We Don’t Understand

Mystery

In case you didn’t know MSC Income Fund (MSIF) became a public BDC not very long ago and is “externally managed” by an internally managed BDC – Main Street Capital (MAIN). We imagine the newbie BDC’s shareholders have been left scratching their heads over a puzzling strategic change of direction that has recently occurred. We certainly are. Right after going public – and without much explanation as to why – MSIF announced its decision to shift away from investing in lower middle market companies going forward, to exclusively focus on providing “private loan” financing in the form of senior debt.

That Was Then

Prior to going public, MSIF had a balanced approach where portfolio construction was concerned – much in the style of (no surprise) MAIN itself. The-then non-traded BDC portfolio mixed lower middle market loans and equity investments with private loans. The new strategy, though, is exclusively private loan focused, viz. no more equity investing. It strips away the equity upside that shareholders previously enjoyed. Even more perplexing, MAIN’s own portfolio is still heavily rooted in those lower middle market debt and equity investments. If those investments remain good enough for MAIN’s own books, why not for MSIF?

Maybe

Maybe earnings and NAV stability for MSIF were the goal, but the early evidence suggests this might come at a cost. The private loan portfolio is already showing signs of credit strain, with several resulting in realized losses and others on non-accrual status. Over time, the remaining lower middle market positions in MSIF’s portfolio will disappear, leaving just one category of loan. That’s a narrow strategy that doesn’t offer much upside.

Mr/Ms. Market Speaks

As this chart below shows, since MSIF’s IPO its stock price has fallen out of bed, while MAIN has reached news highs. The sector as a whole – as represented by BIZD – has also outperformed MSIF.

Since its IPO, MSIF’s stock price has declined from $15.53 to 14.21, an approximate 8% drop. Meanwhile, MAIN’s stock has risen from around $50 to $65.65, a 31% gain. The difference is glaring. MAIN trades at a premium of roughly 200% to its net asset value, while MSIF trades at a discount—a clear sign of investor skepticism toward the new direction.

VIEWS

Turn Around

It’s not too late for the external manager of MSIF to change course. There’s nothing stopping the BDC from returning to a balanced strategy that includes continuing to invest in lower middle market companies as well as private loans. Yes, that would make MSIF a sort of MAIN mini-me, but that’s not a bad thing – going by the manager’s red hot popularity. Moreover, that would save MAIN – and effectively its shareholders – from investing the tens of millions of dollars they’ve contracted to buying up MSIF’s stock, if it trades below book. That could be money down the drain if MSIF’s price continues to decline. On the other hand, if MSIF is successful, further rounds of equity could be raised for the benefit of the shareholders of both MSIF and MAIN. The opportunity is still there to “do the right thing”, but an abrupt strategic about-face is necessary.