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Intrinsic Value is all-important and is the only logical way to evaluate the relative attractiveness of investments and businesses.
Greetings and welcome to Main Street Capital Corporation’s Second Quarter Earnings Conference Call. At this time, all participants are in a listen-only mode. A brief question and answer session will follow the formal presentation. [Operator Instructions] As a reminder, this conference is being recorded.
At this time, I'd like to turn the conference over to Zach Vaughan with Dennard Lascar, Investors Relations. Please go ahead.
Thank you, operator and good morning everyone. Thank you for joining us for Main Street Capital Corporation’s second quarter 2020 earnings conference call. Main Street issued a press release yesterday afternoon that details the company’s second quarter financial and operating results. This document is available on the Investors Relations section of the company's website at mainstcapital.com.
A replay of today's call will be available beginning in an hour, after the completion of the call and will remain available until August 14th. Information on how to access the replay was included in yesterday's earnings release. We also advise you that this conference call is being broadcast live through the internet and can be accessed on the company's homepage.
Please note that, information reported on this call speaks only as of today August 7, 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 SEC.gov.
Main Street assumes no obligation to update any of the 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.
Thanks Zach. Good morning everyone and thank you for joining us today. Joining me for our call today with prepared comments are David Magdol, our President and Chief Investment Officer; and Brent Smith, our CFO. Also joining us for Q&A portion of our call are Nick Meserve, our Managing Director and Head of our Middle Market Investment Group and Jason Beauvais, our General Counsel.
All of us at Main Street hope that you and your loved ones are able to stay safe and healthy. We recognize that the last six months have been a very challenging time for everyone and that significant uncertainty continues to exist about the near term and long-term impact of the COVID-19 pandemic on our society and economy, and the eventual timing for the return to normal.
Despite these challenges, we remain committed to and focused on generating long term value for our fellow shareholders. Given the ongoing impact of the pandemic, similar to last quarter’s call, I will start today's call with some comments regarding the pandemic’s impact. I will then comment on our performance in the second quarter, some developments within our asset management business, our recent dividend announcement, our investment activities in current investment pipeline, and several other updates.
Following my comments, David and Brent will provide additional comments on our investment strategy, investment portfolio, and financial results, after which will be happy to take your questions. Since our last conference call, we continue to prioritize the health and well-being of our employees, and the management teams and employees of our portfolio companies. We greatly appreciate the efforts of these individuals, and we continue to be very pleased with our efforts and activities, since the beginning of the pandemic.
These individuals have historically been a key strength for our firm, and they give a significant confidence in our ability to continue to maximize our opportunities in the current environment and in the future. But the economic environment since our last call has continued to be very challenging and, in many cases, likely more challenging than most people envisioned in the early days of the pandemic. We believe that the performance across most of our portfolio companies has stabilized, and we continue to feel good about the overall quality of our investment portfolio.
We are also pleased that despite the ongoing impacts of the pandemic, we’ve continued to have success executing on new investments in both our lower middle market, and private loan strategies. We recently enhanced our already strong liquidity position with our $125 million bond offering in July. And we remain confident that our very conservative capital structure and significant liquidity position will allow us to continue to manage through the current challenges, and to successfully execute on the opportunities that exist with our portfolio companies and our pipeline of attractive lower middle market and private loan investment opportunities.
We're also very pleased with our recent announcement of the agreement, under which we would become the sole investment adviser to HMS Income Fund. We believe that this transition is a natural progression of our historical role with HMS, and we are excited about positioning the fund for the future, while also executing our overall strategy to grow our asset management business within our internally managed structure, and continue to provide this unique benefit to our Main Street stakeholders.
Now turning specifically to our results for the second quarter, these results reflect the negative impact of the pandemic on the overall economy, most specifically in the decreased amount of dividend income we realized from our equity investments, and in an increase in the number of investments on non-accrual status at quarter end, and the number of investments that are underperforming consistent with the results being experienced across the broader market.
We are confident that the decrease in dividend income is a temporary issue, which will recover as the impacts of the pandemic subside, and our investment team continues to maintain significant focus on working through the underperforming investments to realize the best possible outcome for our stakeholders.
Despite the impact of these items, as a result of our diversified investment portfolio, together with the advantages of our differentiated investment strategy, the alignment of our interests with our lower middle market portfolio company management teams, our efficient operating structure and alignment of interest with our shareholders, combined with our conservative capital structure and strong liquidity position, we believe that we are well-positioned to weather the current market conditions and provide a favorable outcome for all of our stakeholders. And we remain comfortable with our commitment to maintaining a stable monthly dividend payment level going forward.
To that end, earlier this week, our Board declared our fourth quarter 2020 regular monthly dividends of $0.205 per share payable on each of October, November and December. An amount that is unchanged from our monthly dividends for the third quarter.
Now turning to our investment activities in the second quarter and our current investment pipeline, we completed lower middle market investments of $85 million in the quarter, including an investment in one new company. And as of today, our characterized our lower middle market investment pipeline as average. Included in this investment pipeline, are several follow-on investments in existing portfolio companies, as these companies execute on various attractive opportunities.
Despite the impact of the pandemic, we continue to be very active in our lower middle market strategy, and we have several new investment opportunities in the pipeline that we expect to complete in the near future. More importantly, based upon our historical experiences over the last two decades as the industry leading partner for lower middle market companies and their management teams, we expect that our very unique debt and equity investment offering, combined with our ability to be a long term to permanent partner to these companies, will result in a significant increase in new opportunities as the economy begins to recover.
During the second quarter, we continue the successful focus of our non-lower middle market investment growth on our private loan portfolio, resulting in this portfolio growing by $9 million on a net basis in the quarter, while our middle market portfolio decreased by $25 million. As of today, our characterized our private loan investment pipeline is average.
When looking at the performance of our investment portfolio during the quarter and since quarter end, we're pleased with the performance across most of our portfolio companies has stabilized, allowing us to begin the recovery of the unrealized depreciation we experienced in the first quarter due to the pandemic.
And in closing, our officer and director group has continued to do regular purchases of our shares, investing approximately $1.2 million during the second quarter. On a collective basis, our director and officer group owns Main Street shares valued at approximately $103 million at quarter end.
With that, I will turn the call over to David.
Thanks, Dwayne and good morning, everyone. As Dwayne highlighted in his remarks, although this was a challenging quarter for Main Street, as we and our portfolio company partners continue to respond to the unexpected and negative impacts created by the pandemic, overall, we saw stabilization and modest improvement across our portfolio company investments.
In our lower middle market portfolio, we work closely with our portfolio company management teams in assessing and responding to the rapidly changing market conditions. We very much appreciate how tirelessly our portfolio company partners work to support our joint investment interests during these difficult times. We've been extremely pleased with the proactive and responsive nature of our portfolio company executives and are very grateful for their partnership approach.
Despite the challenging environment, our intentional and diversified investment strategy has served us well. Our portfolio is diversified by end market, industry, vintage and security type. This diversification has been the cornerstone of our philosophy over or nearly 13 years as a public company, and as a true benefit of our permanent capital structure.
Most notably, because of the season nature of our lower middle market portfolio, our portfolio company leverage in this segment of our business remains modest, with a median net senior debt-to-EBITDA ratio of 2.7 to 1 and a median total EBITDA to senior interest expense ratio of 2.8 to 1.
As of June 30th, we had investments in a 177 portfolio companies spanning across more than 50 industries. Our largest portfolio company represented approximately 3% of our total investment portfolio fair value at quarter end and 3.7% of our total investment income for the last 12 months. Further, the vast majority of our portfolio investments represented less than 1% of our assets and our income.
During the second quarter, the contributions from our lower middle market portfolio continued to be well diversified with 41 of our 68 lower middle market companies with equity investments having unrealized appreciation at quarter end.
In the most recent quarter, our dividend income received from our portfolio companies was significantly lower than the same period of last year. This was expected and consistent with what we have experienced in prior periods of market disruption, as our portfolio companies with our support choose to maintain cash flow liquidity purposes instead of making distributions.
As cash continues to build the portfolio company level and market conditions improve, we are confident that we will benefit from increased distributions in future periods. Our lower middle market investment activity in the second quarter included investments of approximately $85 million, including an investment of $49 million in one new lower middle market investment, which after aggregate repayments of debt principal and return of invested equity capital from several lower middle market investments resulted in a net increase of $40 million in our lower middle market portfolio.
During the quarter, we fully exited our lower middle market debt and equity investments in IDX Broker, realizing a gain of $9.3 million, resulting in a total internal rate of return of approximately 15.8% and 1.9 times money invested in our accumulative debt and equity investments.
At quarter end, our lower middle market portfolio included investments in 69 companies representing approximately $1 billion of fair value, which is 158% of our cost basis. As we have discussed on previous conference calls, given our favorable view of the lower middle market and private loan opportunities that exist today, we have primarily focused our investment activities on these segments of our business, within our middle market activities focused on highly selective investments, with the intent to shrink the middle market portfolio on a relative basis.
In our private loan portfolio, we had investments in 64 companies, representing approximately $654 million of fair value. And during the quarter, we had a net increase in this portfolio of $9 million. In our middle market portfolio, we had investments in 44 companies, representing approximately $410 million of fair value. And during the quarter, we had a net decrease in this portfolio of $25 million.
The total investment portfolio at fair value of quarter end was approximately a 100% of the related cost basis, and we had 11 investments on non-accrual status, which comprised approximately 1.9% of the total investment portfolio at fair value and 6.3% at cost.
Turning to the outlook for the remainder of 2020, we intend to focus our efforts on continuing to support our existing portfolio companies while thoughtfully making investments primarily in new lower middle market and private loan opportunities.
Our ability to provide flexible debt and long-term equity solutions are always a key differentiator for us in the lower middle market. But in the current environment, our ability to provide term sheets that speak for 100% of the outside debt and equity capital to close the transaction is particularly important for smaller privately held business owners and their advisors.
Our investment committee has worked together for nearly 20 years in prolific times and in times of market dislocation. We are confident that we will be able to prudently deploy capital with very attractive risk adjusted return profiles for the remainder of 2020 and in 2021, in an effort to create significant shareholder value with our new investment activities.
With that, I'll turn the call over to Brent to cover our financial results, capital structure and liquidity position.
Thanks, David. Our total investment income in the second quarter decreased over the same period in 2019, to a total of $52 million, primarily driven by a decrease in dividend income, which as David mentioned has been negatively impacted by the COVID-19 pandemic, and a decrease in interest income primarily due to the lower LIBOR rates.
The decrease in dividend income is consistent with our commentary from our first quarter earnings call, where we say that we expected the decline as our portfolio companies generally decided to take a conservative approach and maintain additional liquidity, due to the significant uncertainty associated with the pandemic. And as the cash flows of some of our portfolio companies were negatively impacted to varying degrees due to COVID-19.
Our operating expenses excluding non-cash share based compensation expense decreased by $1.4 million over the same period of the prior year to a total of $17.9 million, primarily related to a decrease in cash incentive compensation levels partially offset by an increase in deferred compensation expense, due to the increase in the fair value of our deferred compensation plan assets during the second quarter.
The ratio of our total operating expenses excluding interest expense, as a percentage of our average total assets was 1.4% for the second quarter, on an annualized basis at 1.2%, on a trailer 12-month basis. The activities of our external investment manager benefited our net investment income by approximately $2.2 million during the second quarter, to the allocation of $1.8 million of operating expenses for services we provided to it, and $0.4 million of dividend income.
We recorded a net realized loss of $8.6 million during the second quarter, primarily related to the realized losses from the exit of three middle market investments, partially offset by a net realized gain related to the exit of two lower middle market investments, and the partial exit of another lower middle market investment.
We recorded net unrealized appreciation on the investment portfolio of $6.5 million during the second quarter, primarily relating to $11.7 million of net appreciation on our private loan portfolio. $8.2 million of net appreciation on our middle market portfolio and $7.5 million of appreciation relating to our external investment manager. Partially offsetting the net appreciation was $16.4 million of net depreciation on our lower middle market portfolio, and $5.2 million of net depreciation on our other portfolio.
Our operating results for the second quarter resulted in a net increase in net assets of $43.4 million or $0.66 per share. Our overall capitalization and liquidity remain strong, as our total liquidity is currently in excess of $600 million. We were pleased to be able to enhance our current liquidity position by recently issuing a $125 million follow-on of our outstanding investment grade notes that mature in April 2024, and using those proceeds to repay a portion of our revolving credit facility.
This follow on to the investment grade notes was an addition to the $75 million follow-on we executed this past December. It continues to illustrate the support of our institutional debt investors. The follow-on was issued at a yield-to-maturity of approximately 4.4% and brought the total amount of notes outstanding to $450 million.
We also raise approximately $26 million in net proceeds under ATM equity issuance program, further enhancing our capital structure. Overall, we continue to feel that our conservative leverage, continued access to capital, and strong liquidity has us well positioned to not only continue to successfully navigate through this challenging period, but to also be opportunistic in terms of investment opportunities in the market.
As we look forward to the third quarter, and consistent with the second quarter, we're not providing guidance for distributable net investment income, due to the ongoing impacts of COVID-19 and the related uncertainty that still exists in relation to the overall economy and the operating results of our portfolio companies.
However, consistent with the second quarter financial results, we expect that our distributable net investment income will be below our monthly dividends, primarily due to a continued lower level of dividend income from our lower middle market equity investments.
With that, I will now turn the call back over to the operator, so we can take any questions.
Thank you. We will now be conducting a question-and-answer session. [Operator instructions] Thank you. Our first question is coming from the line of Robert Dodd with Raymond James.
Hi, guys and congratulations on the quarter and weathering a curvy quarter. If I can on the dividend income, obviously, it was down year-over-year, but frankly a lot less than I thought it would be.
I mean the -- I remember the commentary about portfolio companies retaining cash from the last recession back in year 2008, 2009. And recognize the portfolio is very different today than it was then. But can you give us any color on, I mean, back then it was down 50%. Can you give us any color on was the dividend income from those portfolios of the 68 for even equity, was it concentrated from a couple or was there anything odd about that because, I mean, a very good number, but I think it may have exceeded your expectations as well given you did better than the kind of the NOI indications from last quarter. So, any additional color there would be really helpful?
Sure. Robert. So, what I would say is, as you've heard us say in the past, even kind of in a non-COVID type environment, dividend income is always the hardest part of our income stream to predict. So, it's one that is we look at, kind of four periods, always has the most uncertainty associated with it.
What I always say in the second quarter, I think we were pleased with the dividend income amounts. It was, as you said, less than what it was in the first quarter, and definitely less than what it was in prior quarters.
I would say the composition of it, while there are a few names that make up a significant portion of dividend income. I wouldn't say that the concentration this quarter was materially different than what it was in prior quarters. Obviously, it's a smaller amount, but you have a number of companies that have continued to perform well, despite the COVID environment.
And given, what we've always talked about with our lower middle market companies going into this situation of this COVID time period with modest amounts of leverage, as they continue to perform, they do continue to generate significant cash flow. And we do see some of these companies continue to pay out dividend income.
As we look forward to the next couple of quarters, that's going to be the biggest variable for us when you look at our net investment income performances, how well those companies can continue to perform. And then, how many companies that were contributing to dividend income pre-COVID. How many of them can start contributing again in either Q3 or Q4?
I appreciate that color. And then, one point on HMS and I realized there might be limited amounts you can say. Is there any -- I mean, obviously, that advisory agreement if it all goes through will be one of the largest single sources of income to Main.
So can you and Main shareholders and dividend covenants, can you give us any color on is the intention as it's understood right now, to maintain precisely the same strategy, basically in co-invest with Main and duplicate to a degree that the Main portfolio over there or is that, because as you mentioned, you're positioning the fund for the future, is there going to be any change that that could impact the income to Main and Main shareholders?
Yeah, Robert, what I would say there is that, as we sit here today, we do not expect any changes to the strategy on the HMS income side. Obviously, that's not something that is our own decision. That's something that we'll have to work with the HMS Board on long-term going forward.
But as we sit here today and look at the opportunities that we have and the opportunities that we believe we can deliver to HMS Income Fund, we do not expect changes from the historical strategy going forward.
Got it. Thank you.
Thank you, Robert.
Thank you. Our next question is from the line of Bryce Row with National Securities. Please proceed with your question.
Thanks. Good morning to everyone. Robert asked my dividend question. I wanted to ask you all about the proposed rule here for the acquired fund fees and expenses, I know that you all are very much involved in that regulatory process, so wanted to get your view of that proposal.
And what may happen from a regulatory perspective to get through this 60-day comment period and what -- kind of what maybe regulatory next steps might be to really get us to the next level as an industry? Thanks.
Sure, thanks Bryce. As you know, Vince, our Executive Chairman, he has always been very involved from an industry standpoint and kind of the regulatory activities. He typically would give our response there. But this morning he was invited to testify at the Congressional Oversight Committee hearing regarding the Main Street lending programs, so he's not able to join us. But we do have Jason Beauvais, our General Counsel, who also works extensively with Vince, on those activities. I'll let Jason give the update on AFFE.
Hey, Bryce. As you can imagine, we view the proposed AFFE changes that came out this week as extremely positive and a big step toward getting BDCs back into the indices. As you know, our industry has been working on an AFFE fix since 2014, and we are very pleased that the AFFE took this action.
We're still digesting those 650-page document they put out on Wednesday. But we fully expect to work with other BDCs and SBIA to comment as appropriate on the proposed rules.
Bryce, when you look at it, it definitely should be a positive, even if we don't get inclusion in the indexes. There's a bunch of all the funds out there that are not index based, that this helps them participate in being shareholders of the BDC industry overall net-net, it's going to be a positive.
Yeah, totally agree. And was curious, I don't know Dwayne or Jason, in terms of communication with Russell or even S&P, now that this proposal is out there, I mean, what are next steps with those organizations for them to propose that the BDCs get re-included in the index, which obviously is a step above and beyond what the proposal says now?
Yes, I would say Bryce, the activities are obviously very recent. We have not heard of any new activity with any of those entities. Obviously, that would be a next big step, once you get the new rule passed or approved. But we're not aware of any significant activities there unless Jason knows of something else.
No, I'm not. Although, as you've probably noticed, Bryce, the rules are a little different than we've been pushing the last eight years, six years. We've always asked for BDC to be excluded from the rule and the SEC did something a little different and put a 10% threshold on exclusion. And so, we're not -- hopefully that works for the Russell and S&P indexes or indices. But yeah, like Dwayne said, it’s we haven’t those communications yet.
Okay. I wanted to follow up on the HMS question. And just curious, with that relationship kind of potentially fully coming within MAIN in terms of the whole advisory relationship, will there be a change in how that gets accounted for within your income statement?
Obviously, now you're recognizing some level of dividend income and then an offset to general and administrative expenses, so just curious, if we'll just see essentially a doubling of both of those since the full relationship is coming in health?
Yeah, Bryce, what I would say is we don't expect a change in the accounting or the financial reporting. What we do expect is that, the fee income into our subsidiary will obviously go up as we pick up the full advisory fee as opposed to historically picking up 50% of that advisory fee.
We will likely have some additional G&A costs, but I think they will be less than the incremental fee income. So net-net, we would expect to see our dividend income from the advisory entity to increase going forward post us becoming the sole adviser.
Okay. And then one more if I could. Dwayne, you talked in your prepared remarks about good activity within the lower middle market, even in the second quarter. But within the pipeline, just curious what pricing does look like, now that we've kind of moved beyond this COVID environment? Are you seeing better pricing or is it more kind of a combination of relatively stable pricing and better structure?
Yeah, Bryce, I'll give some initial comments and I'll let David add to it. But I would say, not just in the lower middle market, but across each of our investment strategies, in this environment, we are seeing some better pricing, whether you're looking at the debt opportunity or the equity opportunity.
But I would say the biggest benefit is the types of deals that we're working on in the lower middle market. I would say that we would describe them as fitting our structure a lot better. So, some of this structure a lot of its alignment of interest with the owner operator and the management team, so that would be my initial comment on the lower middle market side.
On the private lower middle market, also think we're seeing some benefit on pricing. But I think we're most excited about generally kind of lower leverage attachment points from a new investment standpoint and definitely more ability for us to influence the structure to be more beneficial to us than it would have been six or 12 months ago.
David, do you want to add on some additional comments on lower middle market?
Yeah. On the pricing -- on the margin, it can be better, but it's not remarkably impacted. What I'd say is that to me, our ability to transact and to prevail in some of these processes are enhanced in the current environment. The idea of our coming in with a non-contingent financing on the transactions that we do a term sheet for debt and equity is particularly powerful in this type of environment.
Whereas, gosh, beginning of the year it was a little bit different because people would price out the equity and debt separately. And that was a more competitive world. So today, just a certainty to close this really, I think it helped with our close ratios.
So Bryce, just to add on actually, and I think you've heard it both in mine and David's comments, but we are excited about the opportunities we're seeing. Our teams, at least the senior members of the teams are starting to travel again. Obviously, you've heard us say in prior quarters or at least last quarter when we talked about the impact of COVID, one of the concerns we had was the ability to get out and meet in person with the owners of these businesses in their management teams, which is critical to our underwriting on the lower middle market side.
But we are getting out and doing that. And, we're looking forward to executing on those opportunities here in Q3 and Q4.
Excellent. Well, thank you all for the time.
Thank you, Bryce.
[Operator Instructions] The next question is from the line of Kenneth Lee with RBC Capital Markets. Please proceed with your question.
Hi, thanks for taking my question. I'm wondering if you could just talk about any kind of amendment activity that you saw within the quarter, within your portfolio. Thanks.
Sure, what I would say, these numbers aren't perfect because you never really know what precisely the driver of every amendment is. But across the portfolio, we had about 30 of our companies go through some type of an amendment in the second quarter.
Those amendments had varying degrees of changes, it could have been either, some movement of interest from cash to pick. It could have been other relief from a cash amortization or other principal payment requirement. Or it could have just been some relief on financial covenants. So it’s a wide range of activities that we're undertaking -- undertaken through those amendments.
What I would say is that, and you heard us say this last quarter and even prior to that when we looked at companies that have underperformed, our goal is to always have us not be the sole source of relief. So all those activities, would have come with some contribution from the other parties involved in the capital structure.
Whether it's the management team, making concessions from a personal standpoint or whether it's a private equity group in our middle market and private loan portfolios, contributing cash to support the business or taking other steps to be -- just to be supportive of the company in conjunction with our flexibility.
Great, very helpful. And just one follow-up if I may, wondering if you could just share with us any updated estimate of the undistributed taxable income? Thanks.
Sure. Our spill over at the end of the second quarter was approximately $35 million or $0.54 per share.
Great. Thank you very much.
Thank you, Ken.
Thank you. This now concludes our question and answer segment, and I'll turn it back to management for closing remarks.
Thank you, everyone, for joining us today. We'll continue to do everything we can on our side to navigate this uncertain environment and continue to create value for our shareholders. We hope everyone stays safe and healthy as possible. And we'll look forward to talking again in a few months.
Ladies and gentlemen, thank you for your participation. This does conclude today's teleconference. You may disconnect your lines and have a wonderful day.