Carlyle Secured Lending, Inc. Q2 FY2023 Earnings Call

Good day, everyone, and thank you for joining us. Welcome to the Carlyle Secured Lending, Inc. Second Quarter 2023 Earnings Call. Please note that today's conference is being recorded. I would now like to turn the call over to your speaker today, Daniel Hahn. Please proceed.

Good morning. And welcome to Carlyle Secured Lending second quarter 2023 earnings call. With me on the call this morning is Aren LeeKong, our Chief Executive Officer; and Tom Hennigan, our Chief Financial Officer. Last night, we filed our Form 10-Q and issued a press release with a presentation of our results, which are available on the Investor Relations section of our website. Following our remarks today, we will hold a question-and-answer session for analysts and institutional investors. This call is being webcast and a replay will be available on our website. Any forward-looking statements made today do not guarantee future performance and any undue reliance should not be placed on them. These statements are based on current management expectations and involve inherent risks and uncertainties, including those identified in the Risk Factors section of our annual report on Form 10-K. These risks and uncertainties could cause actual results to differ materially from those indicated. Carlyle Secured Lending assumes no obligation to update any forward-looking statements at any time. With that, I'll turn the call over to Aren.

Thanks, Dan. Good morning, everyone, and thank you all for joining. I will focus my remarks on three topics for today's call. I'll start with an overview of our second quarter results. Next, I'll touch on the current market environment. And finally, I'll conclude with a few thoughts on our investment activity and current positioning. Starting off with earnings. We continue to see the benefit of higher base rates and attractive pricing on new investments, generating total net investment income of $0.52 per share for the quarter, which is up 30% year-on-year. Our net asset value at June 30th was $16.73 per share as compared to $17.09 for Q1. As Tom will detail later, the change in NAV for the quarter was primarily driven by a markdown on one of our healthcare services investments that was partially offset by earning NII in excess of the dividend. We declared total Q3 dividends of $0.44, consisting of our $0.37 base dividend plus a $0.07 supplemental, both of which were in line with the prior quarter. Although we are pleased with the quarter's earnings, we remain focused on the credit performance of the overall portfolio. The credit fundamentals of our portfolio, in the aggregate, have continued to perform well with revenues up more than 30% and EBITDA margins largely flat year-over-year despite inflationary pressures to the economy. And importantly, our borrowers have reported consistent quality results as we have not seen a meaningful increase in noncash addbacks and interest coverage remained stable. This gives us comfort in the strength of our portfolio. Turning now to the current market environment. We saw the key trends discussed on our last call continue through the balance of the second quarter. Terms and pricing leaned favorably to lenders and deal activity in high yield and syndicated markets is still sluggish with overall net loan supply of 15-year loans. Given these market dynamics, sponsors continue to favor the private credit market to finance the limited number of LBO transactions that have been completed. While we continue to view the LBO market as a core component of our strategy, we also complemented our traditional sponsored pipeline with other sources of transaction flow. In particular, we have seen attractive sourcing opportunities from three main areas. One, as mentioned, new deal flow from sponsor-backed companies. This is our largest generator of our deal flow, and we've continued to be increasingly selective. Two, Carlyle generated and nonsponsored deal flow. The One Carlyle platform provides us access to a wide swath of deal flow. And three, finally, what I would call 'farming the portfolio.' We are able to leverage our position as an incumbent lender along with our long-standing relationships with companies and sponsors to execute collaborative solutions for amendments, extensions, and M&A activity that provide added flexibility to borrowers and attractive incremental economics to our portfolio. Regardless of sourcing channel, we focused our efforts in Q2 on opportunities that were accretive to the portfolio's return. One example of this is that our average spread at origination on new deals improved by approximately 100 basis points compared to this period last year. In addition, as previously mentioned, we generated significant incremental value from our existing borrowers from amendment activity, which has driven tighter documentation, incremental fees, additional equity contribution from sponsors, and spread increases. In the second quarter alone, approximately 16% of our loans saw an improvement in one or more of these areas due to amendment and other related activities. I'll now hand the call over to our CFO, Tom Hennigan.

Thank you, Aren. Today, I'll begin with a review of our second quarter earnings, then I'll discuss portfolio performance and I'll conclude with detail on our balance sheet positioning. As Aren previewed, we had another strong quarter on the earnings front. Total investment income for the second quarter was $60 million, up 3% from the prior quarter. This increase was primarily driven by higher benchmark rates. Total expenses increased in the quarter from $33 million to $34 million. Similar to last quarter, the increase was primarily driven by higher interest expense from rising base rates. The result was total net investment income for the second quarter of $26 million or $0.52 per share, up 4% versus the prior quarter. Importantly, this recent level of earnings is materially above our quarterly core earnings from 2022. Our Board of Directors declared the dividend for the third quarter of 2023 at a total level of $0.44 per share. That's comprised of the $0.37 base dividend plus a $0.07 supplemental, which is payable to shareholders of record as of the close of business on September 29th. This total dividend level of $0.44 allows us to build NAV in the face of an increasingly complex macroeconomic environment. At the same time, it also represents an attractive yield of over 10% on NAV and over 11% on the latest share price. And the $0.52 of NII that we earned this quarter equates to a 12% plus return on 6.30 NAV. In terms of the forward outlook for earnings, we see stability at this $0.52 level based on the combination of current benchmark rates and attractive economics on new deals. So we remain highly confident in our ability to comfortably meet and exceed our $0.37 base dividend and continue paying out supplemental dividends each quarter. On the valuations, our total aggregate realized and unrealized net loss was about $22 million for the quarter. The decrease was driven by a markdown on one of our healthcare services names, American Physician Partners. As we've noted in the past, the healthcare services sector has faced headwinds from labor shortages, wage inflation, and regulatory changes in the US. However, recent financial performance of our other healthcare services names has trended favorably, and we see valuation and earnings upside in these other investments. Additionally, one of the key tenets to our strategy is an acute focus on portfolio management and construction. Maintaining a highly diversified portfolio and conservatively marking it with a prudent use of leverage has allowed us to deliver consistent dividends. Part of our strategy also has been retaining NII. We've retained 15% of NII or $0.32 per share during the LTM period to act as a buffer to NAV volatility. This also has resulted in a dividend coverage ratio of over 140%. Outside of APP, we continue to see overall stability in credit quality across the book. The total fair value of transactions risk rated 3 to 5 indicates some level of downgrades since we made the investment and was down slightly from last quarter. Total nonaccruals decreased from 3.5% to 1.8% based on fair value, aided by the completion of the Pro PT restructuring this quarter. Aren noted that most of our portfolio companies have weathered the inflationary environment well and, of note, we continue to see financial performance improvement and positive valuation migration in investments like direct travel and dermatology associates. I'll finish by touching on our financing facilities and leverage. We continue to be well positioned on the right side of our balance sheet. Statutory leverage was about 1.3 times and net financial leverage ended the quarter slightly lower at 1.1 times, comfortably within our target range. This positioning allows us to effectively deploy capital given the attractive yields and terms available for new investments in the current market. With that, I'll turn it back to Aren.

Thanks, Tom. I would like to finish by highlighting the consistency of our investment approach and reiterate our overall strategy. We are focused on primarily making investments in US companies backed by high-quality sponsors in the middle market. The median EBITDA across our core portfolio at the end of the first quarter was $72 million. Our approach allows us to remain focused on disciplined underwriting, prudent portfolio construction, and conservative risk management. Our portfolio remains highly diversified and is comprised of over 170 investments in 130 companies across over 25 industries. The average exposure to any single portfolio company is less than 1% and 94% of our investments are in senior secured loans. So we feel very well positioned in the current environment. I'd like to now hand the call over to the operator to take your questions. Thank you.

And our first question comes from the line of Melissa Wedel with JPMorgan.

This is A.J. on for Melissa. I have a question on capital returns. First, how are you all thinking about share repurchases going forward? And then given that you're outearning the dividend, could we see a special dividend at the end of the year?

On share repurchases, we closely monitor our current trading price, which significantly influences our evaluation of repurchase levels. In the last quarter, our trading was around 90% to 95% of NAV, and we previously stated that reaching this level would lead us to reduce buybacks, which is evident from the last quarter's actions. We will continue to assess the stock's trading and our overall flow, which is an important aspect for us to manage. While some investors encourage buybacks, we must balance that with ensuring sufficient stock float. Historically, we've repurchased over $150 million and have been supportive over the years. Given the current trading levels, we plan to reduce the buybacks slightly, possibly making smaller purchases. Regarding dividends, we are focused on retaining some net investment income and have done so in the past. We feel confident with returns at the $0.44 level for both NAV and current share price. We might consider a special dividend in the future if necessary, based on the 90% payout requirement, but for now, we intend to maintain the $0.44 dividend, especially if benchmark rates remain stable, with earnings projected between $0.50 and $0.52 per share.

And then just one more. Can you walk us through the Bayside restructuring?

That was a transaction involving a typical restructuring where the lenders agreed to a write-off of debt in exchange for a majority equity stake in that company. As a result, you'll notice multiple levels of debt now on the SOI, along with equity that we're marking as zero. There are different tranches, including a holdco loan and two separate loans at the operating company level, which is why you see multiple line items in that capital structure.

And it comes from the line of Bryce Rowe with B. Riley.

I wanted to maybe ask about portfolio activity, originations, and repayments here for the quarter. Just kind of curious how the pipeline looks and the repayment and sales activity exceeding originations. Just curious how kind of intentional that was, or was that kind of more normal course in terms of the repayment activity?

Bryce, I'd characterize it just as normal course.

We see the situation as dynamic, making strategic decisions at any given time. Our portfolio, as I mentioned earlier, is focused on three main areas: maximizing its potential, exploring sourcing opportunities through One Carlyle, and being very selective with regular sponsored finance. Currently, our average spread for originated transactions is between 6.70 and 6.80, which is significantly better than last year. Our primary aim is to enhance the portfolio consistently. As we consider repayments over the upcoming year, we have a detailed model for managing maturities and are always looking to replace repaid assets, which generally yield around a 5, with new investments that provide spreads of 6.50 and above, along with tight documentation. Ultimately, we're prioritizing quality in our portfolio construction. We're also comfortable holding extra cash to maintain a robust and tested capital structure. As assets come off, our focus remains on quality rather than quantity.

And kind of reading into that, is there an expectation that maybe we see balance sheet leverage compress a little bit more versus relevering up over the, I don't know, over the next six months or so?

When we consider our strategy, we can discuss this in greater detail later, but it's like a complex game we are playing. Over the past year and a half to two years, we've repurchased more than 23% of our float, which translates to a total increase of $0.65. We've moderated our net interest income and reduced leverage, allowing us to retain more resources while minimizing risk in the current market. Our focus has been on selecting higher quality investments while paying down some older debts. In summary, we are carefully evaluating all aspects to create the strongest portfolio possible, and all of these factors are currently being considered.

And then maybe last one for me. Just thinking about capital structure, seeing debt capital markets kind of start to open back up here really over the last month. You've got maturities at the end of next year, so a decent ways away. But just kind of curious how you're thinking about capital structure? Maybe any commentary around the preferreds too, would be helpful.

Are you sitting here in our office? You must be sitting here in our office and our planning sessions thinking about everything. Tom, do you want to start?

We're in constant dialogue with our banking relationships. In fact, we had a meeting less than two months ago. It was like, 'hey, the public market has shut.' Well, guess what, it's opened very quickly. So we're certainly considering various options. We're mindful of those maturities at the end of 2024. We're always looking at what's the best—optimizing the capital structure, diversified capital structure, and looking at the prefs, looking at potential public bond offerings, and getting the right mix in the capital structure. It's something that we have constant dialogue on and we'll continue to assess and do what's best for our shareholders.

And in terms of the—, as Tom said, we're kind of focused holistically and everything I've mentioned and Tom mentioned kind of all works together. And the prefs, we're in constant contact and dialogue with Carlyle proper as well as the Board and thinking about how to think about that as a long-term part of our cap structure. Right now, if you look at the comparable preferred trades in the market, quite frankly, our pref is at 7%, which is about 200 basis points cheap to where the comparable trades are today. So it's actually a pretty good piece of paper as it stands. But we are, along with the unsecureds, thinking about long-term shareholder value. So stay tuned.

Our next question comes from Arren Cyganovich with Citi.

Maybe you could talk a little bit about your investment pipeline, how that's flowing in the competitive environment you're seeing from other BDCs or non-bank competitors?

I'm going to take your questions because I liked your name, you're Arren. So I'd say if you think about—and I mentioned it two questions ago. If you think about the three sleeves of where we source capital, one, you have the sponsor market. The sponsor market is quite busy. Obviously, the BSL market is still choppy, and the high yield market is coming back a little bit, but it is quite busy. I'd say, our average deal in our portfolio is kind of low $70 million of EBITDA. I'd say the large market transactions that we've seen are priced a lot more competitively today. And so we're kind of shying away from those to be able to get better terms and better rate down in our core mid-market. But we are being quite selective in terms of sponsor. The One Carlyle sort of sourcing channel, there's been some transactions that we've announced over the last week or two. Those were – those transactions are less sponsor-driven and more One Carlyle-sourced, so sourced from other teams within Carlyle, that sourcing channel is fairly robust today. Folks trying to partner with Carlyle as a whole and us as Carlyle, that's just direct lending, but our other partners showing up to be a solution provider. So I would expect that to be a much bigger contributor. And then the last piece, which I view as the highest ROIC segment today which, again, after this call, we're happy to get on the phone and walk through things, is literally farming the portfolio. There's a pretty significant portion of this portfolio that we're going after that have the yields that can be improved, docs that can be improved, amendment fees that can be taken, and cash that can be contributed by sponsors in order to amend or extend the transactions and do what's right for the company, be a solution provider to those sponsors but also actually improve our current portfolio with credits we're already very familiar with. And any changes to the current portfolio, those improvements drop straight to the bottom line. So if you were inside of our offices, I guess, two or three weeks ago when we did our Q2 review, you would have kind of heard that message probably ad nauseam which is let's focus on our portfolio and try to be solution providers but also grab value and extract value for our current shareholders because, quite frankly, that's the best risk we have, loans that we are already quite familiar with and improving those terms. So I'd say those are the three general buckets. Is that helpful?

Yes. And then on the American Physician write-down, that seemed to move relatively quickly from, I guess, beginning part of the year to the markdown last quarter. What happened there, what's more specific to that investment versus some of the other healthcare investments?

Arren, this one remains an active and sensitive situation, so we can't get into too many of the deal specifics of that transaction. I think that some of the broader items we've highlighted across the industry are inherent here as we discuss healthcare services, the headwinds in the industry, labor shortages, wage inflation, regulatory changes, specifically the No Surprises Act. In summary, costs have gone up dramatically. And the top line has been squeezed when you were getting last—two years ago, you were getting $150 million encounter and now it's $130 million while you’re faced with wage inflation, that results in a pretty sharp compression of your earnings. And it is really industry-wide, we've seen it with other large-cap healthcare firms, for example, in vision health, it's in a similar space. What I'll note is we've actually compared to our peers, we valued this one relatively conservatively. Last quarter, we were 20 points lower than other BDCs marking this one. The good and bad, I will say, we have the zero valuation right now, full nonaccrual. So the current NAV and the $0.52, that's fully reflective of any negative of this particular position.

And look, I think everyone's asked great questions today because they're all kind of actually elated, Arren. So for us, we have a super — that's a technical term, a super diversified portfolio. So our average position is less than 1%. The goal of keeping leverage low, maintaining—kind of preserving NII just in the event that there’s any bumps in the road, managing portfolio risk, and trying to improve each quarter, that allows us to, quite frankly, mark a little bit more conservatively. So for us, we marked conservatively last quarter. We decided that it was most prudent to mark this position even more conservatively here. The goal of a direct lending portfolio is to have a diversified portfolio that also has predictable and sustainable cash flow. So for us, it isn’t really about the position, it's about kind of the overall portfolio management. So we're trying to be very conservative here but we're taking — we, quite frankly, took a much larger portfolio view as to how and conservatively the market.

Thank you. And as I see no further questions in queue, I will pass it back to Aren LeeKong for closing comments.

Everyone, have a great morning. Thank you. We look forward to speaking to you—some of you next quarter. We look forward to speaking to some of you over the next few days to go deeper on the story. And thank you all for your support. Have a great rest of your summer.

Thank you all for your participation in today's conference. This does conclude the program and you may now disconnect.