Description

Short – Main Street Capital Corp (MAIN)

Thesis Summary

·         MAIN is a BDC that trades at a substantial premium to net asset value and its peers due to the perception that it is “best in class”, but has actually been using accounting shenanigans to boost net asset value.

·         We see between 46% and 52% downside as the Company is forced to take write-downs of its energy related assets and its valuation premium disappears.

·         We believe that MAIN’s success is not due to special investing acumen but more related to its heavy concentration in lower middle market companies based in the southwestern US with substantial energy exposure.

·         These companies are small, low quality companies that disproportionately benefitted from the energy boom and will be impaired by the bust.

·         MAIN has yet to take meaningful write downs in these assets, but it can only be a matter of time with meaningful EBITDA declines at its portfolio companies.

·         MAIN’s regular dividend coverage is tight and should deteriorate to 0.9 x due to slower dividend growth on the Company’s equity positions and losses in energy investments. Peers trade at a much higher dividend yield and average over 1.0 x coverage.

·         The Company’s investors also rely on a special dividend which should be eliminated. The Company appears to have begun to bury losses in unconsolidated taxable subsidiaries in order to maintain this special dividend; a practice that is clearly uneconomic and highly questionable.

·         Increasingly aggressive accounting practices have obscured deterioration in the portfolio over the last couple years even if energy investment valuations were correct. This leaves the company with few levers left to pull.

·         MAIN’s valuation premium creates a strong risk reward for the short with limited upside and substantial downside. MAIN trades at 1.4 x NAV versus the peer group at 0.8 x and its regular dividend yield is 7.1% versus the peer group yield of 12.0%.

Note: This write-up was my VIC application and is thus a couple weeks out of date on numbers and valuation multiples and was written before Q3 results. The Q3 results have done little to affect my conviction in the short. Feel free to post questions in the comments section.

Introduction

Main Street Capital (“MAIN”) is a business development company (“BDC”) which makes equity and debt investments in middle market and lower middle market (“LMM”) companies.  The Company trades at a material premium to its BDC peer group because of the perception that its management team has some special, differentiated investing talent that its peers lack.  We believe that the consensus view on MAIN is absolutely wrong.  MAIN has not driven its historical outperformance through any unique investing skill.  Instead, MAIN has merely ridden the energy boom and is now downplaying its energy exposure and materially overvaluing its LMM energy related investments.

BDCs are typically known for making risky high-yield investments in small businesses and using moderate financial leverage to deliver an attractive return, which is paid out to investors in dividends.  BDCs then endeavor to raise equity at a premium to their intrinsic value in order to grow dividends.  These vehicles appeal to yield-hungry retail investors.  However, as many BDCs have performed poorly and the public market has become saturated, investors have soured on the space.  The average BDC now trades at an 18% discount to the net asset value (“NAV”) of its investments and a 12.0% dividend yield, reflecting investor skepticism over the quality of NAV and the sustainability of dividends.

Investors view MAIN differently and currently value the shares at a 39% premium to NAV and a 7.1% dividend yield (or an 8.9% yield if special distributions are included).  Investors believe that MAIN deserves this premium valuation based on its history of steady dividend growth and its ability to grow net asset value through the appreciation of its private equity investments in LMM companies.  Unlike its BDC peers, MAIN owns not only debt, but also substantial equity in the risky small businesses in which it invests.  Since its equity investments appear to have performed well, investors believe that MAIN has found the magic formula.

We strongly disagree. We believe that MAIN has simply made risky investments in cyclical energy related companies during a boom time.  MAIN invests in the same low quality small businesses as its peers and actually takes more risk with 23% of its NAV in the equity of LMM companies.  MAIN’s primary differentiator is that 30% of its LMM investments are energy related and 60% of its LMM investments are in the Southwestern U.S. near its Houston headquarters.  With oil prices collapsing, we believe that MAIN’s performance will deteriorate in the coming quarters.  As Warren Buffet famously said, “Only when the tide goes out do you discover who has been swimming naked.”

MAIN’s share price should decline meaningfully as the following catalysts highlight the Company’s aggressive use of accounting shenanigans to paint the picture of a better BDC:  1) management is forced to write down investments in energy and related industries due to large declines in EBITDA; 2) lower dividends, realized losses and potential debt restructurings should result in a cut to MAIN’s regular and supplemental dividends; 3) losses at energy related companies will expose MAIN’s questionable valuation practices at other portfolio companies; and 4) an evaporation of MAIN’s premium to NAV will put an end to accretive equity offerings which have hidden problems in the investment portfolio in the past.  As these catalysts occur, we believe that MAIN’s shares will decline closer to their fair value of between $14.49 and $16.25, representing downside of between 46% and 52%.

The Quality of MAIN’s LMM Investment Portfolio Companies Has Deteriorated

We believe that MAIN’s LMM portfolio is concentrated in small, low-quality companies that are poorly positioned to face a much tougher economic environment with the energy bust impacting its core Southwestern U.S. geographies.  Like its BDC peers, MAIN has grown assets at an extremely aggressive pace causing the Company to lose focus and compromise its standards.  Since its IPO in 2007, MAIN has grown its investment portfolio from $90 million of investments in LMM companies to $1.8 billion of assets, diversified across LMM, middle market syndicated loans and private loans.  Part of the reason for MAIN’s diversification efforts is that its average LMM investments starts out at $8.3 million, implying that a $1.8 billion portfolio would require an impossible 217 LMM investments.  However, despite the difficulty in sourcing LMM investments MAIN has grown the number of companies in its LMM portfolio by 156%, from 27 investments in 2007 to 69 investments today.  Moreover, MAIN is also investing in middle market and private loans, so its portfolio now consists of 189 companies, a 600% increase since 2007.  MAIN cannot possibly be as selective in making LMM investments or provide the same level of oversight over its LMM portfolio as it did in the past.

Even a simplistic analysis of MAIN’s LMM investment portfolio demonstrates that its portfolio companies are very small and of questionable quality.  MAIN’s LMM investments average $6.1 million in EBITDA, implying that high quality companies in the portfolio with 25% EBITDA margins generate $24 million in revenue and lower quality companies with 10% EBITDA margins generate $60 million in revenue.  According to a survey of CFOs by the American Institute of Certified Public Accountants, companies with $21 million in revenues had 75 employees, and those with $50 million in revenue had only 170 employees.  Therefore, MAIN’s average investment is a small company without sophisticated financial controls.  

More importantly, MAIN’s average LMM portfolio company raised first lien debt at an interest rate of 12.8%.  According to the most recent NFIB Small Business trends report, the average small business was able to access short-term bank financing at an interest rate of 5.4%.  While MAIN provides longer-term financing to its portfolio companies, an interest rate of 2.4x the average rate on short-term small business borrowings indicates that there is significant risk embedded in MAIN’s LMM portfolio.

In fact, MAIN concedes that it has never been able to invest in high quality LMM businesses, and recently it has further compromised its standards on its LMM investment portfolio.  On the Q2 2015 earnings call, MAIN’s CEO stated that its typical LMM investment had "limited access to less expensive senior cash flow financing.  Maybe the top quartile of those companies that were of interest to sponsors could access that type of financing.”  Now “we see the sponsors moving into maybe the second quartile and they are bringing with them access to senior cash flow financing….  The third quartile companies and fourth quartile companies, and I am ranking in terms of growth prospects, continue to not really have that access and that’s kind of been where we’ve been transacting.”  In summary, MAIN’s CEO admits that its LMM portfolio previously consisted of second quartile companies at best and has recently migrated to the third and fourth quartile.  These are hardly the ideal investments in a challenging economic environment.

Finally, MAIN’s LMM portfolio is concentrated in cyclical industries. MAIN’s largest industry concentrations are: 14% oil service; 10% machinery; 9% hotels, restaurants and leisure; 9% telecom services; 8% specialty retail; and 7% engineering and construction.  These are generally risky, cyclical industries.  With MAIN’s heavy exposure to the Southwestern U.S. and the collapse in energy prices, its portfolio companies are likely entering the wrong side of the cycle.  

In summary, MAIN’s LMM portfolio companies are very small niche players who have limited access to bank lending and mediocre growth prospects by MAIN’s own admission.  Moreover, these businesses participate in cyclical industries with heavy exposure to the energy industry.

MAIN’s Disclosures Understate its True Energy Exposure

We believe that MAIN’s heavy exposure to risky investments in companies in the Southwestern U.S. with significant energy exposure should cause significant problems for its low quality LMM portfolio companies.  In order to source its LMM investments, MAIN stays close to its headquarters, with 53% of the cost basis and nearly 60% of the value of its LMM portfolio residing in the Southwestern U.S.  While only 14% of the Company’s LMM investments at cost are directly in the energy equipment and services industry, the decline in oil prices should affect many investments classified as machinery, engineering and construction, distribution or transportation.

We have performed a detailed analysis of MAIN’s investment portfolio and believe that the Company’s exposure to investments with significant oil and gas exposure is far higher than MAIN discloses.  MAIN claims that its direct energy equipment and services and oil and gas exposure is only 9% of its overall portfolio.  MAIN has little energy exposure in its middle market portfolio to compensate for its outsized LMM exposure.  However, when one includes companies with significant oil and gas customer exposure, these represent around 30% of the LMM portfolio and 18% of the overall investment portfolio value.

An analysis of MAIN’s portfolio demonstrates that the primary driver of MAIN’s performance has not been any special investing talent of its principals but rather its exposure to the Southwestern U.S. and energy related companies.  Southwestern U.S. investments have been responsible for 92% of all of MAIN’s unrealized gains, despite representing only 32% of the overall portfolio and 53% of the LMM portfolio at cost.  This demonstrates that MAIN’s returns are far less diversified than they appear.

Energy related investments have also been a significant driver of performance.  Energy related companies represent 35% of MAIN’s equity portfolio according to MAIN’s valuations as compared to 11% of its debt investments.  Since equity investments have the most sensitivity to positive and negative developments, these equity investments in energy related companies have been MAIN’s best performers during boom times, generating a 112% return for MAIN relative to cost basis.  That is almost double the return of equities in the rest of the portfolio, which have generated a 60% return.  In fact, appreciation in equity securities of energy related companies comprises 59% of the unrealized gains in MAIN’s entire portfolio.  While this may have made sense in June 2014 when oil was peaking, it makes little sense today.  Risky investments in low quality, cyclical companies can drive outsize returns in a boom.  However, those returns can evaporate very quickly in a bust, wiping out years of appreciation.

MAIN’s Energy Related Investments are Dramatically Overvalued

We believe that MAIN’s valuations of the energy and related investments in its portfolio are completely divorced from the reality facing investors in the public markets.  Energy related stocks and bonds have been the worst performers since the peak in oil prices in the summer of 2014.  However, if we believe MAIN’s valuations of its oil and gas investments, one would conclude that there has been almost no change in industry conditions.

Publicly Traded Energy Equities and Bonds Have Seen Dramatic Losses

The oil service holders ETF (OIH) is down 47% since June 30, 2014.  This index holds the most well-capitalized international oil service firms like Halliburton (HAL) and Schlumberger (SLB).  Shares of smaller domestic oil service providers like Basic Energy Services (BAS), C&J Energy Services (CJES), Key Energy Services (KEG), Pioneer Energy Services (PES), and Superior Energy Services (SPN) are down an average of 82% as they face solvency issues.  In June 2014, these companies had market capitalizations ranging from $1.4 billion to $5.6 billion, dwarfing MAIN’s average LMM investment. 

Senior secured debt securities of energy companies have also been decimated.  Leveraging off work done by Raymond James, we have analyzed $109 billion of debt at face value, consisting of 209 senior secured loans made to 96 operating entities that have impaired debt in energy related industries.  As of September 16, this debt was trading at 43 cents on the dollar on a weighted average basis.  Once again, unlike MAIN’s LMM investments these were large companies that had much better availability to credit than MAIN’s LMM companies before the energy bust.  The average entity in our sample size had $1.1 billion of debt outstanding, compared to MAIN’s typical $8.3 million LMM investment.  The median interest rate in our sample was 7.5%, compared to 12.8% for a MAIN LMM investment.

MAIN’s Valuation of Private Energy Investments Does Not Reflect Reality of Public Comparables

While MAIN marks its publicly traded investments to market, the Company has significant discretion in valuing its private investments.  Despite its reputation as an astute investor in the energy markets, MAIN has seen significant losses in its publicly traded energy securities.  For example, MAIN’s investment in Halcon Resources (HK) 9.75% 2020 bonds is trading at 34 cents on the dollar, its RGL Reservoir Operations First Lien Senior-Secured 2021 Term Loan is trading at 41 cents on the dollar, and its Permian Holdings 10.5% 2018 bonds are trading at 42 cents on the dollar. 

However, in stark contrast to the issues in the broader equity and debt markets, MAIN has only taken modest markdowns on its own oil and gas investments.  If we exclude Quality Lease Holdings, which declared bankruptcy before much of the decline in oil prices, MAIN’s direct energy services investments have depreciated by only 12% from their June 30, 2014 values.  Furthermore, these investments are still trading at a value that is 26% higher than MAIN’s cost basis.  In fact, if we segment MAIN’s oil services portfolio into publicly traded versus private as of Q2 2015, MAIN’s marked-to-market public investments are trading at a 19% discount to their cost basis while its marked-to-model private investments are at a 36% premium.  If mid-cap oil service stocks are down 82% and much larger energy related companies are seeing a 57% markdown on their debt, MAIN’s portfolio of low quality LMM oil service companies cannot be doing as well as its valuations suggest.

Stocks of companies that are not directly in the energy industry but have significant exposure to it have also declined meaningfully over the last year.  We have been short industrial and technology stocks that fit this description like CIRCOR International (CIR).  CIR is down 41% from its June 30, 2014 levels and its 2015 EBITDA is projected to be 39% lower than projections in June 2014.  CIR is a far superior business to MAIN’s average LMM portfolio company.  CIRCOR is a leader in an oligopoly industry within the broader oil services space.  CIR had net cash and a $1.4 billion market capitalization before oil declined.  However, unlike CIR, MAIN’s filings state that its energy related investments have more than doubled in value versus their cost basis, suggesting no impact from the current crisis. 

MAIN’s oil and gas exposed debt investments have not performed quite as well.  Oil and gas debt has been marked at 79 cents on the dollar versus an average of 98 cents on the dollar for all other debt in MAIN’s portfolio.  However, if we exclude the large loss on Quality Lease Holdings, MAIN’s energy exposed debt is trading at 95 cents on the dollar.  Unsurprisingly, the vast majority of this decline is from marked-to-market publicly traded securities, with marked-to-model private companies unaffected.  This makes little sense with public first-lien energy related bonds and loans trading at 43 cents on the dollar.

MAIN Should Recognize Losses as EBITDA at Portfolio Companies Declines

MAIN’s filings suggest that equity securities are valued using some combination of market comparable Enterprise Value-to-Adjusted EBITDA multiples and a discounted cash flow model.  Based on the performance of publicly traded oil services companies, we find it hard to believe that MAIN’s portfolio investments in oil and gas and related industries are not seeing significant reductions in EBITDA or projected cash flows.  Looking at the top ten holdings in the Oil Service Sector ETF, the average EBITDA decline is expected to be 34% in 2015 and another 9% in 2016, representing a 43% decline in EBITDA over the two-year period.  If we use our domestic oil service companies like BAS, CJES, KEG, PES and SPN, EBITDA declines average 77% in 2015.

We do not believe that MAIN can avoid markdowns on these investments indefinitely.  MAIN’s average LMM investment has $6.1 million in EBITDA.  MAIN values its equity investments at 6.7x EBITDA, and the investment has 2.0x debt-to-EBITDA leverage. If we subject this company to a 43% decline in EBITDA like the OIH companies and keep the multiple and debt levels constant, the value of MAIN’s investment would decline by 61%.  If we analyze a similar debt investment, the consequences of a large EBITDA decline are equally significant.  MAIN’s average debt investment has 3.7x EBITDA to senior interest coverage and approximately 3.1x EBITDA-to-total interest coverage.  Since oil service and industrial companies are capital intensive, it seems reasonable to assume maintenance capital expenditures absorb 25% of EBITDA.  Thus, this debt investment would then have 2.4x EBITDA less capital expenditure-to-interest coverage.  If we subject this investment to a 43% decline in EBITDA, EBITDA less capital expenditure-to-interest coverage declines to 1.0x.

Based on this analysis, we believe that it is only a matter of time before MAIN has to take significant markdowns on its energy related investments.  The only way the Company could avoid these markdowns is either by dramatically increasing the EBITDA multiple at which it is valuing its portfolio or by employing a DCF analysis with projections that imply a quick recovery in oil and gas related EBITDA.  Neither method would represent fair and honest accounting.

Losses in MAIN’s Energy Related Investments Should Drive Substantial NAV Declines

In summary, MAIN has energy related equity investments of $170 million or $3.40 per share and energy related debt investments of $146 million or $2.92 per share.  Approximately 41% of these are directly in the oil services industry with the rest being energy related like our CIR case study.  Based on the performance of energy and related stocks, we believe that an appropriate valuation would be a 50% write-down of all equities and a 30% write-down of all debt.  We also contemplated a scenario where direct energy investments were written down by 65% and energy related investments were written down by 35%.  These analyses suggest that an appropriate write-down of MAIN’s energy portfolio ranges from $2.58 to $3.00 per share.

The deterioration in MAIN’s energy portfolio could not have come at a worse time, as the overall equity and credit markets have deteriorated over the course of Q3 2015.  The average of the three largest senior loan ETFs has declined 3.3% during the most recent quarter.  If we apply this decline to MAIN’s non-energy debt, we get an additional $0.90 per share decline in NAV.  Moreover, the Russell 2000 Index was down 12% in the quarter.  If we apply half of that decline to MAIN’s non-energy equity portfolio, this creates another $0.29 of depreciation in MAIN’s NAV per share.  Therefore, without even contemplating any declines in MAIN’s energy portfolio, the Company should see $1.19 in NAV decline or 5% of its Q2 2015 NAV.

In summary, MAIN’s NAV should decline by between $3.77 and $4.19, or 17% to 19%, from $21.84 today, based on our analysis of MAIN’s energy exposure and market related pressures.  At a peer average price-to-NAV multiple, the shares would be worth between $14.49 and $14.83, representing 51-52% downside.

Deterioration in MAIN’s Energy Portfolio Should Pressure the Company’s Dividend

We believe that pressure on the cash flows of MAIN’s energy related investments should cause pressure on MAIN’s dividend.  MAIN’s premium valuation is underpinned by its history of steadily increasing its dividend.  Over the last several years, MAIN has had an unstated policy of raising its monthly dividend by $0.005 approximately every six months.  Therefore, MAIN’s investors expect steadily growing dividends.  We believe that the Company will not be able to maintain this policy and may even cut its regular dividend with the pressure on its energy related investments.

MAIN’s dividend coverage has deteriorated in recent years as Net Interest Income (“NII”) coverage of the regular dividend has gone from 1.2x coverage in 2012 to 1.1x over the last 12 months.  NII per share is essentially flat over the first six months of 2015 and while MAIN does not provide formal guidance, it has suggested that NII per share may be down in the low single digits in the second half.  If this is indeed the case, MAIN’s NII coverage of its current dividend will be 1.0x, leaving little room for its customary $0.005 per month dividend raise in March 2016.  Further deterioration of MAIN’s energy investments will only exacerbate this pressure on MAIN’s cash flows.

Equity Dividends from Portfolio Companies are Declining

Dividends from the equity investments in MAIN’s portfolio have played a large and growing role in MAIN’s ability to generate NII.  Dividends on equity investments represented 23% of MAIN’s NII in 2014 up from 17% in 2012.  Dividends from MAIN’s portfolio companies should decline meaningfully with energy related companies comprising 35% of the value of MAIN’s equity portfolio.  We believe that dividends at MAIN’s energy related companies could decline by 75% based on an analysis of EBITDA declines at energy related companies.  This would cause a $0.12 headwind to NII.  Since MAIN barely covers its current dividend as is, this would bring dividend coverage to 95%.

MAIN’s inability to grow dividends on its equity investments is already apparent in the Company’s financial results.  In the first half of 2015, dividends on MAIN’s equity investments excluding its external advisory company grew a mere 0.3%.  This compares to 69% growth in the first half of 2014 and a 46% compound annual growth rate (“CAGR’) over the three years ending in 2014.  This dramatic deceleration in dividends must be a direct consequence of flagging cash flows at MAIN’s energy exposed portfolio companies.

This deterioration in dividend income growth is further evidence that MAIN has not properly valued its LMM investments.  The value of MAIN’sequity investments has increased by 38% over the last year but the dividends from these investments are flat.  Approximately 77% of MAIN’s equity investments pay dividends and many are taxed as flow-through entities, meaning that they pay out 100% of their taxable earnings.  Therefore, dividends paid by portfolio companies should mirror their earnings.  With flat equity values driven by flat dividends, MAIN would have to eliminate $2.11 per share of NAV growth.

Defaults on Energy Related Debt Could Necessitate a Dividend Cut

MAIN’s dividend coverage will face further pressure if MAIN’s energy related investments begin to default on their debt.  Currently, performing energy related investments generate 14% of MAIN’s NII.  Given that three of MAIN’s publicly traded energy investments, representing 7% of that income, are trading as if they will likely default, we think it is reasonable to contemplate a scenario where 25% of MAIN’s energy related investments default.  This would cause a further $0.09 headwind to NII per share.  Combined with the reduction in dividend income, this would reduce MAIN’s NII per share by $0.21, resulting in a dividend coverage ratio of 91%. Since the average BDC has dividend coverage of 102%, this could result in a 10% dividend cut.  MAIN also has no further room for error if non-energy portfolio companies default in a more difficult credit market. The average BDC has an 11.7% dividend yield. With a 10% dividend reduction and a peer average dividend yield, MAIN would be worth $16.25, representing 46% downside from current levels.

Supplemental Dividends at Risk, Upheld by Financial Shenanigans

While MAIN’s regular dividend may face a cut, we believe MAIN will be forced to eliminate its supplemental dividend entirely, resulting in a 20% further dividend cut.  MAIN pays two types of dividends: regular dividends and supplemental dividends.  Registered investment companies (“RICs”) like MAIN are required to pay 90% of their taxable income in dividends.  When RICs do not pay out all of their taxable income in regular dividends, they are required to pay a supplemental dividend within nine months.  In the past, MAIN paid out a dividend that was conservative, and taxable income exceeded its regular dividend because of realized gains and growth in dividend income from its portfolio companies.

Since the Company’s regular dividend yield is meaningfully below that of the peer group and MAIN did not believe it was getting appropriate credit for its supplemental dividend, MAIN recently began treating supplemental dividends as if they were regular dividends.  MAIN has begun paying out supplemental dividends of the same amount every six months.  If we include supplemental dividends in MAIN’s dividend yield, its 8.9% yield is closer to the 12.0% peer group average yield.  Therefore, if MAIN were to suspend the payment of supplemental dividends, we believe investors would perceive this as a dividend cut and the shares would come under significant pressure.

Over the past several years, MAIN has reassured investors that its supplemental dividend is sustainable.  The Company has highlighted that it has substantial taxable income from prior years that has yet to be distributed as a special dividend, called “spill-over” income.  We believe that MAIN’s reassurances on the consistency of its supplemental dividend are misleading.  MAIN has very large unrealized losses in several portfolio investments that could erase prior gains.  Currently, MAIN has four LMM or private loan investments with debt that is in non-accrual status.  At least one of these companies is in bankruptcy proceedings and MAIN is valuing these investments as nearly worthless.  These investments have a cost basis of $51 million and are currently being valued at $6 million representing an unrealized loss of $45 million.  In all likelihood, MAIN will ultimately recognize these investments as realized losses.  The unrealized losses on these investments represent 117% of MAIN’s “spill-over” income and realizing taxable losses on these investments would result in the elimination of MAIN’s supplemental dividend.

In our conversations with MAIN’s management, they have intimated that realized losses at these companies may not impact the Company’s spill-over income because some of these investments have been moved into unconsolidated taxable subsidiaries.  They argue that this will offset future income taxes incurred at the corporate level.  We are always wary of unconsolidated subsidiaries, which companies often use in aggressive accounting practices.  Moreover, we question the business logic of deferring the tax benefits of $45 million in unrealized losses when the Company has only realized $33 million of net gains in its entire history.  We believe that MAIN’s desire to maintain its supplemental dividend may be leading the Company to bury taxable losses in its unconsolidated subsidiaries through accounting shenanigans.

MAIN may already be moving other losing investments in unconsolidated taxable subsidiaries in order to maintain its supplemental dividend.  During the first six months of 2015, the amount of undistributed taxable income available for supplemental dividends has decreased by 17%.  However, this does not include $12 million of losses not consolidated for tax purposes, which seems unusual.  If MAIN had consolidated these losses, its spill-over income would have been 32% less than the reported level at the end of Q2 2015.  Over the last four years, MAIN has generated taxable income (not losses) from its unconsolidated subsidiaries of $11 million and has not had a single year of taxable losses.

In summary, we believe that MAIN will need to eliminate its supplemental dividend.  The only way for MAIN to avoid doing this is to engage in further financial manipulation.  Either way, we see the potential for meaningful declines as a 20% dividend cut should cause a 20% or greater decline in the share price.

NAV Increases are Driven by Management’s Estimate of Unrealized Gains

While the crux of our short thesis is our conviction that MAIN’s energy related investments will force declines in NAV and pressure on the dividend, we believe that the Company’s overall valuation methodology is highly questionable.

MAIN’s selling point to differentiate itself from the flood of BDCs in the public markets is that it is not merely a debt investor, but rather also has material equity investments in LMM companies that have performed well over the past several years.  MAIN has 23% of its NAV in equity and warrant investments and has generated $151 million ($3.03 per share) of net unrealized appreciation from these investments.  MAIN argues that these equity investments and the unrealized gains they generate provide the potential for future supplemental dividends and growth in NAV.

While MAIN’s sales pitch is great in theory, MAIN almost never realizes gains on its investments.  In fact, in the nearly eight years since the Company’s IPO, MAIN has cumulative net realized gains of $33 million or $0.65 per share.  These realized gains represent a mere 2% of the cost basis of investments in MAIN’s current portfolio.  Moreover, if the Company realized its unrealized losses on impaired assets MAIN would actually have no realized gains, but rather a cumulative realized loss of $13 million since its inception as a public company.  MAIN might argue that Warren Buffett is famous for holding his investments for the long-term and not realizing gains, but MAIN’s investments are not The Coca-Cola (KO) or American Express (AXP).  As we established earlier, these unrealized gains emanate from equity positions in low-quality LMM businesses, many of which are energy companies that are not properly valued.

Finally, the Company’s equity investments in these LMM investments often leave them in a minority position, which would make the investment very difficult to monetize unless MAIN can convince its partner to sell.  MAIN averages 36% equity ownership in its average portfolio company and only has the ability to nominate the majority of the board members in approximately 60% of its LMM investments.  As a rule, traditional private equity firms and strategic acquirers will not purchase minority equity positions in very small businesses.

In summary, we suspect that the vast majority of MAIN’s investments are valued at a higher price than an independent third party would pay.  Therefore, MAIN has not sold many investments since inception and cannot realize its unrealized gains without taking significant markdowns and calling into question the value of the rest of its portfolio.

MAIN’s Valuation Process Leaves the Company with Significant Discretion

We believe that MAIN’s valuation process leaves the Company with the ability to delay markdowns on its portfolio investments.  According to MAIN, it pursues a multi-step valuation process every quarter; a process we highly doubt is viable.  This process flows as follows: 1) the investment team responsible for monitoring the investment performs a valuation; 2) preliminary valuation conclusions are reviewed by and discussed with senior management; 3) an unnamed “nationally recognized independent valuation firm performs certain mutually agreed upon limited procedures on a selection of management’s LMM portfolio valuation conclusions;” 4) the audit committee of the board reviews all inputs in valuation provided by the investment team, senior management and the independent valuation firm; and 5) the board of directors assesses and ultimately approves the fair value of each investment in the portfolio in good faith.

We have significant concerns with this multi-step process. First, the investment team who sourced the deal is required to take the first cut at valuing the investment.  This seems like a conflict of interest because this team would be reluctant to admit that they had made an investing mistake until it became obvious.  Second, MAIN’s portfolio consists of very small businesses with unsophisticated financial departments.  It seems unlikely that these companies would have a realistic sense of their quarterly financial results and a well-constructed forecast of future financials on a timely basis every quarter.  This would require these companies to compile their financials faster than much larger public companies, and relay the information quickly enough for MAIN to perform its multi-step valuation process.  Third, MAIN’s external investment advisor only performs limited valuation procedures on a small sample of MAIN’s LMM investments every quarter, meaning there is little external validation of this process.  Fourth, MAIN has 105 LMM and private loan investments and 189 total investments that its senior management team and board of directors supposedly review quarterly.  The audit committee of MAIN’s board of directors has five members, who are not full time employees of MAIN.  We doubt that five individuals can provide strong oversight in reviewing the valuations of over 100 private marked-to-model companies every 90 days.  Therefore, it is not surprising that MAIN might be slow to write down losing investments.  However, we believe that the deterioration in the Company’s energy portfolio will ultimately leave MAIN no choice. 

Management Has Historically Been Slow to Recognize Losses

Our view that MAIN has delayed reporting losses in its energy portfolio is justified by the Company’s historical record of not recognizing its losing investments in a timely manner.  In January 2013, MAIN made an investment in a company called Quality Lease and Rental Holdings.  The company provided drill site services and equipment rentals to the upstream oil and gas industry, as well as high quality custom-built mobile housing at drilling locations.  MAIN’s investment consisted of $38 million in senior secured term debt and $2.5 million of equity.  This investment soured quickly and just eight months later, MAIN wrote down its equity investment from $2.5 million to $500,000, but kept the value of its senior secured term-loan at par.  Then, just one quarter later, the investment went into non-accrual status, and MAIN wrote-off its equity and cut the value of its debt by 46%.  MAIN was a 20% equity holder and primary lender to this company, but apparently thought its loan was secure less than 90 days before it stopped making payments.  MAIN saw problems because it wrote down its equity position.  There should have been warning signs that the debt was at risk too.  We suspect that this may have been a case where the investment team did not relay information to the Company’s audit committee on a timely basis.

Poor Investment Performance Over Last Several Years Masked by Unsustainable Benefits

MAIN’s NAV growth has decelerated over the last year and a half as its strategy to diversify away from its core LMM investments has soured.  Since the end of 2013, MAIN has grown its NAV by a CAGR of 6.4%.  While this is respectable on the surface, it is less than half of the 13.6% CAGR from 2009 to 2014.  This NAV growth does not include the deterioration from potential losses in the energy portfolio that have yet to be recognized.  However, even if we take MAIN’s NAV at face value, the Company’s performance is less impressive than it seems.  We believe that MAIN has already used aggressive tactics to disguise recent poor investing performance, leaving the Company with few levers to pull in disguising the future deterioration of its energy investments.

Diversification Efforts Have Been Unsuccessful

As MAIN’s assets have grown from $90 million at year-end 2007 to $1.8 billion today, MAIN has diversified away from LMM investing with limited success.  Currently, LMM investments comprise 45% of MAIN’s portfolio while the rest is comprised of middle market investments, private loan investments, and even investments in other private equity and mezzanine loan funds.  This compares to a pure LMM portfolio when MAIN completed its IPO.

MAIN has not been able to replicate its supposed success in LMM investing in the rest of its investment portfolio.  The Company’s middle market and private loan investments have both generated unrealized losses while LMM investments have generated a 23% unrealized gain compared to their cost basis.  Moreover, MAIN’s LMM debt investments average 62% higher interest rates than middle market loans and 31% higher than private loans.  Therefore, if we believe MAIN’s valuation methodology, LMM investments are the “secret sauce” for higher returns with lower risk.  While MAIN’s LMM portfolio should face problems in the future, middle market and private loan investments are not the solution.

Accretive Equity Offerings Have Driven Recent NAV Growth Rather than Fundamental Operations

MAIN has taken full advantage of its premium valuation by completing two large secondary offerings over the last year and a half.  Because its shares trade at a premium to NAV, secondary offerings are accretive to the Company’s NAV per share.  However, they have also provided MAIN with more capital than it can wisely invest.

Unfortunately, accretive equity offerings have become a necessary component in MAIN’s strategy as the Company has not grown NAV without them.  Excluding the impact of accretive equity offerings, MAIN’s NAV would have actually decreased by $0.01 over the last year and half, compared to the 10% growth the Company reports.  This performance is only marginally better than a peer average NAV decline of 1.8%, calling the justification for MAIN’s premium valuation into question.  If energy losses drive down MAIN’s premium valuation, it will lose the ability to issue equity for NAV growth.  In fact, if BDC shares trade below NAV, they cannot issue equity without an explicit shareholder vote.

Aggressive Valuation Practices Further Mask Poor Underlying Performance

We believe that MAIN uses its discretion over the valuation process not only to delay reporting losses, but also to inflate the value of its LMM portfolio.  Substantially all of MAIN’s investments are Level 3 securities according to the SEC. Level 3 securities, which rose to prominence during the Lehman Brothers bankruptcy, are securities where the valuation requires the use of inputs that are both “unobservable and significant to the overall fair value measurement.”

MAIN uses three approaches to value the Level 3 securities in its investment portfolio: 1) a third party quoted market price; 2) a discounted cash flow valuation based on management projections; and 3) an EV/EBITDA market comparable approach.  MAIN values only 39% of its portfolio by third party market quotes, so the other 61% of MAIN’s portfolio is valued according to projections provided by MAIN’s management.  MAIN generally does not hold equity in publicly traded companies, but does invest in publicly traded debt.  Therefore, MAIN’s equity portfolio is generally not valued according to the market method, but 53% of its debt and other investment portfolio is marked-to-market.  Unsurprisingly, MAIN values its equity portfolio at an 80% gain versus its cost basis and its debt portfolio is valued at a 4% loss.

While MAIN does not discuss the valuation of individual portfolio companies, the Company discloses general information on the valuation of its equity portfolio as a whole.  These disclosures demonstrate that MAIN has steadily increased the valuation multiples it places on its investments.  These increases in valuation multiples are not supported by commensurate increases in the Russell 2000 Index of small capitalization stocks, which has remained essentially flat.  On December 31, 2013 MAIN valued its equity investments at a 6.0x EV/EBITDA multiple.  Excluding outliers, portfolio company valuations ranged from 4.0x to 7.2x EV/EBITDA with certain outliers valued as high as 11.5x EBITDA.  In Q2 2015, MAIN valued its equity securities at an average multiple of 6.7x EBITDA with a range of 4.0x to 8.5x with certain outliers valued as high as 17.5x EBITDA.  We find these disclosures interesting because very few LMM companies are worth 17.5x EBITDA, and we do not understand why EBITDA valuations would increase by over 10% during this period.

This seemingly small increase in valuation multiples is significant when applied across MAIN’s entire portfolio of equity securities.  Assuming 2.0x debt-to-EBITDA leverage at MAIN’s LMM investments, this multiple expansion would explain $1.19 per share of the increase in NAV per share over the last year and a half.  We find this multiple expansion particularly hard to fathom with MAIN’s heavy exposure to energy related companies.  With the Russell 2000 Index declining 12% during the Q3 2015, we are curious to see whether MAIN’s equity investments see multiple contraction this quarter.  Without multiple expansion and equity offerings, NAV would have declined by 6% over the last 18 months.

MAIN Has Pursued Other Non-Traditional Means of Increasing NAV

With MAIN’s poor performance in its private loan and middle market portfolio, and a more difficult environment for its LMM portfolio companies, we believe MAIN has become more aggressive in searching for non-conventional ways to increase NAV.  Over the last year, MAIN has begun to value its own external asset management company as if it is an independent portfolio company.  This company essentially shares the management and incentive fees on a private BDC called HMS Income Fund.  In general, private BDCs have a poor reputation in the financial markets.  Individual investors usually buy these vehicles, which carry high upfront sales loads, high ongoing fees, and poor liquidity.

While we applaud MAIN for finding an opportunity to add to its fee income, we question the Company’s practice of valuing this “investment” in NAV under the name MSC Advisers I.  We seriously doubt that MAIN could sell its advisory relationship with one private BDC to an independent third party for its stated $30 million valuation.  If we annualize the most recent quarter of fees, assume a typical 40% asset management margin on those fees, and apply a normal tax rate, MAIN values this investment at a 15.0-16.0x P/E multiple.  A comparable group of eight of the largest publicly traded traditional public asset managers currently trades at 13.9x 2016 EPS estimates and alternative asset managers like Ares Management (ARES), Fortress Investment Group (FIG), and Och-Ziff Capital Management (OZM) trade at even lower valuation multiples ranging from 5.2x to 8.7x 2016 EPS estimates, with an average of 6.9x P/E.  We believe that MSC Advisors I deserves a lower multiple than either one of these peer groups and question whether it should be valued at all.  Over the last year and a half, MSC Advisers I has contributed $0.58 to NAV per share, or approximately 2.5% of total NAV.

In summary, without the contribution of multiple expansion, accretive equity offerings and MSC Advisors, MAIN’s NAV per share would have actually declined by 9% over the last 18 months.  This decline is worse than the peer average of 1.8%.  The Company’s NAV deterioration would be even worse if its energy related investments were valued appropriately, resulting in a total NAV decline of 29% including all factors.  We do not believe that this level of performance justifies the premium multiple at which MAIN trades and expect deterioration in the energy portfolio to serve as a catalyst to revalue MAIN lower.

Conclusion

Investors have rewarded MAIN handsomely for its perceived outperformance over its peers, paving the way for substantial downside in the shares as they realize that this success was driven by a bet on the energy markets and deceptive, aggressive accounting practices.  MAIN’s valuation multiple of 1.4x its NAV per share dwarfs the 0.8x multiple accorded to the 40 other BDCs we have analyzed.  Even the top quartile of other BDCs trade for an average multiple of 1.0x their NAV per share.  A reversion to a top quartile price-to-NAV multiple alone would result in a 24% decline in the share price, even if MAIN’s NAV were unchanged and not impacted by its hidden energy exposure.  Similarly, MAIN trades at a 7.1% dividend yield (8.9% if special dividends are included), a 4.9% premium to the peer average of 12.0%.

We believe that the energy downturn over the past year will cause substantial erosion in MAIN’s NAV and dividend, triggering a dramatic revaluation of its shares closer to peer company levels.  While MAIN may delay recognizing markdowns of its portfolio companies, the dramatic declines in EBITDA that should occur at its energy related companies cannot be ignored through a year-end audit process.  We believe that market deterioration and markdowns of MAIN’s energy related investments could precipitate a 17-19% decline in the Company’s NAV and 10% dividend cut (28% including special dividends).  At a peer average price-to-NAV multiple of 0.8x, the shares are worth $14.49 to $16.25, resulting in 46% to 52% downside to MAIN shares.  When MAIN concedes to the reality of the current $45 oil environment, investors may not look kindly on the accounting shenanigans that drove much of the Company’s success in the past.  

As always, we continue to monitor MAIN, general conditions in the energy and credit markets, and acquisition multiples in the LMM space, and will add to, or subtract from, the position as conditions warrant.

Important Disclaimers:

Any forward-looking opinions, assumptions, assessments, or similar statements constitute only subjective views. This information should not be relied on for investment decisions and is subject to change due many factors, including fluctuating market conditions and economic factors.  Such Statements involve inherent risks, many of which cannot be predicted or quantified and are beyond our control.  Future evidence and actual results could differ materially from those set forth in, contemplated by, or underlying these Statements, which are subject to change without notice.  In light of the foregoing, there can be no assurance and no representation is given that these Statements are now, or will prove to be, accurate or complete.  We undertake no responsibility or obligation to revise or update such Statements. 

I do not hold a position with the issuer such as employment, directorship, or consultancy.
I and/or others I advise hold a material investment in the issuer's securities.

Catalyst

1) Management is forced to write down investments in energy and related industries due to large declines in EBITDA; 
2) Lower dividends, realized losses and potential debt restructurings should result in a cut to MAIN’s regular and supplemental dividends; 
3) Losses at energy related companies will expose MAIN’s questionable valuation practices at other portfolio companies; 
4) An evaporation of MAIN’s premium to NAV will put an end to accretive equity offerings which have hidden problems in the investment portfolio in the past.