Main Street Capital Swings at a Fat Pitch

Main Street Capital has always been unique in its industry for being an investor and asset manager. It makes the majority of its revenue and earnings from managing its own money, but it also has a growing side business in managing other people's money.

For much of 2015, the company's executives have been looking for new ways to grow its asset management business. They may have finally found their answer.

Meet the senior loan fundThis wasn't exactly the route I expected Main Street Capital to go. As recently as the first quarter of 2015, Main Street's CEO, Vince Foster, downplayed the traditional senior loan fund as a way for the company to drive its earnings.

Speaking to analysts, Foster said that he didn't think the company would "be inclined to use one of the existing senior loan structures." By all appearances, however, Main Street is copying the senior loan fund model with a small, but lucrative, twist.

The press release suggests that Main Street Capital will invest $17 million for a 20% equity stake in the new senior loan fund. Its partner, Capital Southwest Corporation , will invest $68 million for the other 80%. The fund will be leveraged with debt, for leverage of up to 2 times debt to equity.

But unlike most arrangements where the profits are split proportionately, Main Street Capital is getting better terms. Main Street Capital will put up only 20% of the equity investment in the joint venture, but receive 24.4% of the profits.

How it affects Main Street CapitalSenior loan funds dial up risk to boost returns. Whereas BDCs are typically limited to 1:1 leverage, senior loan funds held inside a BDC are usually levered as high as 2:1. The net result is that, once the capital is fully invested, BDCs tend to earn double-digit yields on their equity investment.

Ares Capitalearned about 14% annualizedreturn on its similar program in the first half of 2015. Fifth Street Finance'sgrowing program generated an annualized return of just under 18% in its most recent quarter. Neither have a particularly lucrative arrangement like Main Street Capital, however, where the BDC collects a disproportionate share of the profits.

Senior loan funds obviously have their ups and downs. Their success is ultimately built on more leverage, which magnifies the gains and the losses in the underlying portfolio. But when you can negotiate a deal where you get a greater proportion of the profits relative to the amount of capital you invest, it's a no-brainer.

It won't be needle-moving in the here and now, but if this is the blueprint for future deals, Main Street shareholders should be very pleased.

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Jordan Wathen has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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