Thank you for joining us, and welcome to the Carlyle Secured Lending, Inc. Fourth Quarter 2023 Earnings Conference Call. All participants are currently in listen-only mode. Following the presentations, we will have a Q&A session. This program is being recorded. Now, I would like to introduce your host for today, Daniel Hahn, Shareholder Relations. Please proceed, sir.

Good morning, and welcome to Carlyle Secured Lending's fourth quarter 2023 earnings call. With me on the call this morning is Aren LeeKong, our Chief Executive Officer; and Tom Hennigan, our Financial Officer. Last night, we filed our Form 10-K and issued a press release with the 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. As has become custom, I will focus my remarks on three topics for today's call. First, I'll provide an overview of the fourth quarter and full-year 2023 financial results. Next, I'll touch on the current market environment. And finally, I'll conclude with a few comments on the quarter's investment activity and portfolio positioning. Starting off with earnings. We continue to see our financial performance benefit from the higher base rate environment. In the fourth quarter, we generated net investment income of $0.56 per share, which is an increase of 8% from the prior quarter and represents an annual yield of 13% based on 12/31 NAV. This continues to trend upward from last quarter and the LTM period. As a result of our continued execution of our strategy, the quality of our portfolio and our confidence in the future, beginning this quarter, we are increasing the base dividend by $0.03 from $0.37 to $0.40 per share. Our Board of Directors declared a total first quarter dividend of $0.48 per share, consisting of our new base dividend of $0.40 plus an $0.08 supplemental, a total increase of 9% compared to the prior quarter and an increase of 8% on the base dividend. Our net asset value as of December 31 was $16.99 per share. That's up $0.13 or approximately 1% from the September 30 period, primarily as a result of our Q4 earnings outpacing our dividend. Turning now to the market environment. 2023 was defined by market volatility, slow private equity capital formation and muted M&A activity for most of the year. For context, private equity deal activity and M&A activity were down significantly in '23 compared to '22 and '21, though there was a pickup in M&A activity in the fourth quarter. With this backdrop throughout the year, our investment team leveraged the breadth and depth of the One Carlyle platform to drive value in the evolving market environment by generating significant volume across our existing portfolio of borrowers and Carlyle's broad sourcing network. Leveraging our incumbencies allowed us to source transactions where we had diligence and information advantages, and existing portfolio companies accounted for approximately half of our deal closings during the year. Our flexible origination capabilities enabled us to source transactions from the lower end of the middle market at $25 million of EBITDA and opportunistically all the way up to $450 million of EBITDA in the last year. That includes sponsored and non-sponsored companies across North America and Europe. Outside of our core middle market strategy, we leveraged the One Carlyle network to source complementary, differentiated specialty lending transactions within the asset-based and recurring revenue markets. These trends were evident throughout the year and continue with fourth quarter origination activity. We continue to be pleased with the overall credit performance of our existing portfolio, with revenue and EBITDA up quarter-over-quarter and since inception. Compared to the prior year, portfolio company revenue and EBITDA both expanded by an average of approximately 13% and compared to the prior quarter, 1% and 3%, respectively. Non-accruals were stable in the fourth quarter. And as Tom will discuss in detail later, we expect these levels to improve in the coming quarter. Tactical origination activity, strong credit fundamentals and the current rate environment drove record income for CGBD. Despite the rising base rate environment over the last two years, we have been intentionally conservative with our dividend through the cycle. In our view, our new dividend policy, which Tom will expand upon later, provides a sustainable base dividend along with a transparent framework for supplemental dividends that will enable investors to better anchor their expectations. Lastly, I'd like to spend a few minutes on current positioning. Our portfolio remains highly diversified and is comprised of 173 investments in 128 companies across over 25 industries. The median EBITDA across our portfolio at the end of the quarter was $76 million. The average exposure in any single portfolio company is less than 1%, and 95% of our investments are in senior secured loans. I will now hand the call over to our CFO, Tom Hennigan.

Thanks, Aren. Today, I'll begin with a review of our fourth quarter earnings, then I'll discuss portfolio performance, and I'll complete with detail on our balance sheet positioning. As Aren previewed, we had another strong quarter on the earnings front. Total investment income for the fourth quarter was $63 million, up about $2 million from the prior quarter. This increase will be driven by the continued positive impact of base rates and an increase in both other income and OID acceleration, which were aided by prepayment activity. Total expenses of $34 million were flat versus prior quarter. Of note, total interest expense was up modestly as base rates stabilized during the quarter. The result was net investment income for the fourth quarter of $28 million or $0.56 per share, up nearly 8% from the prior quarter. And this level represents an all-time high for core NII in any quarter. Our Board of Directors declared the dividends for the first quarter of 2024 at a total level of $0.48 per share. That's comprised of the new $0.40 base dividend plus an $0.08 supplemental, which is payable to shareholders of record as of the close of business on March 29. This total dividend level reflects an increase of 9% over the previous $0.44 per share and reflects the earnings power and stability of our portfolio despite a complex macroeconomic environment. Our base dividend coverage of 140% for the quarter remains above the BDC peer set average. And we've grown the base dividend by 25% since 2022. At the same time, the total dividend level also represents an attractive yield of over 12% based on the recent share price. In terms of the forward outlook for earnings for the rest of 2024, we see stability at this $0.50 plus level based on the latest interest rate curves and our current conservative positioning on leverage. Despite rising rates, we've maintained a conservative, disciplined approach that we believe will enable us to continue consistent dividend payout in a variety of rate environments, including when rates normalize. So we remain highly confident in our ability to comfortably meet and exceed our new $0.40 base dividend and continue paying out supplemental dividends each quarter. And going forward, we're going to shift to a floating supplemental dividend construct and target paying out at least 50% of excess earnings through the supplemental dividend, which will allow us to be flexible as the portfolio evolves and base rates fluctuate. On valuations, our total aggregate realized and unrealized net gain was about $0.5 million for the quarter, supported by a slight net positive movement in valuations. This increase in valuations combined with Q4 earnings exceeding the dividend resulted in our NAV increasing from $16.86 to $16.99 per share. Turning to the portfolio. We continue to see overall stability in credit quality across the book. Similar to last quarter, there were no new non-accruals and no additions to our watch list, which are deals with risk ratings 4 or 5. Total non-accruals were effectively flat quarter-over-quarter, and we're very pleased to report that Dermatology Associates was successfully recapitalized in early February with the lenders taking equity control. So we expect an improvement in non-accruals when we report March results. We continue to proactively manage the portfolio and are working with sponsors to ensure borrowers have adequate liquidity. You'll see that PIK interest ticked up over the course of 2023. In almost all cases, when we provided PIK relief for existing borrowers, that was accompanied by significant equity support from the sponsor. 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. Leverage is down quarter-over-quarter, and we're intentionally running leverage conservatively at the lower end of our target range to maintain the flexibility to invest in attractive opportunities. Statutory leverage was about 1.2x, and net financial leverage ended the quarter modestly lower, right about one turn, the lowest level since early 2022. This positioning allows us to remain opportunistic as the macroeconomic environment evolves and deal activity looks to pick up in 2024. 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 investment strategy. We are primarily focused on making senior secured floating rate investments to U.S. companies backed by high-quality sponsors primarily in the mid-market. Market demand for private credit remains high. And we continue to focus on sourcing transactions with significant equity cushions, attractive leverage levels, strong documentation and attractive spreads relative to not only the current market but also historical originations through our disciplined underwriting, prudent portfolio construction and conservative approach to risk management. With attractive new originations, a stable portfolio and reduced non-accruals, we benefited from continued execution of our strategy in 2023 and remain committed to delivering a non-volatile cash flow stream to our investors through consistent income and solid credit performance. I'd like to now hand the call over to the operator to take your questions, and thank you so much.

And our first question comes from the line of Bryce Rowe from B. Riley.

Wanted to maybe piggyback on some of the prepared comments there around potential pickup in activity. We've heard that from other BDCs. And if you could kind of just help us think about what that might look like, especially relative to the leverage profile of your balance sheet at this point. I mean you've noted that you're at one of the lowest leverage points in quite a while. So just kind of want to understand how that could evolve over the course of '24.

Yes. When we consider leverage, it's a complex topic. Currently, we're able to originate loans at S plus 6 or higher, whereas last year, the average loan in CGBD was around S plus 650. Our team can confirm the exact figures. We're focused on paying out a sustainable and stable cash flow, which is essential for any BDC without becoming over-leveraged. The aim isn't merely to perform at the highest level but to ensure we provide that steady cash flow. Therefore, leverage is closely tied to our overall strategy. In terms of activity, there was an increase in transactions in the fourth quarter, and the first quarter has remained consistent. However, our initial focus is not on how many more deals we can do. Instead, we want to ensure that each new transaction improves our current portfolio. We evaluate how any increase in volume affects the fund's performance. It's not about quantity but about generating stable cash flows. While leverage may not remain at one turn indefinitely, we are currently benefiting from it in this market given our base returns. I apologize if this doesn't precisely answer your question, but I hope it addresses it in some way. Even if deal activity increases, I prefer having a broad selection to choose the best opportunities. I always welcome more deals, but the goal remains how to build a solid portfolio that produces predictable cash flows for everyone involved. I hope that clarifies things.

Yes, for sure. Appreciate it. Definitely gets to the meat of the question. And maybe a follow-up for Tom, since you talked about it in the prepared remarks, the Dermatology Associates investment crystallized here in February, as you noted. Can you talk about what the mechanics of that might look like in the first quarter, given that you were actually carrying at a fair value mark above cost?

Right. So the new capital structure, like the similar structure, is going to have two tranches of debt, the first debt and the last debt. And then you'll see there will be a new equity tranche on our SOI. One important note is, in the aggregate, our total fair value will be, a crystal ball, that’s roughly unchanged. So total fair value is not going to change very much. It's just there'll be different instruments, and there'll be more value moving from what is now our last out on non-accrual to an equity tranche and then there'll be more debt on accrual status in those new tranches. So net-net, positive impact on a quarterly but full quarter basis of about $0.01 per share.

Okay.

There is no impact on fair value, but non-accruals are decreasing significantly with that transaction, and the total is being removed from non-accrual statistics.

Yes. Okay. Got it. And then maybe last one for me. You all have swapped out the fixed rate for a floating rate on the baby bonds. Maybe an obvious answer from you all, but just any thought around why do that as opposed to just keeping a fixed rate there?

With the 8%, when we consider our maturities at the end of 2024, we aimed to be cautious and diversify instead of relying solely on a market rebound. This is our first step in managing these upcoming maturities. An 8.2% rate for the market was decent, but honestly, it’s not a rate we wanted to maintain long-term. Therefore, we believed it was best to switch to a floating rate, especially with the expectation that base rates may decrease. Over time, this will allow us to pay significantly less than 8.2%, according to our projections for rate curves. Our next step is to potentially pursue an index-eligible deal, whether that happens later in 2024 or early 2025, to increase our overall unsecured debt exposure, which is something we are actively working on and will monitor throughout the next year.

And our next question comes from the line of Finian O'Shea from Wells Fargo Securities.

Aren, I appreciate the portfolio cover as it relates to the core middle market strategy and opportunistically partaking in the larger market and/or ARR deals. So in these instances, does that mean the direct lending platform that serves the BDC under you is opportunistically doing other styles? Or is it that the BDC complex is claiming this deal flow from other Carlyle credit verticals? And then second part there, are you still dedicated to the core middle market? Or are you drifting up market by design?

Let me start with your first question, which is a good one. Our focus is on the core middle market. If you look at our entire platform, the median EBITDA of the companies we lend to is around $76 million. We have a significant origination presence in direct lending and private credit. When my team and I consider direct lending, our aim is to build a substantial portfolio where the average position is below 1%. Our main product is the cash flow stream generated from this portfolio. In the first half of last year, transactions were limited, and we saw opportunities in the upper market, particularly in companies with EBITDA well above $100 million. We were able to secure spreads exceeding those in the mid-market, around 675 to 700 basis points, while obtaining similar covenants and terms. This allowed us to engage in direct lending from a risk perspective. We faced a choice about what would be safer for our investors. If we could obtain comparable terms and protections to the mid-market while having the security of larger businesses that typically lack such covenants, we chose to pursue opportunities in that upper market. However, by the second half of the year, as competition increased in the upper market and retail flows returned to other direct lending strategies, we shifted back to our core mid-market focus, which we define as being in the range of $25 million to $75 million. Regarding asset-backed lending (ABL) strategies, we have a dedicated team that focuses on ABL for core middle market companies, emphasizing downside protection through tangible assets like receivables and real estate rather than cash flow loans. Additionally, we have a sizable software team that reports to me, and while they've engaged in annual recurring revenue (ARR) deals opportunistically, we've been less exposed to ARR compared to some peers. Ultimately, my goal is to maximize returns while minimizing risk. We concentrate on direct lending but will opportunistically explore upmarket opportunities if they arise, although currently, we're more focused on the mid-market. I hope that clarifies things.

Yes, very much. And to get back to Dermatology Associates. Sorry if I missed any of this part of the dialogue, but it sounds like you just took control or received control. But this, of course, had been a long challenged credit, where you had restructured the debt somewhat previously. So can you give some more color on the state of the investment now? Do you plan to put more money into it or maybe immediately bring in a new sponsor partner? And then has the EBITDA trajectory stabilized? Or is it still in decline?

I’ll start with the last part since that's one of my favorite questions. The company has shown 12 consecutive quarters of EBITDA growth, demonstrating steady performance with a consistent upward trend and modest increases each quarter, all coming after the pandemic. Looking ahead, we expect stable growth. We're not aiming for major expansions or significant new investments at this time. The new equity group will determine the right moment to exit the investment. We plan to invest wisely without any elaborate strategies. The company’s performance remains stable and is improving, and we will assess the right timing for exiting the investment.

That's a great question. Over a year ago, we at Carlyle Direct Lending took significant steps to carefully analyze our processes and ensure we were being prudent and proactive in managing our portfolio, especially in delicate situations. We're not at the beginning of this journey; rather, we're nearing the end, and we have a strong handle on it. Many of our competitors are just starting this process. While it may seem uneventful, our approach is to maintain a solid portfolio, and we'll only share that we’ve made a significant turn when we have a consistent track record of positive results. Our focus remains on ensuring we approach things conservatively, and we feel confident in our current position.

And our next question comes from the line of Arren Cyganovich from Citi.

A question on maybe just the competitive dynamics as activity increased.

Arren, could you speak up? You're a bit hard to hear.

I'm muffled. Sorry. Is it better?

Sure.

Sorry about that. I guess from a competitive standpoint, as activity is increasing or hearing spreads are tightening a bit, how is that changing, I guess, relative to maybe three or six months ago?

I've listened to a few calls from our peers, and that question seems common. This situation isn't unique. When there are large returns, as we learned in Economics 101, capital flows in to chase those returns, which causes spreads to normalize. Compared to the first quarter and first half of last year, the average deal size was likely around 675 to 700, which is abnormal. Following an unusually wide spread and a high base rate where returns were above 13%, things have tightened considerably since then. In the upper end of the market, transactions over $100 million, which might have been in the BSL market previously, have shifted from above 600 to between 500 and 550. For standard mid-market direct lending deals, we're averaging around 550 to 625. Despite these changes, base rates remain where they are, allowing for historically high returns with minimal leverage. However, in the upper market, the existence and structure of covenants resemble the BSL market more closely, indicating a trend towards cov-lite arrangements. In the standard mid-market, covenants are more common, and documentation is generally holding firm. Leverage levels are also stable, not significantly increasing even as spreads have narrowed, with averages still in the low 5s and some cases in the high 4s, reflecting a low amount of leverage overall. Therefore, depending on market conditions, we remain opportunistic in our approach. Certain areas of the market are notably more competitive and aggressive, and we tend to bypass those to find better opportunities. The larger market is currently the most competitive, which is why we are being selective. In the mid-market, more value can be found, with a greater chance of covenants and stronger documentation. Overall, leverage levels across the market are lower than historical averages.

Yes, that’s correct. Just a quick question about your other income. I believe you mentioned it increased quarter-to-quarter due to prepayment activity. We are noticing more prepayment fees. Do you anticipate that your other income will align more with your longer-term historical performance in this type of environment? Or do you expect it to decrease back to the levels seen in the previous three quarters?

Arren, it's Tom. When we examine other income or event-driven income, we consider a mix of total OID acceleration and other income. This line item usually fluctuates based on repayments and amendment activities. Historically, it's been just under $4 million per quarter. Earlier in 2023, due to lower prepayment activity, it dropped to about $3 million per quarter, even below that. This quarter, the total came in around $4.5 million. Compared to the historical trend, this is about $0.5 million or $0.01 higher than what we've typically seen. It marked an increase for the fourth quarter, but it’s only slightly above the historical average.

And our next question comes from Melissa Wedel from JPMorgan.

Most of my questions have already been addressed. I wanted to follow up on one of the slides regarding the risk rating distribution. This seems like a minor point, considering the strong fundamental performance of companies in the portfolio as a whole. However, I did notice a slight increase in the number of 3- and 4-rated portfolio companies. My question is, if you are seeing any specific challenges for these portfolio companies, where are they originating from? Is it due to ongoing inflationary pressures or rising labor costs? I’m interested in your insights.

So maybe I'll start, and Melissa, thank you for the question, and Tom, feel free to join in. Regarding risk ratings, we have several processes in place to ensure we have a comprehensive understanding of the situation. The key point I want to make is that when we adjust ratings from 2 to 3 or 3 to 4, it often has less to do with immediate problems—especially if it's a 5, which indicates serious issues. In many instances, it's more about us ensuring that we allocate the right resources around Carlyle proactively. One aspect we've sometimes overlooked in direct lending is that if there is an issue and you're actively managing your book while monitoring your numbers, you typically have 12 to 24 months to prepare ahead of time. So when we see small movements from 2 to 3 or from 3 to 4, it's generally a matter of us signaling that we need additional resources to closely examine a name or two. Additionally, compared to a year ago, much of what we've observed was driven by inflation. You might recall that we faced challenges in the health care sector last year, which we've since addressed, primarily due to inflationary pressures. This past year, if you assess our overall portfolio, the inflation effects still linger in some areas, but our average business has seen about a 13% increase in revenue and slightly more than that in EBITDA. This indicates that both revenue and EBITDA are generally growing in tandem, with EBITDA now outpacing revenue. So while inflation was a major topic a year ago, it's not as significant now. In fact, it's interesting to note that while we were discussing inflation concerns, we're also talking about potential interest rate cuts. This indicates we've likely turned a corner with our portfolio overall. Tom, is there anything I missed?

This quarter, the changes in risk ratings have been influenced by two loans in the fourth category that contributed to the increase in fair value. One of these loans is in Dermatology, which has shown a steady increase each quarter. The other is Pro-PT, now referred to as Bayside, which is also on non-accrual but has seen a valuation improvement. Overall, we have experienced slight upward momentum, which is encouraging. Our two non-accrual deals are trending positively. In the third category, there was an increase of approximately $15 million mainly due to two transactions. As we focus on these credits, it's important to note that the risk associated with them has increased. Leverage is up, and EBITDA has likely decreased since the time of closing. However, we are not concerned about losses in this context. We are aware of the notable themes affecting these deals, particularly in consumer discretionary sectors where demand has weakened, and also across our industrial portfolio where we are observing destocking trends, leading to a couple of downgrades. These are some key themes to consider as we look at the movement from category two to category three.

But much more relative to a year ago, where everything was inflation, now just more idiosyncratic, and we're on top of it. Does that help, Melissa?

It's very helpful.

Thanks for joining the call.

This does conclude the question-and-answer session of today's program. I'd like to hand the program back to Aren LeeKong for any further remarks.

Thank you, operator. Everyone, thanks for joining. We look forward to talking to you later in the day. We appreciate your partnership, and talk to you next quarter.

Thank you, ladies and gentlemen, for your participation in today's conference. This does conclude the program. You may now disconnect. Good day.