Main Street's Dividend Outlook Remains Solid Despite Worsening Economic Conditions

Signs of an economic slowdown and rising interest rates have heightened concerns that companies with limited financial flexibility will likely come under more stress than others.

A deteriorating economic backdrop is a particular worry for business development companies (BDCs) like Main Street Capital, which provides debt and equity financing to relatively small and highly levered companies that can't access traditional financing.

While we recognize the overall environment has deteriorated for some companies in Main Street's portfolio, the BDC has a strong track record of financing businesses with stronger credit profiles that are better positioned than most to endure recessions.

Given the firm's industry-leading portfolio plus the BDC's solid debt profile and distribution coverage, we are reaffirming Main Street's Safe Dividend Safety Score.

Even so, investors should be mindful of the potential recessionary risks that could result in some volatility for the stock as economic worries fluctuate.

Because recessions affect businesses and industries differently, there's comfort in Main Street's broad diversification, where no investment accounts for more than 3% of the overall portfolio and the firm has less than 10% exposure to any given industry.

Most of the firm's investments are also in first-lien secured loans, which get paid first when a borrower defaults and give Main Street the right to seize property if its loans go unpaid. This strategy reduces the risk of significant loan losses during downturns.

Also noteworthy is the firm's solid underwriting track record, where less than 3% of loans have defaulted in any given year since 2008, including during two severe recessions.

While just 0.6% of loans are currently in default, that number is likely to rise in the quarters ahead as economic forces strain businesses. 

However, Main Street is better positioned today to sustain the firm's attractive payout than it was heading into the Great Financial Crisis and Covid panic of 2020 thanks in part to the accumulation of a solid amount of undistributed taxable income often referred to as spillover.

Spillover represents gains Main Street has periodically realized upon the exit of successful investments. These retained funds can be used to provide an offset against the inevitable credit losses that occur when making investments in non-investment-grade debt securities.

Whereas the firm could cover nearly 30% of 2009's annual dividend with undistributed earnings, and just 14% in 2020, we estimate Main Street's current spillover could fund around 35% of this year's dividend if needed.

This spillover will only be needed for dividend support if Main Street's net investment income (NII), or interest and dividends earned by the firm less expenses, no longer covers the dividend – which over the past 15 years has only happened during a recession.

Main Street's payout ratio currently sits at its lowest level since 2018, providing a somewhat larger margin of safety compared to its dividend coverage prior to the pandemic.

Furthermore, we believe the BBB- rated firm has enough liquidity to fully cover the payout if NII and spillover fall short over the course of a moderate recession.

Overall, Main Street has wiggle room for supporting the dividend in the event of a recession, thanks to its strong portfolio, healthy balance sheet, and financial flexibility.

We will continue to monitor economic developments that could amplify the strain on Main Street's portfolio and ability to cover the payout.

Overall, Main Street is one of few BDCs for conservative income investors to consider. The firm is not immune from the industry's challenges, but Main Street is one of the best-positioned BDCs to maintain its dividend in good times and bad, as it has since going public in 2007.