Fitch Ratings has affirmed Main Street Capital Corporation's Long-Term Issuer Default Rating (IDR), secured debt rating and unsecured debt at 'BBB-'.

The Rating Outlook on the Long-Term IDR is Stable.

The rating actions have been taken as part of a broader review of business development companies (BDCs), which included 18 publicly rated firms. For more information on the peer review, please refer to 'Fitch Completes 2023 BDC Peer Review' available at www.fitchratings.com.

Key Rating Drivers

The ratings affirmation reflect Main Street's portfolio focus on senior debt investments, strong portfolio diversification, solid record in credit and equity investing, above-average asset coverage cushion following the reduction of its regulatory requirement to 150% from 200% in May 2022, consistent operating performance, experienced management team, and strong funding flexibility with demonstrated access to the public debt and equity markets.

Rating constraints specific to Main Street include above-average exposure to equity investments, which could yield more valuation volatility over time, and a focus on lower middle market (LMM) companies with below-average EBITDA, which could increase portfolio risk in an economic downturn. This is mitigated by Main Street's solid credit performance historically with a strong underwriting record. Fitch also believes Main Street's lack of affiliation with a broader investment platform could be a headwind longer term should bank financing become more constrained for the sector.

Rating constraints for BDCs more broadly include the market impact on leverage, given the need to fair-value the portfolio each quarter, dependence on access to the capital markets to fund portfolio growth and a limited ability to retain capital because of distribution requirements. In addition, Fitch believes BDCs will experience weaker asset quality metrics in 2023 amid macroeconomic headwinds and higher debt-service burdens and slower growth prospects at portfolio companies.

At Dec. 31, 2022, Main Street had a $4.1 billion investment portfolio, at fair value, consisting of 70.8% first lien debt investments, against a rated peer average of 74.7%, and combined exposure to common and preferred equity investments of 29%, well-above the rated peer average of 11.1%. Elevated equity and preferred equity exposure reflect the firm's differentiated strategy of lending to LMM companies (50% of the portfolio), which come with equity co-investments. Fitch believes these equity investments can yield more valuation volatility over time, although Main Street has a solid record in the market sector, generating $152.4 million of cumulative net realized gains on its LMM portfolio since its IPO.

The average EBITDA of Main Street's portfolio is below the peer average, given its focus on LMM investments, but the firm has superior portfolio diversity compared with peers, which limits the impact of any one portfolio company experiencing credit deterioration. At Dec. 31, 2022, Main Street's top 10 investments represented 22% of assets and 44% of equity, against the rated peer average of 20.9% and 46.7%, respectively.

Main Street's asset quality has been strong historically. While net realized losses increased to 4.4% of the portfolio, at value, in 2020, given the impact of the Covid-19 pandemic, they bounced back to 0.1% through 2022. At year-end 2022 (YE22), Main Street had investments in 12 portfolio companies that were on non-accrual status, representing 0.6% of the debt portfolio at fair value, and 3.7% at cost. These are down from pandemic peaks of 3.8% and 9.2%, respectively, at Sept. 30, 2020.

The company's core earnings have been generally stable and consistently above the peer average. Fitch attributes this to Main Street's investment strategy and focus on LMM companies, which offer a higher yield, and the internally managed model that offers more cost efficiency relative to externally managed BDCs. The portfolio's net investment income (NII) yield was 7.0% in 2022, up from 6.3% in 2021, and above the rated peer average of 5.1% for 2022. Fitch expects earnings to remain fairly stable.

Leverage, as measured by par debt-to-equity, was 0.95x at Dec. 31, 2022. Excluding Small Business Administration (SBA) borrowings, Main Street's statutory leverage was 0.79x, which was within the firm's targeted range of 0.8x-0.9x. Leverage at YE22 implied an asset coverage cushion of 34%, which was above the peer average and above the high-end of Fitch's 'bbb' category benchmark range of 11%-33%. Fitch expects the firm to operate with a higher asset coverage cushion than peers, given the risk profile of the portfolio. A sustained decline in the cushion below 25% could result in negative rating action because of the higher-risk nature of the portfolio.

At Dec. 31, 2022, unsecured debt represented 52% of total debt, which was above the peer average and above the upper-end of Fitch's 'bbb' category benchmark range of 35%-50% for BDCs. Fitch expects Main Street to remain opportunistic about accessing the unsecured debt markets and expects its unsecured funding mix to remain above 35%.

At Dec. 31, 2022, Main Street had solid liquidity, consisting of $49 million of cash and $568 million of aggregate undrawn capacity on its secured revolving credit facility and SPV facility. Liquidity availability was more than sufficient to cover Main Street's outstanding unfunded commitments, which amounted to $274.4 million at YE22. Main Street's $450 million of notes due May 2024 are its nearest term debt maturity.

NII coverage of base dividends declared amounted to 125.9% in 2022, against a four-year average of 105.2% (2019-2022). Fitch believes that Main Street's approximately $77 million of undistributed earnings as of Dec. 31, 2022 provides a degree of cushion to dividend stability through market cycles. The company has historically distributed excess income via special dividends, but intends to retain realized gains on equity investments to support portfolio growth. Non-cash income and expenses were 5.4% of investment income in 1Q22, which compares favorably with peers.

The Stable Rating Outlook reflects Fitch's expectations for a relatively consistent portfolio mix between first lien debt and equity investments, consistent core earnings generation, solid asset quality, and the maintenance of the asset coverage cushion at or above 25% and the unsecured funding mix at or above 35%.

Rating Sensitivities

Factors that could, individually or collectively, lead to negative rating action/downgrade:

A sustained reduction in the asset coverage cushion below 25%. A significant increase in second lien and/or equity and preferred equity investments, without a commensurate increase in the asset coverage cushion, a material increase in non-accrual levels, meaningful realized or unrealized losses, a sustained decline in unsecured funding below 35% of total debt, deterioration in cash earnings coverage of the dividend, or an impairment of the firm's liquidity profile could also yield negative rating action.

Factors that could, individually or collectively, lead to positive rating action/upgrade:

A strong and differentiated asset quality performance of recent vintages over time and an increase in the asset coverage cushion to at least 33% on a sustained basis, assuming no change in the origination strategy, or absent that, a meaningful reduction in perceived portfolio risk. The maintenance of strong credit performance, funding flexibility, ample liquidity, solid dividend coverage and consistent core operating performance would also be necessary to yield positive rating action.

DEBT AND OTHER INSTRUMENT RATINGS: KEY RATING DRIVERS

The equalization of the secured and unsecured debt ratings with the Long-Term IDR reflects solid collateral coverage for all classes of debt, given Main Street's funding mix and the fact that the company is subject to a 150% asset coverage limitation.

DEBT AND OTHER INSTRUMENT RATINGS: RATING SENSITIVITIES

The secured and unsecured debt ratings are sensitive to changes in the Long-Term IDR and the firm's funding mix. A material increase in secured funding could result in the unsecured debt being notched down from the IDR.

Best/Worst Case Rating Scenario

International scale credit ratings of Financial Institutions and Covered Bond issuers have a best-case rating upgrade scenario (defined as the 99th percentile of rating transitions, measured in a positive direction) of three notches over a three-year rating horizon; and a worst-case rating downgrade scenario (defined as the 99th percentile of rating transitions, measured in a negative direction) of four notches over three years. The complete span of best- and worst-case scenario credit ratings for all rating categories ranges from 'AAA' to 'D'. Best- and worst-case scenario credit ratings are based on historical performance. For more information about the methodology used to determine sector-specific best- and worst-case scenario credit ratings, visit https://www.fitchratings.com/site/re/10111579

REFERENCES FOR SUBSTANTIALLY MATERIAL SOURCE CITED AS KEY DRIVER OF RATING

The principal sources of information used in the analysis are described in the Applicable Criteria.

ESG Considerations

Unless otherwise disclosed in this section, the highest level of ESG credit relevance is a score of '3'. This means ESG issues are credit-neutral or have only a minimal credit impact on the entity, either due to their nature or the way in which they are being managed by the entity. For more information on Fitch's ESG Relevance Scores, visit www.fitchratings.com/esg.

(C) 2023 Electronic News Publishing, source ENP Newswire