Main Street Capital - Q2 2023

Transcript

Operator (participant)

Greetings, and welcome to the Main Street Capital Corporation second quarter earnings conference call. At this time, all participants are in listen-only mode. A brief question-and-answer session will follow the formal presentation. If anyone to require operator assistance on the conference, please press star zero on your telephone keypad. As a reminder, this conference is being recorded. It is now my pleasure to introduce your host, Zach Vaughan at the Dennard Lascar Investor Relations. Thank you, sir. You may begin.

Zach Vaughan (VP)

Thank you, operator. Good morning, everyone. Thank you for joining us for Main Street Capital Corporation's second quarter 2023 earnings conference call. Joining me today with prepared comments are Dwayne Hyzak, Chief Executive Officer; David Magdol, President and Chief Investment Officer; and Jesse Morris, Chief Financial Officer and Chief Operating Officer. Also participating for the Q&A portion of the call is Nick Meserve, Managing Director and Head of Main Street's Private Credit Investment Group. 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 Investor Relations section of the company's website at mainstcapital.com. A replay of today's call will be available beginning an hour after the completion of the call and will remain available until August 11th. Information on how to access the replay was included in yesterday's release.

We also advise you that this conference call is being broadcast live through the internet and can be accessed on the company's homepage. Please note that information reported on this call speaks only as of today, August 4, 2023, and therefore, you are advised that time-sensitive information may no longer be accurate at the time of any replay, listening, or transcript reading. Today's call will contain forward-looking statements. Many of these forward-looking statements can be identified by the use of words such as anticipates, believes, expects, intends, will, should, may, or similar expressions. These statements are based on management's estimates, assumptions, and projections as of the date of this call, and there are no guarantees of future performance.

Actual results may differ materially from the results expressed or implied in these statements as a result of risks, uncertainties, and other factors, including, but not limited to, the factors set forth in the company's filings with the Securities and Exchange Commission, which can be found on the company's website or at sec.gov. Main Street assumes no obligation to update any of these statements unless required by law. During today's call, management will discuss non-GAAP financial measures, including distributable net investment income, or DNII. DNII is net investment income, or NII, as determined in accordance with U.S. Generally Accepted Accounting Principles, or GAAP, excluding the impact of non-cash compensation expenses. Management believes that presenting DNII and the related per share amount are useful and appropriate supplemental disclosures for analyzing Main Street's financial performance, since non-cash compensation expenses do not result in net cash impact to Main Street upon settlement.

Please refer to yesterday's press release for a reconciliation of these non-GAAP measures to the most directly comparable GAAP financial measures. Two additional key performance indicators that management will be discussing on this call are net asset value, or NAV, and return on equity, or ROE. NAV is defined as total assets minus total liabilities and is reported on a per share basis. Main Street defines ROE as the net increase in net assets resulting from operations divided by the average quarterly total net assets. Please note that certain information discussed on this call, including information related to portfolio companies, was derived from third-party sources and has not been independently verified. Now I'll turn the call over to Main Street's CEO, Dwayne Hyzak. Dwayne?

Dwayne Hyzak (CEO)

Thanks, Zach. Good morning, everyone, and thank you for joining us today. We appreciate your participation on this morning's call, and we hope that everyone's doing well. On today's call, I will provide my usual updates regarding our performance in the quarter, while also providing updates on our asset management activities, our recent dividend declarations, our expectations for dividends going forward, our current investment pipeline, and several other noteworthy updates. Following my comments, David and Jesse will provide additional comments regarding our investment strategy, investment portfolio, financial results, capital structure and leverage, and our expectations for the third quarter, after which we'll be happy to take your questions.

We are very pleased with our performance in the second quarter, which was highlighted by a return on equity of 19.2% and includes new quarterly records for NII per share, DNII per share, and NAV per share for the fourth consecutive quarter. Our strong performance included continued positive results from our lower middle market and private loan investment strategies, and significant contributions from our asset management business. These results demonstrate the continued and sustainable strength of our overall platform, the benefits of our differentiated and diversified investment strategies, the unique contributions of our asset management business, and the underlying strength and quality of our portfolio companies.

We are also pleased that we continue to maintain an attractive investment pipeline in both our lower middle market and private loan investment strategies, and this attractive investment pipeline, together with our conservative liquidity position and capital structure, provides us a continued favorable outlook for the third quarter. Our DNII in the second quarter exceeded the monthly dividends paid to our shareholders by 66% and the total dividends paid to our shareholders by 24%. This strong performance allowed us to deliver significant value to our shareholders, while still conservatively retaining a meaningful portion of our income and growing our NAV per share. These positive results and our favorable outlook for the third quarter resulted in our recommendations to our board of directors for our most recent dividend announcements, which I'll discuss in more detail later.

Our NAV per share increased in the quarter due to several factors, including our retention of the excess NII per share above our total dividends paid in the quarter, the impact of fair value increases in our investment portfolio, and the accretive impact of our equity issuances in the quarter. Our lower middle market portfolio companies continued their overall favorable performance, which resulted in another quarter of net fair value appreciation and strong dividend income contributions from our equity investments in this portfolio. As we look forward to the next few quarters, we remain excited about the benefits we expect certain of our lower middle market portfolio companies to realize from the acquisitions they have completed over the last 12 months, largely funded by follow-on debt investments we made in those portfolio companies, and we expect to see additional fair value appreciation in these portfolio companies in the future.

We've also seen an increase in potential exit activities in our lower middle market portfolio that could lead to favorable realizations over the next few quarters. We are pleased with our investment activity in the second quarter, which included total lower middle market investments of $131 million and investments in three new portfolio companies. These investments were offset by increased repayments we received on several debt investments and the full exit of our investments in two lower middle market portfolio companies. This investment activity resulted in a net decrease in the cost basis of our lower middle market investments of $7 million. We were also pleased with our private loan investment activities in the quarter, which included total investments of $168 million.

We also received increased repayments and realized a loss on a private loan investment during the quarter, resulting in a net decrease in the cost basis of our private loan investments of $11 million. We've also continued to produce attractive returns on our asset management business. The funds we manage through our external investment manager continued to experience favorable performance in the second quarter. This positive performance resulted in significant incentive fee income for our asset management business for the third consecutive quarter. As a result, we received a significantly higher contribution to our net investment income from our asset management business.

We remain excited about our plans for these external funds that we manage as we execute our investment strategies and other strategic initiatives, we are optimistic about the future performance of the funds and the attractive returns we are providing to the investors of each fund. We also remain optimistic about our strategy for growing our asset management business within our internally managed structure and increasing the contributions from this unique benefit to our Main Street stakeholders. As part of this growth strategy, we're happy to update that we've made meaningful progress on our next private loan fund, we are planning to have our first closing for the fund before the end of the third quarter. We look forward to sharing additional details and updates on the new fund on our next conference call.

Based upon our results for the second quarter, combined with our favorable outlook in each of our primary investment strategies and for our asset management business, earlier this week, our board declared a supplemental dividend of $0.275 per share, payable in September, representing our largest and eighth consecutive quarterly supplemental dividend. Our board also declared an increase in our regular monthly dividends for the fourth quarter of 2023 to $0.235 per share, payable in each of October, November, and December, representing a 6.8% increase from the fourth quarter of 2022. The increased supplemental dividend for September is a result of our strong performance in the second quarter, which resulted in DNII per share, which exceeded our regular monthly dividends paid during the quarter by $0.445, or 66%.

The September 2023 supplemental dividend will result in total supplemental dividends paid during the trailing 12-month period of $0.775 per share, representing a 22% increase over the June 2023 supplemental dividend, and an additional 29% paid to our shareholders in excess of our regular monthly dividends, and significantly increasing the current yield we are paying to our shareholders. Our DNII per share for the second quarter exceeded our total dividends paid by $0.22 per share, or 24%. We are pleased to be able to deliver this significant additional value to our shareholders, while also maintaining a significant portion of our excess earnings to support our capital structure and investment portfolio against risks from the current economic uncertainties that may be realized in the future, and to further enhance the growth of our NAV per share.

We currently expect to recommend that our board continue to declare future supplemental dividends to the extent DNII significantly exceeds the regular monthly dividends paid in future quarters, and we maintain a stable to positive NAV. Based upon our expectations for continued favorable performance in the third quarter, we currently anticipate proposing an additional supplemental dividend payable in the fourth quarter of 2023. Now, turning to our current investment pipeline. As of today, I would characterize our lower middle market investment pipeline as average. Despite the current broad economic uncertainty, we continue to expect to be active in our lower middle market strategy.

Consistent with our experience in prior periods of broad economic uncertainty, we believe the unique and flexible financing solutions we can provide to lower middle market companies and their owners and management teams, and our differentiated long-term to permanent holding periods, should be an even more attractive solution in the current environment and should result in very attractive investment opportunities for us. We are excited about these new investment opportunities, and we expect our current pipeline will be helpful as we work to maintain our positive momentum from the last several quarters. We also continue to be very pleased with the performance of our private credit team and the significant growth they have provided for our private loan portfolio and our asset management business. As of today, I would also characterize our private loan investment pipeline as average. With that, I will turn the call over to David.

David Magdol (President and Chief Investment Officer)

Thanks, Dwayne, and good morning, everyone. As Dwayne highlighted in his remarks, we believe our strong second quarter financial results continue to demonstrate the strength of Main Street's platform, our differentiated investment approach, and our unique operating model. We are pleased to report that the overall operating performance for most of our portfolio companies continued to be positive, which contributed to our attractive second quarter financial results. As we've discussed in the past, the largest portion of our investment portfolio and the primary driver of our long-term success has been and continues to be our focus on the underserved lower middle market, and specifically, our strategy investing in both the debt and equity in lower middle market companies. Our view on the attractiveness of investing in the lower middle market remains unchanged, and we expect this to continue to be our primary area of focus in the future.

Each quarter, we try to highlight key aspects of our investment strategy and differentiated approach. For today's call, we thought it would be useful to spend some time on our private loan investment strategy, which is the second largest part of our investment portfolio and is a primary driver of our asset management business. This strategy has grown significantly over the last several years and principally represents investments in the senior secured debt of private equity-sponsored businesses. Our private loan investments are primarily originated directly by our internal investment professionals through strategic relationships with private equity firms and their capital market intermediaries. Our private loan investments are typically first lien debt investments with attractive yield profiles and favorable terms.

As of quarter end, 99% of our private loan secured debt investments are first lien loans, 98% bear interest at floating interest rates, which have an attractive weighted average yield of 12.6%. Over six years ago, we announced our strategic decision to dedicate significant resources towards growing our private loan portfolio, while de-emphasizing our middle market portfolio, which, as a reminder, are typically syndicated loan investments in larger companies. We set a goal of growing our private loan portfolio to a greater percentage of our assets than our middle market portfolio, which seemed ambitious at the time, since the middle market portfolio was almost double the size of our private loan portfolio.

During this period of repositioning, we were also deliberate in setting a goal to maintain our emphasis on our lower middle market portfolio and growing our lower middle market portfolio to approximately 50% of our total assets at fair value. From year-end 2016 through the second quarter of this year, we have increased the total fair value of our private loan portfolio by 337%, and from 17% of our total portfolio at fair value to 35%. Over the same period of time, we reduced the total fair value of our middle market portfolio by 53%, from 32% of our total portfolio at fair value to only 7%.

We also increased the total fair value of our cornerstone lower middle market portfolio by 143%. Today, the lower middle market portfolio represents 52% of our total assets at fair value, which is above our target when we started this initiative. Our purposeful and intentional strategic shift to grow our private loan portfolio was primarily driven by our belief that an attractive and growing direct lending environment would exist in the future, and that private loan investments provided a more attractive risk-adjusted return profile than in middle market investments. Today, the weighted average yield in our private loan portfolio is meaningfully higher than in our middle market portfolio.

Even more important than higher yields, we are confident that our underwriting process and more favorable contractual terms and conditions of our private loan investments will provide significantly better returns, net returns after credit losses than in the investments available to us in the middle market investment strategy. Based on the capabilities and relationships of our private credit team, the overall growth of our private loan portfolio platform, and the strength of our deal flow, Main Street has also benefited from our ability to utilize our private loan investment strategy to grow our asset management business. Through our external investment manager, our private loan strategy effectively allows Main Street to leverage our investment professionals' time and our platform to benefit from the attractive fee-based income we receive from third-party clients, while at the same time providing highly attractive investment opportunities and returns for those clients.

Now, turning to the overall composition and results from our investment portfolio. As of June 30th, we continue to maintain a highly diversified portfolios with investments in 195 companies, spanning across more than 50 different industries among our lower middle market, private loan, and middle market portfolios. Our largest portfolio company represented 3.1% of our total investment portfolio fair value at quarter end and 4% of our total investment income for the last 12 months. Majority of our portfolio investments represented less than 1% of our income and our assets.

Despite the continued increases in benchmark interest rates, the vast majority of our lower middle market, private loan, and middle market portfolio companies have interest rate coverage and debt service coverage ratios calculated on a pro forma basis for current interest rates as of July 1, well above 1x, we continue to be confident in their ability to service their debt obligations today and in the future. In addition, and as a reminder, our lower middle market portfolio companies are predominantly fixed-rate debt investments and therefore are not impacted by increasing market index rates. Our investment activity in the second quarter included investments in our lower middle market portfolio of $131 million, which, after aggregate repayments on debt investments, return of invested equity capital and realized losses, result in a net decrease in our lower middle market portfolio of $7 million.

driven by the capabilities and relationships of our private credit team that I previously discussed, we also completed $168 million in total private loan investments, which, after aggregate repayments of debt investments, return of invested equity capital, and realized losses, resulted in net decrease in our private loan portfolio of $11 million. During the quarter, we had a net decrease in our middle market portfolio of $39 million as we continue to de-emphasize this strategy. At the end of the first quarter, our lower middle market portfolio included investments in 79 companies, representing over $2.2 billion of fair value, which is over 26% above our cost basis. We had investments in 88 companies in our private loan portfolio, representing $1.5 billion of fair value.

In our middle market portfolio, we had investments in 28 companies, representing $296 million of fair value. The total investment portfolio at fair value at quarter end was 113% of the related cost basis. Additional details on our investment portfolio at quarter end are included in the press release that we issued yesterday. In summary, Main Street's investment portfolio continues to perform at a high level and deliver on our long-term results and goals. With that, I will turn the call over to Jesse to cover our financial results, capital structure, and liquidity position.

Jesse Morris (CFO and COO)

Thank you, David. As Dwayne and David mentioned, we are very pleased with our operating results for the second quarter. Our total investment income in the second quarter increased by $42.4 million, or 50% over the same period in 2022, and $7.3 million, or 6.1%, over the first quarter of 2023, to a total of $127.6 million, and included strong performance from each of our income components. Interest income increased by $33.3 million, or 52% from a year ago, and $3.9 million, or 4.2%, over the first quarter.

We estimate that the increases in benchmark index rates drove approximately 40% of the increase from the prior quarter and about 50% of the increase from the prior year, with the remainder driven primarily by the continued growth in our debt investments. Dividend income increased by $7.7 million, or 43%, from a year ago, and $1.4 million, or 5.7%, over the first quarter. This represents the second consecutive quarterly record for dividend income and demonstrates a continued strong performance of our lower middle market portfolio companies and the external investment manager. Fee income increased $1.4 million from a year ago and $2 million over the first quarter, driven by closing fees on new and follow-on investments and repayment activity. The second quarter investment income included elevated dividends and accelerated prepayment or other activity that are considered less consistent.

In the aggregate, these were $2.4 million above the average of the prior four quarters and $2.7 million lower than the first quarter. Our operating expenses increased by $11.4 million over a year ago, largely driven by increases in interest expense and compensation-related expenses, partially offset by an increase in expenses allocated to the external investment manager. Interest expense increased by $9.5 million over the prior year, driven primarily by increases in benchmark index rates and from the addition of new debt obligations at higher interest rates, combined with an increase in average outstanding borrowings to fund our investment activity and support the growth of our investment portfolio.

Cash compensation expenses increased by $1.6 million over a year ago, driven primarily by increases in incentive compensation accruals as a result of our positive operating performance and increased headcount to support higher levels of investment activity and assets under management. Non-cash compensation expenses increased by $2.2 million from a year ago, including increases in share-based compensation and deferred compensation expenses. The ratio of our total operating expenses, excluding interest expense, as a percentage of our average total assets, was 1.4% for both the quarter and the trailing twelve-month period, and continues to be amongst the lowest in our industry. Our external investment manager contributed $8.5 million to our net investment income during the quarter, an increase of $3.4 million from a year ago, and $0.5 million over the first quarter.

The manager earned $3.7 million in incentive fees during the quarter, an increase of $3.6 million from a year ago, and $0.4 million over the first quarter as a result of the positive performance of the assets under management, and ended the quarter with total assets under management of $1.4 billion. During the quarter, we recorded net fair value appreciation, including net realized losses and net unrealized appreciation on the investment portfolio of $29.4 million. We recorded net fair value appreciation of $22.7 million in our lower middle market portfolio, which, as Dwayne mentioned, was driven by the continued positive performance of our portfolio companies.

We recorded net fair value appreciation in our private loan portfolio of $0.6 million and net fair value appreciation of $4.5 million in our middle market portfolio, with a positive contribution from changes in market spreads and quoted market prices, improved performance from certain historically underperforming companies, offset by depreciation due to underperformance of certain portfolio companies. We also recognized $1.3 million of appreciation in the fair value of our external investment manager, driven by increased revenues, partially offset by a decline in peer multiples. We recognize net realized losses of $75.5 million in the quarter. The realized losses recognized were primarily the result of the exit or restructure of several long-standing underperforming investments, partially offset by realized gains on the exits of lower middle market investment and a private loan investment.

The vast majority, or approximately 90% of the unrealized depreciation related to the investments for which we realized a loss in the second quarter, was recognized prior to this year, and approximately 45% of the unrealized depreciation was recognized in 2021 or prior. When looking specifically at the impact of the second quarter, these realized losses were completed at a net realized fair value, $2.3 million, greater than the fair value for such investments at the end of the first quarter of 2023.

We ended the first quarter with nine investments on non-accrual status, comprising approximately 0.3% of the total investment portfolio at fair value and approximately 1.7% at cost, which represented a meaningful reduction from the 13 investments on non-accrual status, comprising approximately 0.6% of the total investment portfolio at fair value and approximately 3.2% at cost as of the end of the first quarter. NAV per share increased by $0.46, or 1.7% over the end of the first quarter, and by $2.32, or 9.1% when compared to a year ago, to a record $27.69 on June 30, 2023.

We continue to believe that our conservative leverage, strong liquidity, and continued access to capital are significant strengths that have us well positioned for the future. Our regulatory debt to equity leverage, calculated as total debt, excluding our SBIC debentures, divided by net asset value, was 0.75, and our regulatory asset coverage ratio was 2.34 at quarter end, are intentionally slightly more conservative than our target range of 0.8x to 0.9x and 2.1x to 2.25x, respectively. For the quarter, we continue to be active in our at-the-market program, raising a net $43 million from equity issuances. We ended the quarter with strong liquidity, including cash and availability under our credit facilities of $726 million.

We believe that this provides us with ample liquidity to continue to be opportunistic and pursue attractive investment opportunities throughout 2023, while continuing to maintain a conservative leverage profile. In July, we expanded the commitments on our corporate facility by $15 million to $995 million under the same terms and conditions as the existing commitments. The expanded commitment came from an existing lender in the facility, which we greatly appreciate and believe it was a strong vote of confidence. Return on equity for the first quarter and six months ended June 30th, were 19.2% and 17.1% on an annualized basis, respectively. For the trailing 12-month period, ROE was 16.7%. All of these are above our long-term targets, which we believe represent strong results compared to the industry.

DNI per, per share for the quarter was a record $1.12 per share, an increase of $0.05 or 4.7% over the first quarter, and $0.34 or 30% over the same period a year ago. The combined impact of certain investment income considered less consistent or non-recurring in nature to DNII was $0.03 per share above the average over the last four quarters and $0.04 per share above the same quarter a year ago. The impact to NII, which include these items together with deferred compensation expense, was $0.02 per share above the average of the last four quarters in the same quarter a year ago.

DNI per share exceeded the total regular monthly dividends per share paid to our shareholders in the second quarter by $0.445 or 66%, and our total dividends per share by $0.22 or 24%. As Dwayne mentioned, given the strength of our operating results and the outlook for 2023, our board approved an increase to our monthly dividends to $0.235 per share for the fourth quarter of 2023. The second increase this year, a supplemental dividend of $0.275 per share, payable in September 2023, our eighth consecutive and largest quarterly supplemental dividend.

The total monthly and supplemental dividends declared for the third quarter of 2023 are $0.965 per share, representing a 7.2% increase over the total dividends paid in the second quarter of 2023, and a 30% increase over the total dividends paid in the third quarter of the prior year. Looking forward, given the strength of our underlying portfolio, we expect continued strong performance in the third quarter of 2023, with expected DNII per share of $0.98 to $1.00 per share, with the opportunity to exceed this level, driven by the level of dividend income and portfolio investment activities during the quarter. With that, I will now turn the call back over to the operator so we can take any questions.

Operator (participant)

Thank you. We will now conduct a question and answer session. If you would like to ask a question, please press star one on your telephone keypad. A confirmation tone will indicate your line is in a question queue. You may press star two if you would like to remove your question from the queue. If a participant chooses speaker equipment, it may be necessary to pick up your handset before pressing the star key. Once again, dial star one to ask a question at this time. One moment while we pull for our first question. Our first question comes from Bryce Rowe with B. Riley. Please proceed.

Bryce Rowe (Senior Equity Research Analyst)

Thanks a lot. Good, good morning. Let's see. Wanted, wanted to maybe start on the supplemental Dwayne. I mean, you, you all highlighted, the, the, the record level for the supplemental here, in, in, in the next quarter. Just, just curious how you're, how you're thinking about kind of formulaically coming, coming to that level. Thinking about kind of future quarters, you know, how to, how, how to size it up, you know, relative to, to, to what you've paid out over the, you know, over the last few quarters.

Dwayne Hyzak (CEO)

Sure, Bryce, good morning, and thanks, thanks for the question. What I would say is that when you, when you look at it, and I think we've given some of this guidance before, we, we are funding the supplement or determining the supplemental based upon the, the excess DNII above the monthly. Obviously, as you know, when you look at the numbers, we're still retaining a significant amount of, of the excess, you know, for our, our NAV and for, just for conservatism purposes. I think we feel really good about where we set the supplemental in terms of it being, you know, being a conservative number relative to performance, as well as something that, going forward, we, we have good visibility and confidence that we'll continue to pay a meaningful supplemental.

Not guaranteeing it's gonna be, you know, $0.275 per share going forward, 'cause that is a really, really good quarter. We do have confidence that it will continue to be a meaningful contribution to our shareholders from a, you know, from a dividend standpoint.

Bryce Rowe (Senior Equity Research Analyst)

Okay, that's great. Maybe kind of changing gears here a little bit. Just, you know, your comment around, you know, potential exits, and exit activity. Can you help us kind of think about maybe just the pace and maybe what's driving some of the, some of the exit activity? I don't know if we've, we've seen, you know, or heard that, that type of comment from other BDCs. Maybe it's the fact that you play in, you know, smaller markets and some of them, some of the exit activity is not necessarily kind of market driven. It's gonna be, you know, company specific.

Dwayne Hyzak (CEO)

Sure. Sure, Bryce. I-- we, we wanted to highlight it 'cause we agree with you that it's probably a little bit of a, an anomaly or an outlier versu

We can't, you know, really predict whether any of those transactions will move forward and close, but we, we are seeing more, more activity than we, we had seen in the last couple of quarters, which is why we, we wanted to highlight it in our, in our prepared comments.

Bryce Rowe (Senior Equity Research Analyst)

Great. Last one for me. You know, a bit of cleanup activity with some of the longer-standing underperformers. Was that kind of a matter of just, you know, of timing, things kind of happened when they did? Would you describe that as more kind of intentional and trying to, again, clean up some of the non-performers?

Dwayne Hyzak (CEO)

Yeah, I, I would say it's more of the former, Bryce. You know, some of these, some of these transactions, when you look at the, the legacy underperforming investments, several of those were transactions where we are not the lead or even, you know, the most significant investor. To some extent, we're along for the ride in terms of, you know, determining how and when a restructure or an exit happens. You know, there were a couple of the transactions where we did have, you know, more influence, but I'd say that when you look at most of those items, they were things that were, you know, largely, largely out of our control, where we had, you know, we had involvement but not, not control over it.

We, you know, we just had to wait for some process, whether it was a sale process, a restructuring, or some other, transaction, to, to, you know, work its way through to a final transaction before we could recognize those realized losses. I, I think Jesse highlighted it in his comments. Most of the depreciation, you know, was taken, you know, not just in prior quarters, but really in prior years. These were, you know, some long-standing, underperforming companies that we, you know, we finally, you've got to resolution on in the quarter.

Bryce Rowe (Senior Equity Research Analyst)

Okay. great. Well, I'll jump back in queue. Appreciate the time this morning.

Dwayne Hyzak (CEO)

Thanks, Bryce.

Operator (participant)

The next question comes from Robert Dodd with Raymond James. Please proceed.

Robert Dodd (Director)

Hi, guys, congrats on the quarter. Dwayne, on the lower middle market pipeline, which you characterized as average, can you give us any color of that pipeline? Kind of how much is looking like it's add-on acquisitions, which you have capital, these small companies may be looking to make acquisitions and Is that a greater than average share of the average pipeline, or is it just kind of ticking along kind of normal mix for add-ons versus new platforms?

Dwayne Hyzak (CEO)

Sure, Robert, thanks for the question and good morning. I would say.

Robert Dodd (Director)

Good morning.

Dwayne Hyzak (CEO)

That when you look at the, the pipeline, you know, we we're excited about the pipeline, one, because we think the, the volume or the, the size of pipeline, both in terms of number of companies and, and dollar amounts of potential investment, are both strong and are, are, you know, numbers are in line with what we would want them to be. To your point on the, the follow-on versus new investments, I think this has been a trend we've talked about for the last couple of years, really going back to 2019 and 2020, and to some extent, it's intentional on our side. We are seeing a consistent amount, consistent amount of that pipeline, represented by follow-on investment opportunities in our existing portfolio companies, which as you've heard us say in the past.

From a risk-reward standpoint, you know, we, we really value those, those opportunities because they're with our better performing companies, you know, management teams and, you know, industries that we know well, having been an investor in those companies for some period of time. When we have an opportunity to deploy additional capital, one, we value it significantly because we think it's a really good investment. And then when you look at our, our equity investment in those same companies, it gives us an opportunity for significant fair value appreciation in the future, which has been one of the things we've seen for the last couple of quarters for the companies that have made acquisitions over the last 12 or 18 months. We, we think it's a, a good, you know, high-quality pipeline in terms of the types of companies.

To your point, it is a, a good mix from our from our perspective, in terms of, you know, new investments as well as follow-ons. I'll just see if David wants to add anything to that, you know, to that commentary on the pipeline.

David Magdol (President and Chief Investment Officer)

Yeah. The only thing I'd add is that certainly we're pleased with some of the increased activity in our, in our add-ons over time. We also have a nice mix of, of platform opportunities here, and the platforms today make the add-ons in the future. We do have a nice mix, and consistent with our strategy, the minority equity portion of that has really taken some steam in today's market conditions, and those transactions fit us particularly well. I'd say last thing is just on the one-stop-shop type of opportunity that we provide, the intermediaries are really appreciative of knowing that we've got a non-contingent financing in this environment, we feel like it's a really, a good way to lead.

Robert Dodd (Director)

Got it. I appreciate the color on that. And on the leverage, I think Jesse said that it's in-intentionally conservative, versus your target at 0.75 right now. I mean, could you give us any color on, on why you're being intentionally conservative right now? I mean, I would think it would be either because the pipeline was really strong, but average in your reserving capital, or you were worried about the economy, but neither of those things seem to be the case. So why are you intentionally conservative right now?

Dwayne Hyzak (CEO)

Sure, Robert, I'll, I'll give some initial comments, and then Jesse can add on if he, if he has some additional points to, you know, to make to it. What, what I would say is we've always valued a conservative capital structure and strong liquidity positions. We, we do expect, even though we, we gave guidance that both the lower middle market and private loan pipelines are average, we, we do expect to be active, not just in the, the next quarter, but for the next couple of quarters. We're, we're preparing for that opportunity from a, you know, from an investment standpoint.

We also do a-acknowledge that we have a maturity in May of 2024, so we're intentionally making sure that we have as, as much flexibility and as many options as possible, you know, to deal with that, that maturity in, in 2024. Those would be the, the key factors. I'll let. If Jesse has some other comments you want to, want to add on.

David Magdol (President and Chief Investment Officer)

Yeah, I mean, I, I think you covered it, Dwayne. I mean, as you said, just having the flexibility and, and, you know, core, as you know, from our prior comments, just having a, a very strong balance sheet has been a, a core strategy for us, you know, particularly in these times. Yeah.

Robert Dodd (Director)

Got it. Thank you.

Dwayne Hyzak (CEO)

Thank you, Robert.

Operator (participant)

The next question comes from Mark Hughes with Truist. Please proceed.

Mark Hughes (Analyst)

Yeah, thank you. Good morning.

Dwayne Hyzak (CEO)

Morning, Mark.

Mark Hughes (Analyst)

In the asset management business, you say how you're going to be closing the private loan fund pretty shortly. Could you kind of refresh me on the cadence you expect to grow, you know, the size of this fund, kind of how it compares to earlier funds? Do you expect that cadence to accelerate, you know, if the deal flow, deal market opens up?

Dwayne Hyzak (CEO)

Sure, sure, Mark. I'll, I'll give you a couple of reference points just as reminders, and it'll help guide our expectations for the, for the second fund. The, the first private loan fund that we have, we raised just over $100 million of, of limited, limited partner equity capital. When you take that $100 million, you put some leverage on it, you get to just over $200 million from a, from a maximum investment capacity. That, that fund is performing very, very well as we, as we gave in our, you know, our earnings release and in our commentary.

When you look at fund two, our goal is to have it be at least the same size from an equity standpoint, with the goal being that, that we increase the size to be larger than the, the $100 million of LP equity capital. Obviously, today's environment is, you know, there's a lot of uncertainty and a lot of moving parts, so I think our ability to increase above the $100 million level of equity will be somewhat impacted by the overall markets, but we, we feel confident that we're going to be able to achieve that goal. Then our, our other big catalyst will be, you know, how much institutional investor interest and participation can we get in that new fund?

That will really drive, you know, drive the, the upside opportunity to, you know, to be significantly larger than the $100 million level. Let, let me know if that, if that answers your question, Mark, or if you'd like me to give some additional details there.

Mark Hughes (Analyst)

If you could tell me a little bit about the future, that would be great, too. Kind of how, how you see it progressing? Is this an annual event? How, how should we think about it?

Dwayne Hyzak (CEO)

Sure. So maybe to give some color to the first fund, because I, I think if we achieve our goals, we would expect to have similar performance from a ramp standpoint as, as the first fund. The first one fund, we closed the fundraising in February, March of 2022, and we're effectively fully invested in that fund today. If you, if you look at that type of a timeframe, if we're successful, and again, there, there could be movement, obviously, based upon market conditions and, and our ability to be successful in sourcing new investment opportunities, but I think we have a, a high level of confidence in our private credit team's ability to, to do that. We would expect to be having a cadence of a new fund every, you know, 18-36 months.

I know that's a pretty wide range, but that'll be, you know, really impacted by the marketplace, as well as how large of a capital raise, are we successful in raising with, with the second fund? If it's larger, you know, that, that time period could get a little bit extended. If it's more similar in size to the first fund, you know, we, we would be on the, on the, on the front end of that from a timeline standpoint.

Mark Hughes (Analyst)

Maybe just a big picture question. Lot of the BDC peers talk about their, the corporate structure, the parent, related companies that give them very good deal flow. Can you talk about, you know, how you compete with your private loan strategy, you know, in that context, you know, how you're able to differentiate and be successful?

Dwayne Hyzak (CEO)

Sure. I'll, I'll give a few comments, and I'll let, let Nick Meserve, who's in the room with us, who leads our private credit investment strategy and our, our private credit team, give, give some additional comments. I would say when you compare us to the, the really large platforms, we, we are in different parts of the marketplace from our perspective. You know, do, do we see some of those players from time to time? We, we might, but they are not the regular competitors when we're looking at our private loan strategy or private loan investment activity. We, we don't really view our platform relative to some of the really big guys as a disadvantage in that marketplace.

Frankly, you know, we view it as a, as a positive from, from our perspective, because the types of transactions that we're executing in our private loan strategy, they fit us really, really well from a size standpoint, and, and they wouldn't fit some of the other players well. When you look at it from a competitive landscape, you know, standpoint, even if the big guys were interested, they're going to be interested in a much larger investment than we are. They may pay some attention to the transactions we're participating in, but it's not going to be their priority from a competitive standpoint. I'll let Nick, Nick, give any additional color he wants to, he wants to add.

Nick Meserve (Managing Director)

The, the thing I'd add to that would be also how we source our transactions. you know, we're not bringing them in from either wealth advisors or banking relationships. It's mainly direct from the sponsors or through intermediaries they hire to, to find financing. So those two are our, our main channels of finding activities, with direct to the sponsor being preferred, and then, you know, the, the intermediaries of. There's five or six that kind of run most of the, the smaller end of the market, and we're in contact with them on a, a weekly basis to, to source new transactions.

That, that's an avenue that we have that it doesn't really necessarily matter whether you've got a bigger platform, sourcing different transactions, because we're, we're only really focused on a certain size and a certain type of transaction that fits us.

Mark Hughes (Analyst)

Thank you. Appreciate it.

Dwayne Hyzak (CEO)

Thanks, Mark.

Operator (participant)

The next question comes from Vilas Abraham with UBS. Please proceed.

Vilas Abraham (Senior Equity Research Analyst)

Hey, everybody. Thanks for the question. Just to dig in a little bit more on that 50% target on the lower middle market portfolio, can you put any kind of time frame around that? I think the private loan portfolio is about 35% to 40% now. Is there, is there a level that you want to see that grow to over a certain amount of time as well?

Dwayne Hyzak (CEO)

Sure. I'll, I'll take a stab at answering the question. You can tell me if we don't, if we don't cover it completely. Our, our long-term goal is to have the lower middle market portion of our investment portfolio be above 50%. I think realistically, moving it to 55 or 60 over a long period of time is a, is a good goal. Over time, when you look at the private loan and middle market portfolios, we, we have been and will continue to shrink the middle market as a percentage of the total portfolio, as well as just the, an absolute dollar. That portion of our portfolio will move to growth of both lower middle market and, and private loans.

In a perfect world, whatever time period you want to pick out, five or 10 years into the future, middle market will be, you know, there'll be something there, but it'll be, it'll be less than what it is today, and you'll see increases in both the lower middle market and the private loan, portions or percentages of the overall portfolio. Let, let me know if that, if that gives you what you were looking for.

Vilas Abraham (Senior Equity Research Analyst)

Okay. Is the message that, like, leaning into private loan right now is more, more tactical, and then kind of long term, you guys are still where you have been in terms of how you're thinking about that?

Dwayne Hyzak (CEO)

We the private loan investment strategy for us is very important to our business as a whole, both for our balance sheet and for our asset management business. When you look at our asset management business today, it's not exclusively private loan, but if you look at the growth, the growth of the asset management business is if not exclusively, you know, private loan, it's the vast majority of it. When you look at the Main Street platform as a whole, private loan is and will continue to be a big, big part of our investment strategy and activities. When you look at Main Street's investment portfolio and our balance sheet, specifically, you're going to continue to see more lower middle market than you would private loan.

I would say the, the private loan portion of our balance sheet going forward, we do not expect that to shrink. The, the piece that we expect to, you know, to decline or decrease going forward is the middle market portion of our existing portfolio, and both the lower middle market and private loan portions of the, the Main Street investment portfolio on, on our balance sheet will both continue to increase going forward.

Vilas Abraham (Senior Equity Research Analyst)

Okay. That's, that's helpful. Can you talk a little bit about EBITDA growth trends, your portfolio companies? You know, where are you seeing things now versus, say, say, a year ago? You know, are there certain industries that, you know, may be, you know, decelerating a little bit more than others? Any color there would be great.

Dwayne Hyzak (CEO)

Sure. I'll give some comments, and then, then David can, can add on if he wants to, you know, to add some additional comments. I'd say we continue to, to view that the performance of our companies broadly or kind of across the portfolio is, is very good. You can see that in our appreciation, you know, changes in fair value appreciation. You can also see it in the, in the dividend income. When you look at individual industries or companies, I would say our, our view, which is consistent with, with what I think you probably heard us say in the past, is it's more company specific than it is industry specific.

You know, we, we have some companies and some management teams that are doing an exceptional job, and, and you see that come through in their, in their fair value appreciation and in their, and in their contributions to dividend income. I, I wouldn't say we're seeing anything specific, you know, by industry or, or any other, you know, specific vertical. I think we, we do have some industries that, you know, may be showing a little bit of, of, you know, slowdown, and I, I think it's what you would see from the broader economy. I think we're, you know, we're, we're taking a little bit more of a risk-off approach on certain consumer, you know, type industries. By and large, the portfolio as a whole is performing very, very well.

In certain situations, the, the companies that are performing well are performing about as well as they've ever performed in, in any market environment, which gives us a lot of comfort and, and gives us a, a positive view towards both future fair value appreciation and dividend income contributions from those, you know, from those high-performing companies. David, I don't know if you if there's anything you want to add to that?

David Magdol (President and Chief Investment Officer)

I think you covered it.

Vilas Abraham (Senior Equity Research Analyst)

Okay. If I could, just squeeze one more in, just on the DNII for Q3. A little bit of a step down here. Should we think of that as a, as a combination of, you know, lower dividend income and, and slightly smaller portfolio? Just some of the drivers there. Any, any color you can give would be great. Thank you.

Dwayne Hyzak (CEO)

Sure. I'll let, let Jesse come back with some numbers, but I, I think when you, when you look at it, we, we try to highlight, as, as we do each quarter, some portion of, of DNII or NII that's non-recurring, so it's items that are, are elevated for some reason. Some of that is dividend income, some of it could be accelerated income from repayments. We, we had a combination of those, those two, which we, we have that every quarter. What I would say the biggest, biggest change between Q2 actual and Q3 projections is you, you don't have those elevated items in there. Just, just to highlight one other thing, is those elevated items not only impact Main Street, but they impact some of our asset management clients that would be in those same investments.

As, as you see us benefit at Main Street directly from those elevator or, or accelerated income items, you, you see it also come through the asset management business as those same asset management clients, you know, generate or receive the same benefit from an accelerated income standpoint. I'll let, let Jesse maybe give a few numbers to, you know, to, you know, to add on to that.

Jesse Morris (CFO and COO)

Yeah, no, that's, that's right, Dwayne. Thank you. You know, the. What we call these elevated items, like, you know, as a reminder, those come from accelerated income, prepayment fees and then, you know, certain dividend items that are that we consider elevator or less consistent. You know, at, at the beginning of the quarter, those are hard to predict and can drive the outperformance, as I, as I think I indicated in my comments, and drove a lot of the outperformance in terms of the, the initial guidance in the second quarter to, to where we ended at. For the, for the second quarter, we had $0.08 per share, or about $6.5 million of those items that drove the results for the second quarter.

You know, we have not, included, much or, or at all, that into our guidance for the third quarter, as we sit here today.

Vilas Abraham (Senior Equity Research Analyst)

Great. That's it for me. Thank you very much.

Jesse Morris (CFO and COO)

Thank you.

Operator (participant)

Our next question comes from Eric Zwick with Hovde Group. Please proceed.

Eric Zwick (Director of Equity Research)

Thanks. Good morning. Most of my questions have been answered, so just kind of one final one here from me. We heard from another BDC this morning, who recently increased and expanded their credit facility, that the negotiations or kind of discussions were a little bit more involved and intense than any time in recent history. I'm curious with your July expansion, was it fairly straightforward, given that it was a relatively, you know, small increase and the fact that it was kind of already allowed under the accordion feature, or were there any negotiations that accompanied it?

Dwayne Hyzak (CEO)

Yeah, I'd say it was pretty, pretty straightforward. We didn't, didn't have a lot of detailed negotiations or trouble getting there, which is we, we. I think Jesse said in his comments, we really appreciate the support of all the banks in our credit facilities and the addition that we received in the most recent period is just a further, you know, kind of further reason why we really value those relationships. I think our bank group as a whole, based upon the feedback we get from them, is very happy with the performance, very happy with the relationship across the board. I think we saw that, you know, come through with the, you know, the ease at which we were able to add the, you know, the $15 million of expanded capacity.

Again, if Jesse wants to add anything, I'm happy to let you jump in there.

Jesse Morris (CFO and COO)

No, I think you got it.

Eric Zwick (Director of Equity Research)

I appreciate the color. Thanks for taking my question.

Dwayne Hyzak (CEO)

Thanks, Eric. Appreciate it.

Operator (participant)

This concludes our question and answer session. I would like to turn the floor back over to management for closing comments.

Dwayne Hyzak (CEO)

Thank you, everyone, for joining us again this morning, and we look forward to speaking to you again in early November.

Operator (participant)

Ladies and gentlemen, thank you for your participation. This does conclude today's teleconference. You may disconnect your lines at this time.