 

-Wtd. avg. effective yield of 10.7%.

-Largest investment at 2.6% of portfolio FV and 3.7% of total investment income.

-Historical focus on LMM. Moved into PL and MM debt investments b/c hard to scale LMM (and needed “stable” income to support higher recurring dividend). 

-Non-accruals at 4.4% of portfolio at cost and 1.5% of fair value. 

*Notably, a number of troubled investments are still accruing despite appearing destined for BK and significant write-downs. 

*Publicly available information suggests further impairments are imminent. 

*Several troubled investments have been restructured (some in BK) with minimal mark-downs where debt was converted to equity.

-Credit performance looks better b/c company has been growing significantly and deferring  or delaying recognition of losses on holdings. Can do this through restructuring, extend and pretend, etc. especially with LMM companies where information is not public.  

-Seemingly wide industry diversification, but I believe this is misleading and there is much more energy exposure than the pie chart would suggest. More on this below.

-Private loans are not securities, thinly regulated with little disclosure. Investors do not enjoy legal protections from underwriters etc.

-More than 100% of net unrealized appreciation in 2018 came from the external asset manager subsidiary.

From 2014 to Q2’19, NAV has grown 22% or $4.28. Including dividends, total return of $19.29. Realized net gains have only added $0.02 after-tax. Realized and unrealized net gains have totaled $1.33 over that time (almost that entire increase is from external investment manager). Accretion from stock issuance has added $4.88, which explains more than 100% of NAV growth.  

In recent investor deck, MAIN said, “Equity investments are key component of LMM portfolio...Key contributor to our 90% growth (5.9% CAGR) in net asset value (NAV) per share since 2007 through March 31, 2019.” This is a gross mischaracterization since vast majority of NAV growth has been through accretive stock issuance, not the paltry gains from equity investments in a 10 year bull market. 

LMM investments are much less liquid with limited access to financing, so there should be substantial liquidity discount in the valuation process, but it appears they are valued at a premium despite size and anemic growth prospects.  

Risks

There is a lot to like about MAIN. As a rare internally managed BDC, it benefits from a lower cost structure vs. peers. Investors benefit from the expense leverage and fee income from MAIN’s external manager which advised HMS Income (and I-45). However, the way MAIN shows the expense differential is a bit misleading as it benefits from cost sharing with the external manager which is also included as a portfolio company within the investment portfolio. At the end of the day, MAIN’s structure is cheaper and more aligned with shareholders than most other BDCs. Critically, this has enabled access to low-cost capital, bolstering the investment spreads.  

Risks to the short thesis include:

-Continued froth in markets, driven by low interest rates. It seems lately that the expensive has been getting more expensive and cheap getting cheaper. If this continues, won’t be a great environment for the short to work. 

-Circular nature of book value accretion through equity offerings. Higher the stock, greater the accretion from issuance.

-Acquisition of another external manager. 

-Favorable change to AFFE rules which would increase institutional and index interest.

I believe these risks are offset by the rich valuation which seemingly discounts these positive events. Also, many of these risks can be hedged by owning a basket of BDCs against this short.

Valuation

-Consensus expects $2.55-$2.60 in Non-GAAP EPS/NII for 2019 and 2020, implying a 17x P/E multiple and 6% earnings yield. This compares to peers at a ~10x P/E and ~10% earnings yield. 

-In terms of ROE, MAIN still does not stand out vs. peers. MAIN’s ~10%-11% ROE expected over the next two years is largely consistent with the BDC group at ~10%.

-Despite similar ROE profiles, MAIN trades at a mammoth 1.8x BV vs. peers at 0.9x-1.0x with a range of 0.7x-1.2x. 

-Through the lens of the dividend yield, all-important for retail investors, MAIN also doesn’t screen well at 6%-7% depending on if supplemental dividends are included vs. peers at ~10%. Monthly dividends are $0.205, which is $2.46 per annum or a 5.6% yield. Supplemental dividends are paid twice a year with most recent declared at $0.24 for December. All-in, looking at $2.94 annualized or a 6.7% yield at current Px. The supplemental semi-annual dividend is going to continue to come down but MAIN is cagey about the pace.

-Most notably, even best in class peers with solid track records that generate 10%-12% ROEs trade at 0.9x-1.2x BV. After MAIN, the next highest P/BV multiple is 1.2x (TSLX).

-A meaningful amount of MAIN’s investment income is non-cash, if using a more conservative cash/economic earnings measure, 2019 EPS/NNI is closer to $2.20, implying a 5% earnings yield. 

-Note that all of these measures incorporate no prospective credit losses.  

I think MAIN should trade in-line with well regarded peers, with the favorable internal management and expense structure offset by weaker investment function and focus on a riskier market niche. A 1.0x BV multiple ($24) would imply 45% downside while 1.2x ($29) would imply 34% downside. This price target does not take into account portfolio depreciation/write-downs which would catalyze the re-rating.  

Management/Disclosure/Transparency

-I believe that MAIN intentionally limits transparency into the business.

-Management owns a decent chunk of stock, but much of this has come from equity compensation and pre-IPO stake.  

-Selective disclosure, PRs announce successful exits with metrics disclosed but silent on unsuccessful ones. 

*The disparity is almost comical. 

*Realized gains discussed at length, losses buried in fine print or obscured. 

-Many important pieces of information are missing from MAIN’s SEC reporting. Examples:

*Investment ratings are notably absent even though HMS Income fund discloses. 

*Actual financial data on portfolio investments is very difficult to find.

*No idea what the add-backs to EBITDA are.

-In many cases, the transparency MAIN does provide is modified in such a way that makes the information useless. Examples: 

*Disclosure on EBITDA multiples exclude outliers and EBITDA is adjusted. 

*Useless portfolio-wide average/median metrics. 

*Schedules from 10-Q on investment activity lump several line items together, obscuring the movement quarter-to-quarter (commingling portfolio addition/sales/write-downs, etc.).

*Showing unrealized appreciation including external manager with $0 cost basis

-Page 60 of the June 2019 investor presentation is another example of incredibly misleading information re: portfolio default rates and realized loss severity. Take a look.

-It is funny how management/Street discuss on every call the potential exits in LMM portfolio. These are usually very small and non-representative. 

Energy Exposure

-MAIN says exposure to energy is limited to under 10% at cost (including just energy equipment & services plus oil, gas and consumable fuels), however the real exposure is much higher. 

*This breakdown excludes Other Portfolio investments which includes many energy PE fund investments. 

*Industry classifications are not accurate.

-Given their geographic skew, businesses are much more levered to oil/gas vs. rest of country. 

-While there is probably some leakage here, many other industries not included are also closely tied to energy in MAIN’s markets so I believe real exposure is higher.

-The previous write-up focused on this issue more and I think these points remain valid. Despite massive declines in public equities and debt tied to the industry, MAIN has recognized very limited losses. I believe more losses are in store. 

-A few highlights:

*Recent investor deck highlights the lack of true mark-to-market at energy-exposed portfolio company Charps, LLC.

*Lent $3mm to Larchmont Resources, LLC (one of Aubrey McLendon’s personal vehicles) in August 2013, this investment is still held at a premium to cost! 

*Copper Trail Energy Fund’s website is defunct and appears to have no direct employees. Yet equity investment made in July 2017 held at 133% of cost. 

*Quality Lease Services restructured debt to equity and marked up.

*Several other private equity fund investments in MAIN’s portfolio which haven’t been impacted somehow with the carnage in the space.

Perception vs. Reality

-MAIN is viewed as a blue chip BDC with a great track record in the LMM niche w/ Street reports frequently highlighting the embedded gains in MAIN’s equity portfolio. 

*This is simply not true.

-Cumulative net realized gains of only $60mm since inception in a decade long expansion.

-71% of unrealized gains from control equity investments are concentrated in four companies.  

-Control investments held at 135% of cost, while affiliate investments held at 94% of cost and non-control, non-affiliate investments held at 96% of cost. Hmmm.

-Despite almost doubling the portfolio from 2013-2018, DNII per share only up 27%. 

-Since 2009, portfolio size up 1,443% while DNII per share only up 171%. 

Questionable Fair Value Accounting

-Just growing the portfolio can obscure the losses from failed investments. MAIN usually refers to the non-accrual investments at FV as % of portfolio, which obviously makes them look small... should be viewed at cost.      

-Obviously the valuation isn’t specific to MAIN, but impact is more pronounced b/c they have a greater proportion of equity investment which are extremely sensitive (adjusted earnings and multiple can inflate value by 100% vs. much smaller difference is aggressive mark on debt b/c upside is capped).  

-50% of LMM investments have been in the portfolio for more than five years. 

-Big chunk of portfolio in equities/warrants, should be extremely volatile in periods of economic stress. Since these are tiny companies, access to capital is de minimus. 

-With control investments, MAIN can keep putting money in/refinance to avoid writedown. -Because credits are tiny, doesn’t take much money to keep portfolio defaults low.

-Typically, MAIN takes losses on its MM/PL portfolio (which is where it has the least amount of pricing discretion) and marks up the LMM equity stakes. 

-In MAIN’s summary fact sheet, they note a “unique primary investment focus on LMM companies, which provides lower correlation to broader debt and equity markets.” This is complete fallacy similar to when a non-traded REIT manager tells investors that the product is less risky b/c it is not correlated to markets. If an asset isn’t marked correctly, it doesn’t mean it isn’t correlated. But that is exactly what MAIN is doing (avoiding marking its assets appropriately) and you can see this in the limited information we receive on portfolio investments.

Examples

-CBT Nuggets produces and sells original content information technology (IT) certification training videos. MAIN initial investment in 2006. Current value of ~$60mm implies equity value of $146mm, which represents 36.7x 2018 operating income, 30.0x 2018 net income and 183x/393x 1Q’19 annualized operating income and net income, respectively. In 1Q’19, revs/gross profit/operating income/net income were -11%/-14%/-89%/-97% from 1Q’18. In 2018, revs/gross profit/operating income/net income were -4%/-2%/-56%/-74% from 2017. The equity multiple on operating income has increased from 8.5x in 2018 to 24.3x in 2017, 38.0x in 2018 and 185.8x on 1Q’10 annualized in 1Q’19. We don’t have information for 2Q’19. Last year, it was mentioned in filings that the company held some bitcoin, but this should be reflected in CBT’s assets, which totaled $21mm, $26mm and $15mm in 2016, 2017 and 2018, respectively. For 2019 YTD, CBT has generated $300k in income despite a purported value of $60mm. We have financial information because CBT was such a significant portion of investment income in 2018.  

-Gamber-Johnson makes computer mounting systems and is a 2016 LBO with a subsequent merger in 2017. Equity has been marked up 3x from $15mm to $45mm. Based on summary financials that MAIN was forced to disclose, equity appears to be marked at a healthy multiple. ~23x 2018 net income of $2.8mm and EV/operating income of ~17x. 

-GRT Rubber marks also appear aggressive w/ equity valued at 26x net income of $2.5mm (was negative in 2017 and 2016).  

-MSC Adviser is MAIN’s external asset management business. It has generated a huge portion of MAIN’s net unrealized gains from a cost basis of $0. This is an attractive business which leverages MAIN’s existing overhead. But historically, operators are not able to monetize these vehicles. The current $70mm value seems aggressive. 

-Guerdon Modular Holdings. Went on non-accrual this quarter. The equity was written down to $0 in 2017, but the debt was kept near par. Then modestly impaired upon maturity with loan extended multiple times. This seems to be a pattern: delay recognition of issues until actual default or BK. 

-Direct Marketing Solutions is a direct mailing company. Acquired from a PE firm in 1Q’18. Equity has already been marked up by 100% on revenue and EBITDA growth of 13%.

*Other investments have seen similarly aggressive markups to equity value within the first year, including Chamberlin.  

So many of their MM/PL debt investments fall apart within a year or two of initial investment, never a good sign. Invested in Pier 1 in Feb 2018 at L+350. Loan now marked at 25% a little over a year later. 

They’ve also invested in a large number of digital marketing companies which are likely to flop. 

Balance Sheet/Leverage

-MAIN runs a pretty clean balance sheet with modest leverage. 

-Net debt to equity of around 0.65x.

-Attractive debt financing with SBIC and investment grade rating.

-They have room to increase this significantly but capital deployment is the issue.

-Their cost of capital is a significant positive. Again, capital deployment limits the value here.

-Important to note that leverage is understated b/c MAIN invests in JVs/SPVs/other funds which themselves are levered. 

-Regarding additional leverage, there is certainly room but they can’t deploy that capital well. So it would be a potential short-term bump with negative long-term consequences, particularly in this environment. 

Dividend

-I don’t think MAIN’s monthly dividend is at risk, but it is under-appreciated how tenuous it is.

-Including the supplemental dividend, MAIN continues to pay out amounts in excess of recurring earnings, let alone recurring cash earnings. 

-MAIN depends on equity income, which represents 21% of total income, to fund the dividend. Equity income is highly volatile even in a great economy. 

-A decent percentage (~5%) of investment income is also non-cash:

*2.2% of investment income is from PIK. 

*1.1% from cumulative dividends not currently paid in cash. 

*2.5% from accretion of discounts. 

-The supplemental dividend may also fade faster than retail investors suspect as realized losses offset any realized gains. 

Earnings Growth

-While MAIN appears poised to grow its book given reasonable leverage and access to cheap capital, several factors limit potential earnings growth.

-Interest rates declining with majority of loans variable rate and large portion of debt fixed rate.

-Losses in portfolio will impact NII. Even when MAIN hides realized loss by converting debt to equity, income takes a big hit. 

-Heavy competition in most markets means poor risk/reward on new investments. 

-Continued growth in LMM portfolio means overhead needs to increase significantly. 

-Inability to scale LMM portfolio means continued reliance on MM and PL investments, which don’t provide as much leeway on marks.  

-These factors provide a valuable cushion to the short thesis. 

Catalyst

-Realized losses in the MM/PL portfolio due to specific credit events. 

-Greater scrutiny of fair value marks within LMM portfolio and energy-related investments. 

-Weakness in the leveraged loan or credit markets. 

-Disappointing earnings due to lack of growth. 

As noted in the write-up, there is no hard catalyst here so should be sized accordingly.