Investcorp Credit Management BDC, Inc. Q1 FY2021 Earnings Call

Welcome to the scheduled earnings first quarter ended September 30, 2020. Your speakers for today's call are Mike Mauer, Chris Jansen and Rocco DelGuercio. I will now turn the call over to your speakers. Please begin.

Thank you, operator, and thanks to all of you for joining us today. I'm joined by Chris Jansen, my Co-Chief Investment Officer; and Rocco DelGuercio, our CFO. Before we begin, Rocco will give our customary disclaimer regarding information and forward-looking statements. Rocco?

Thanks, Mike. I would like to remind everyone that today's call is being recorded and that this call is the property of Investcorp Credit Management BDC. Any unauthorized podcast of this call in any form is strictly prohibited. Audio replay of the call will be available by visiting our investor relations page on our website at icmbdc.com. I would also like to call your attention to the safe harbor disclosure in our press release regarding forward-looking information and remind everyone that today's call may include forward-looking statements and projections. Actual results may differ materially from these projections. We will not update forward-looking statements unless required by law. To obtain copies of our latest SEC filings, please visit our Investor Relations page on our website. At this time, I'd like to turn the call back over to our Chairman and CEO, Michael Mauer.

Thanks, Rocco. To borrow from this Chinese proverb, we continue to live in interesting times. COVID-19 continues to be a public health catastrophe for people around the world. Efforts to contain the pandemic have significant economic consequences, which affect both large and small businesses. Against this backdrop, our challenge is originating and maintaining a portfolio of stable loan investments, which will perform through the cycle with structural protections for the preservation of capital. We're fortunate that our team has remained safe and healthy over the past months, working together seamlessly despite the challenges we face. We have avoided distress in the portfolio through sector selection, mainly by staying away from the industries which have been hardest hit by the pandemic, such as hospitality, restaurants, and traditional retailers. Our borrowers are in 24 sectors doing business across the country. Our work to reposition the portfolio has brought this diversification. And we've also decreased the average size of our loans from $11.2 million 2 years ago to $6.6 million today. Last quarter, we made investments in Clover Technologies and Techniplas, in both cases to protect our existing interest. This quarter, we took similar actions with our loan to Deluxe Toronto. Our new investment was at once opportunistic, carrying significantly better economics than a typical loan, as well as projected, helping the company to bridge to a sale of its assets. Chris will go into more detail about our Deluxe investments as he walks through all of our investment activity during and after the quarter, and then Rocco will discuss our financial results. I'll conclude our prepared remarks with commentary on our leverage, Investcorp's share repurchases, our dividend, and our outlook for the next few months. As always, we'll end with Q&A. With that, I'll turn it over to Chris.

Thanks, Mike. We invested in 3 portfolio companies this quarter, including 2 new portfolio companies. We made first-lien investments in all 3 as well as the preferred equity investment in one of our new portfolio companies. We also had full realizations on 4 investments during the quarter. After quarter end, we funded a delayed draw term loan and had full realizations on 2 investments and a significant partial utilization on the third. First, our additional investments in existing portfolio companies. We increased our position in the first-lien loan to Golden Hippo. This has been a stellar performer for us since we made our first investment last year. We also funded under Golden Hippo's revolver during the quarter. The yield on both of these positions is approximately 8.6%. Second, we participated in a club deal for Advanced Solutions International, or ASI. ASI provides CRM software and related functionality to nonprofit organizations, helping them manage membership, donations, and dues. We made a first-lien investment, which yields approximately 9.4%, as well as the preferred equity investment. We are a lender under Deluxe Entertainment Services super priority term loan. This loan was made to the U.S. parent company of our existing portfolio company, Deluxe Toronto Ltd. The super priority term loan bridged Deluxe's liquidity as it progressed through an M&A process to sell the business. This loan is short-dated; we carried upfront and back-end fees, so the yield has been particularly meaningful. After quarter end, we funded a second draw on the super priority term loan. I'm pleased to share with you that last week, Deluxe's sale was completed and the super priority term loan was repaid in full. The short holding period and the aforementioned fees produced a very high positive IRR. We also received a repayment of approximately 70% of our principal on our Deluxe Toronto loan. We expect additional recoveries on this loan over the coming quarters. Turning to our realizations during the September quarter. We received the full prepayment on the first-lien loan to Endemol early in the third quarter. Our IRR on the Endemol investment, which we have had for approximately 6 years, is 12.9%. We also sold our remaining investment in U.S. Lumber, which produced an IRR of 8.3%. Finally, we were repaid on the term loan D&A for 1888, which is the smallest of the 1888 loans. These 2 loans repaid in accordance with their terms with IRRs of 6.9% on each. After quarter end, we also received repayment in full for our loan to RPX. Our fully realized IRR was 9%. Finally, after quarter end, we committed to a new portfolio company, Veregy. Veregy is an energy services company providing environmentally efficient upgrades, assistance for the municipal, university, school, and hospital markets. Our yield at cost is 7.8%. Using the GICS standard as of September 30, our largest industry concentration was professional services at 12%; followed by construction and engineering at 11.6%; energy, equipment, and services at 10.1%; trading companies and distributors at 9.5%; and containers and packaging at 6.4%. Our portfolio companies are in 24 GICS industries as of quarter end, including our equity and more acquisitions. As of September 30, our portfolio company count was 38 versus 38 at June 30. Our portfolio company count is 37 today due to the repayments of RPX and Deluxe's super priority loan and the pending closing of Veregy.

Thanks, Chris. For the quarter ended September 30, 2020, our net investment income was $2.7 million or $0.20 per share. The fair value of our portfolio was $261.3 million compared to $270.6 million at June 30. Our portfolio's net increase from operations this quarter was approximately $2.8 million. Our new debt investments during the quarter had an average yield of 14.6%, and investments exited during the quarter had an average yield of 10.9%. Fully realized investments had an average IRR of 12.3%. The weighted average yield of our debt portfolio was 9.25%, a decrease of 33 basis points from June 30. As of September 30, our portfolio consists of 38 portfolio companies. 87.8% of our investments were in first lien, 5.4% of our portfolio was in second lien, and 4.2% was in unitranche loans. The remaining 2.6% was invested in equity, warrants, and other positions. 99.5% of our debt portfolio was invested in floating rate instruments, and 0.5% in fixed rate investments. Our average portfolio investment was approximately $6.6 million. Our largest portfolio company investment was PGi at $14.8 million. Our largest single investment is Empire Office at $12 million. We were 1.53x levered as of September 30 compared to 1.69x levered as of June 30. We had 1 portfolio company on nonaccrual as of September 30. And finally, with respect to our liquidity, as of September 30, we had $8.4 million in cash, $6.5 million in restricted cash, and $6 million capacity under our revolving credit facility at UBS. Additional information regarding the composition of our portfolio is included in our Form 10-Q, which was filed yesterday.

Thank you, Rocco. Our guidance on leverage is a target of 1.25 to 1.5x. Last quarter, we were above that target at 1.69x, and this quarter, our leverage has come down substantially to 1.53x. Our guidance has not changed, and we anticipate that our investment activity will bring us into our target range. We covered our September quarterly dividend with NII, and we expect to cover our current quarter as well. As we committed to do, we waived the portion of our management fee associated with base management fees over 1x leverage. Our Board of Directors declared a distribution for the quarter ended December 31, 2020, of $0.15 per share, payable on January 4, 2021, to shareholders of record as of December 10. The Board also declared a supplemental distribution of $0.03 per share payable on those same dates. We believe that this dividend level is stable, and the supplemental distribution is a prudent method to capture the additional earning power of the portfolio. Investcorp has made 2 separate commitments to purchase shares in ICMB. First, Investcorp has made open market purchases under a 10b5 program and did not purchase any additional shares this quarter. To date, 281,775 shares have been purchased since the inception of the program. Secondly, Investcorp has committed to purchase shares at NAV. Investcorp did not make any additional purchases between June 30 and September 30 and has purchased 227,000 shares to date. We look forward to a return to a more normal environment for lending, for our team, and for our country. Still, we are well positioned to stay the course. We have positioned the portfolio to have a strong focus on first liens, resilient borrowers, and we will maintain our disciplined approach to underwriting. Our pipeline opportunities are consistent with the themes in our portfolio. As always, our foremost concern is the preservation of shareholder capital. Thank you.

Please open the line for Q&A.

Clarification, why did interest income go up in the quarter when both your investment assets went down and your portfolio yields went down? Hello?

Chris, it's Rocco. You're talking about interest earned or interest paid?

Interest income on the income statement.

Yes, we experienced some acceleration in interest income. Specifically, Endemol repaid around $400,000, which contributed to that figure. This acceleration is also mentioned in the notes of the financial statement.

Great. Okay. All right. And then I guess on 1888 Industrial Term B, that is the nonaccrual, but 1888 has multiple credits with you guys. Are the other credits still performing?

Yes. So 1888 Term B is the only one that is on nonaccrual book. The other tranches are all performing.

Sorry, I dropped there, Rocco. I'm sorry, I couldn't even hear it. I had a technology problem. Go ahead.

Yes. Chris, could you...

Yes, it's Chris Jansen. Regarding 1888, the Term Loan B is a last out. The other loans are on accrual. The D and E loans, which were paid out, were due at the end of the quarter, and they were also the first acquisitions, although they were quite small in comparison.

Okay. And then I guess my final question is the yield on new investments at 14.6% seems quite high. Just trying to get an understanding why that might be.

Yes. Let me provide some context. We had a short duration on a super priority for Deluxe, which facilitated the sale that Chris mentioned earlier. Given the short duration, it skews the numbers slightly. The yield on that was around 50% over its short life. Excluding that loan, we made two other new investments: one to an existing portfolio company, Golden Hippo, at approximately 8.6%, and two tranches to ASI, which is a new investment. One tranche is super senior at 9.4% and a convertible preferred with very attractive terms yielding a little over 30%. Averaging the yields of Golden Hippo and ASI, while ignoring Deluxe, gives us an average rate of about 10.8%. I hope this provides some clarity.

Great. And Chris, the 3 new investments were Golden Hippo, ASI, and Deluxe.

I wanted to ask if you could provide a breakdown or some general insights on NAV appreciation or recovery this year. I'm interested in understanding what has been restraining book value so far this year, particularly in light of rising loan prices. If there are any credit-specific issues, could you elaborate on those?

I'll begin and then Chris can provide additional insights. The primary factor that has hindered us is 1888, specifically in oilfield services and oil tank operations during the first quarter. Although there has been a gradual recovery, the increase in oil prices has led to a very limited response in terms of rigs becoming operational again and the deployment of oilfield services. You may have noticed ongoing markdowns associated with 1888. This situation is the main obstacle to our recovery. There are a few other credits that have been significantly affected but are showing strong liquidity. I believe these will bounce back as COVID subsides in the next 6 to 12 months. For example, Arcade Bioplan is one, and United Road has also recovered over the last quarter after a decline in the first quarter. PGi has greatly benefited from this trend since March. Chris, please feel free to add more.

This quarter, we've seen strong performance from Premiere Global, which experienced a significant increase in their conference calling services and has maintained solid rates. United Road, which specializes in transporting automobiles from docks to dealerships, has also benefited as they are one of the larger players in the market. While this is fortunate for them, many of their smaller competitors are struggling to survive. With the rebound in U.S. automobile manufacturing, United Road has gained advantages, though this has yet to reflect in their income statement. They have been effective in managing their liquidity, as has Arcade Bioplan, which is also starting to recover and has a solid liquidity position to navigate through challenges.

Okay. That's pretty good commentary. And then next, I just want to get a sense, maybe what is the plan over the next year or so in terms of managing leverage? Are you guys sort of looking to build up more repayments, I guess, kind of put a limit or a control on the level of capital deployment to continue kind of preserving a little bit of liquidity or paying down debt? Or are you just basically looking to balance the 2? So any commentary over kind of just your investment outlook as far as managing liquidity would be helpful.

Yes. We brought leverage down from close to 1.7x to just over 1.5x over the last quarter. Our target range has always been 1.25x to 1.5x. We will continue to look at it in that range. I think over the near term, it's probably at the higher end of that range, around 1.5x. But that 1.25x to 1.5x, we think is the prudent area right now. The thing that we continue to grapple with, and Chris highlighted, is a lot of the good news, you get repayments in. And typically, the notice when we get a repayment in is 7 to 14 days, and the amount of time to do a new investment. If we were to get notice 14 days, that would be lightning speed. There's one we've been working on now for 6 to 8 weeks, and it's still at least 4 to 6 weeks away from completion, assuming that we get there. And most are at least 6 to 8 weeks. So it's managing that pipeline of things coming in versus things that we expect to go out. And there are a few that we have today that we would expect to repay, but that's not certain. They don't give us 60 days notice. And so managing around those flows is the critical thing. And so that target of 1.25 to 1.5x is where we are and where we will continue to be.

I appreciate that. For my last question, from your viewpoint as a participant in the deal market and involved in various club deals, how would you describe the current state of the deal market, particularly regarding the economics? Are you noticing that terms and pricing are returning to pre-COVID levels, and is the environment becoming more competitive? Any insights on this would be appreciated.

For larger deals, we typically start with an EBITDA around $10 million, reaching up to $100 million and sometimes exceeding $200 million. The competition in the $50 million to $100 million EBITDA range is just as competitive, if not more, than it was before COVID, due to a lack of quality deal opportunities. Recently, our deals have mostly been in the $10 million to $30 million EBITDA range, with some slightly lower. In these cases, we are working with clubs of about 3 to 6 lenders, and the spreads are similar or slightly wider than pre-COVID. The equity contributions are larger than before; instead of $30 million to $40 million, we are seeing $40 million to $50 million, with a few cases exceeding $50 million. This increase is partly because we want to ensure comfort with smaller EBITDAs and also because sponsors have significant capital available. They are prepared to invest more in their portfolio companies, preferring to take on less debt at rates between 8% to 12%. They anticipate that once the COVID situation stabilizes, they will likely refinance us in 12 to 24 months. Essentially, larger firms are quite aggressive, while smaller ones are more measured.

Our next question comes from Robert Dodd.

To start with some questions about the portfolio, 1888, as you mentioned, has been a bit of a setback. It made very small B&E loans in the quarter. Should we interpret this as something regarding the sustainability of its capital structure moving forward? Additionally, do you think the ultimate value of the business has been permanently diminished, which might impact the expected recoveries due to COVID, or do you believe it's more of a cyclical issue contingent on the oil market recovery, even if it doesn’t reach triple digits? Can we expect to recover the full value of that loan?

Without sharing any confidential details, I appreciate the attention to this topic. It's complex, and I can outline three key points. We're definitely in a cycle, and while it will eventually recover, I can't predict when that will happen. It's unlikely to bounce back in the next month, but should oil prices rise to $60 a barrel in that timeframe, we could see value recovery in the long run, although I don't expect a quick turnaround. The key question is the timing of that recovery, which remains uncertain. We're focusing on maintaining adequate liquidity and have secured BBB funding to support our efforts. On a positive note, the new CEO has effectively managed expenses during this downturn, which is commendable. Additionally, our management team is concentrating on expanding our non-oilfield services. We have one of the most modern construction fabrication facilities located near Denver, and we are currently in discussions with multiple non-oil and gas partners for significant projects. If we can successfully diversify, we aim to ensure that 30% to 60% of our revenue comes from non-oil and gas sources, which is crucial for weathering downturns. This diversification strategy is in motion, and if it's successful over the next six to twelve months, there could be considerable upside in value. However, it's a complicated situation dependent on various factors, including timing. I'm not sure if that fully answers your question.

You did. You did. I really appreciate that answer. One tiny little one before I move on to the last question. Veregy, when you said the words, energy services, it may be a little nervous for a while, but it sounds like you need school, hospital, can you clarify specifically what kind of energy services it's providing? I mean, hopefully, it's not something...

Absolutely. Chris, do you want to walk through that?

Yes. Robert, it's more along the lines of more efficiently running their cost structures. There's nothing to do with energy out of the ground. It's systems and heating and cooling and pumping and things like that. So it is more the internal works and again, trying to find more energy-efficient solutions for their buildings and their facilities.

I understand. Thank you for the clarification. So, one last question regarding leverage. It seems that leverage will decrease this quarter due to repayments and pipelines. Where do you anticipate the leverage will be? Is the goal in the near term to target the lower end of the leverage range, since you are currently at the high end? What is your target for where you would like to be in this cycle within that leverage range?

Right. So conceptually, all things being equal, what we're finding right now in the new investments, Veregy being one example of great backlog, things like that. ASI that we did a great non-correlated business, diversified customer base. It's a recurring revenue integral part of businesses across the country that if we can continue to reinvest in those as we get repayments, we will. I would expect that we could drop down into the low end of that range, but we're trying to make sure we keep a pipeline and if we keep reinvesting and find the right investments, we could very easily be in a 1.4x to 1.5x. If repayments don't come in, we could blip over to 1.5x. But we're not targeting to blip over it. We're targeting probably to be more in the 1.4x, 1.5x, and then drop down in the lower end and make sure that we've got pipeline to redeploy to be in this 1.4x, 1.5x. So when we drop down, we're not dropping down from 1.25x to 1x. Does that make sense?

Got it. Yes, that makes sense. I appreciate it.

Please open the line for further questions.

Thank you, everyone. We appreciate your time. And I will apologize now for audio quality. Technology has been difficult during COVID, and hopefully, we continue to get that better. But thank you very much.

This concludes today's conference call. Thank you for attending.