MidCap Financial Investment Corp Q2 FY2021 Earnings Call

Good afternoon, and welcome to the Apollo Investment Corporation's Earnings Conference Call for the period ended September 30, 2020. I would now like to turn the call over to Elizabeth Besen, Investor Relations Manager of Apollo Investment Corporation. Please go ahead.

Thank you, operator, and thank you, everyone, for joining us today. Speaking on today's call are Howard Widra, Chief Executive Officer; Tanner Powell, President and Chief Investment Officer; and Greg Hunt, Chief Financial Officer. I'd like to advise everyone that today's call and webcast are being recorded. Please note that they are the property of Apollo Investment Corporation and that any unauthorized broadcast in any form is strictly prohibited. Information about the audio replay of this call is available in our earnings release. I'd also like to call your attention to the customary safe harbor disclosure in our press release regarding forward-looking information. Today's conference call and webcast may include forward-looking statements. Forward-looking statements involve risks and uncertainties, including, but not limited to, statements as to our future results, our business prospects and the prospects of our portfolio companies. You should refer to our most recent filings with the SEC for risks that apply to our business and that may adversely affect any forward-looking statements we make. We do not undertake to update our forward-looking statements or projections unless required by law. To obtain copies of our SEC filings, please visit our website at www.apolloic.com. I'd also like to remind everyone that we've posted a supplemental financial information package on our website, which contains information about the portfolio as well as the company's financial performance. At this time, I'd like to turn the call over to our Chief Executive Officer, Howard Widra.

Thanks, Elizabeth. Good afternoon, and thank you, everyone, for joining us today. Before we begin, I'd like to say that we hope everyone is doing well and you and your families are safe and healthy. I'll begin today's call with an overview of our portfolio and a review of our financial results for the September quarter. Following my remarks, Tanner will review our investment activity for the quarter and will discuss the impact of the COVID-19 pandemic on our portfolio. Greg will then review our financial results and provide an update on our liquidity position. We will then open the call to questions. During today's call, we will be referring to some of the slides in our investor presentation, which is posted on our website. As we all know, the COVID-19 pandemic has been an unprecedented shock to the global economy. We believe our portfolio repositioning over the past several years has allowed us to enter this challenging period with a well-diversified senior corporate lending portfolio invested in less cyclical industries with granular position sizes. Despite the significant economic headwinds due to the pandemic, our corporate lending portfolio continues to perform well, and we continue to recoup some of the unrealized losses taken in the March quarter. Over the past two quarters, our corporate lending portfolio has recovered approximately $22 million or $0.34 per share of unrealized losses. We believe the performance of our corporate lending portfolio during this challenging period demonstrates its resiliency and quality. The corporate lending portfolio, which represents 79% of the total investment portfolio, is at 86% first lien, 100% floating rate and 86% sponsor backed. No investments were placed on nonaccrual status during the quarter. We continue to work closely with our sponsor clients and portfolio companies, and we have generally been pleased with how sponsors and borrowers have been managing through the current environment. Conversations with sponsors and management teams continue to be cooperative and constructive. We are generally seeing strong equity support by sponsors. Away from corporate lending, results for the quarter were negatively impacted by our investment in Merx and from noncore and legacy investments, which Tanner will discuss. During the September quarter, we made significant progress deleveraging to within our target range of 1.4x to 1.6x. The fund's net leverage ratio declined to 1.56x at the end of September compared to 1.66x at the end of June and 1.71x at the end of March. The decline in the September quarter was due to a combination of strong repayment activity and net gain of the portfolio and retained earnings. Repayments in the September quarter included approximately $21 million from noncore assets. Since the end of September through November 3, we have received additional gross paydowns of approximately $130 million. Pro forma for these paydowns and some net fundings and assuming no changes to fair value up or down, net leverage is currently approximately 1.47x. Given our progress to date and our visibility into additional repayments for the remainder of the December quarter and beyond, we are now in a position to make new investments as market activity resumes, while we also continue to manage our existing portfolio. Moving to our financial results. Net investment income for the quarter was $0.43 per share, reflecting a smaller portfolio given net sales and repayments, a lower portfolio yield, partially offset by an increase in prepayment income compared to the prior quarter. In addition, given the total return feature in our incentive fee structure, no incentive fees were accrued during the quarter. The portfolio had a net gain of $5.4 million or $0.08 per share, driven by a net gain of $17.8 million or $0.27 per share on the corporate lending portfolio, partially offset by a net loss on Merx and on noncore and legacy assets. Net asset value per share at the end of September was $15.44, a $0.15 or 1% increase quarter-over-quarter. The $0.15 increase is attributable to the $0.08 net gain on the portfolio and $0.07 of retained earnings. Turning to our distribution. As discussed last quarter, in addition to our quarterly base distribution, the company's Board expects to declare a supplemental distribution and amount to be determined each quarter. Accordingly, the Board has declared a base distribution of $0.31 per share and a supplement distribution of $0.05 per share, payable on January 7, 2021, to shareholders of record as of December 21, 2020.

Thanks, Howard. Beginning with the market environment, credit markets continued to recover during the quarter. Although spreads are still somewhat higher than prior to the COVID-19 outbreak, they declined significantly since peaking in late March or early April. Additionally, covenant waivers and credit amendments have slowed down. The new issue market has also been gaining momentum as borrowers sought to complete deals ahead of the election. The use of proceeds has been expanding from mostly add-on acquisitions to buyout sponsor/sponsor sales and dividends. And while credit documents and structures have tightened, borrowers are seeking private credit solutions over broadly syndicated capital. Moving to AINV, given the composition of our corporate lending portfolio, which is primarily first lien loans to less cyclical businesses, we believe the credit quality of our corporate lending portfolio continues to hold up relatively well during this period. However, as expected, we saw a continued need for covenant relief for some of our borrowers during the quarter. During the quarter, we saw a 40% drop in the number of amendments in our portfolio. Given our focus on reducing leverage, new investment activity was limited, while sales and repayments were relatively strong during the quarter. New corporate lending commitments for the quarter were $18 million across two companies, sales were $13 million, repayments were $108 million and revolver paydowns were $87 million for total exits of $209 million. Net repayments for the quarter were $103 million, including $36 million of net revolver paydowns. As Howard mentioned, given the strong level of repayments, we are now in a position to make new commitments as market activity has begun to resume. Moving to Merx, our aircraft leasing portfolio company. As you know, the pandemic has had a significant adverse effect on the global economy with direct implications for the aviation sector, although we are starting to see some recovery in global air traffic. Merx continues to closely monitor the current market environment and proactively maintain dialogue with its airline clients globally. During the quarter, the fair value of AINV's investment in Merx declined by $5.7 million or 1.8%. The quarter-over-quarter change reflects the decline in the fair value of Merx's fleet given the challenging environment, partially offset by an increase in the value of Merx's servicing business. As discussed in the past, in addition to aircraft leasing, Merx has built a best-in-class servicing platform and acts as a servicer or technical adviser for aviation assets across the broader Apollo platform. Merx is now benefiting from a growing servicing business, which has helped partially offset the decline in fair value of its fleet during the quarter. We believe Merx's portfolio compares favorably with other major lessors in terms of asset, geography, age, maturity and lessee diversification. Merx's portfolio is skewed towards the most widely used types of aircraft, which means demand for Merx's fleet should be somewhat more resilient. Merx's fleet primarily consists of narrow-body aircraft serving both the U.S. and foreign markets. At the end of September, Merx's portfolio consisted of 81 aircraft, 10 aircraft types, 40 lessees in 26 countries with an average aircraft age of 9.6 years. Merx's fleet includes 78 narrow-body aircraft, 2 wide-body aircraft and 1 freighter. Similar to other industry participants, many of Merx's lessees requested rent deferrals and/or rent reductions. Merx has been working with its lessees to provide the necessary flexibility during these unprecedented times. Each request was reviewed on a case-by-case basis. Some of the deferral periods have expired, and we're now seeing a recovery in lease payments. Despite the current industry challenges, we do not expect Merx to require funding from AINV in the near term. The aviation team has the experience to skillfully navigate this period of market stress and the requisite capabilities to mitigate potential adverse outcomes. Additionally, the Apollo aviation platform will continue to seek to opportunistically deploy capital in the face of widespread uncertainty and market disruption. To be clear, Merx is focused on the existing portfolio and not seeking new investments. However, growth in the overall Apollo aviation platform will inure to the benefit of Merx as the exclusive servicer of aircraft owned by other Apollo firms. Moving to overall credit quality. As Howard mentioned, no investments were placed on nonaccrual status during the quarter. At the end of September, investments on nonaccrual status represented $143 million or 4.9% of the portfolio at cost and $30 million or 1.2% at fair value.

Thank you, Tanner, and good afternoon, everyone. Beginning with the statement of operations. Total investment income was $54.9 million for the quarter, comparatively lower due to the smaller portfolio, a slightly lower overall yield and partially offset by an increase in prepayment income. Prepayment income was $2 million for the quarter compared to $300,000 last quarter, reflecting the greater portfolio activity. Dividend and fee income remained below historical levels. The weighted average yield at cost on the corporate lending portfolio declined slightly from 8.1% to 7.9%. Expenses for the quarter were $27 million, down $1.4 million quarter-over-quarter, primarily due to lower interest expense and lower management fees. Interest expense declined due to net sales and repayments and as a result of a decline in the average interest cost by approximately 16 basis points due to a slight decline in LIBOR. Our weighted average interest cost for the quarter was 2.96%. Management fees declined due to the decline in the average portfolio size. There was no incentive paid during the quarter. Net investment income per share for the quarter was $0.43. As Howard mentioned, net leverage at the end of September was 1.56x, down from 1.66x at the end of June due to the $103 million of net sales repayments and an increase in net assets. The increase in net assets were driven by the $5.4 million or $0.08 a share net gain on the portfolio and approximately $4.4 million or $0.07 per share of retained earnings during the quarter. On Page 16 of the earnings supplement, we have broken out the net gain or loss by strategy. We continue to see some reversal of previously recorded unrealized losses, reflecting the further tightening credit spreads relative to the first and second quarters of 2020. Our corporate lending portfolio had a gain of $18 million or $0.27 per share during the September quarter, Merx had a loss of $5.9 million or $0.09 a share and the noncore and legacy assets had an unrealized loss of $6.5 million or $0.10 per share, primarily due to our oil gas investments given the continued weakness in the forward oil curve. NAV per share at the end of September was $15.44, a 1% increase quarter-over-quarter. Moving to liquidity. As the pandemic began, many of our portfolio companies drew on their revolvers during the March quarter to shore up liquidity. Many of these drawdowns were repaid in the June quarter and repayments continued in the September quarter. MidCap is the agent for nearly all of our revolvers and delayed draw on term loan commitments and is actively monitoring every commitment. For context, at MidCap, leverage loan revolvers were 23% utilized pre-pandemic. Revolver utilization peaked at approximately 70% in mid-April and has since declined to 33% today. At the end of September, we had $268 million of immediately available liquidity, up from $227 million at end of June and $224 million at the end of March. Also at the end of September, we had $287 million of additional capacity under our credit facility, up from $167 million at the end of June and $131 million at the end of March. Moving to unfunded commitments. On Page 18 in our earnings supplement, we break out for you our outstanding commitments as of the end of September. During the quarter, we continued to experience considerable net revolver payments. Of the $282 million of unfunded revolver commitments outstanding at the end of September, $183 million are available to borrowers and $99 million are not available to borrowers. The availability is based on limitations and other covenants. Turning to portfolio composition. Our investment portfolio had a fair value of $2.6 billion at the end of September across 147 companies in 29 industries. We ended the quarter with core assets representing 92% of the portfolio, up slightly from the end of June. Noncore assets decreased to 8%, down slightly. First lien assets represented 86% of the corporate lending portfolio. The weighted average attachment point remained at 0.8x. Investments made pursuant to our co-investment order were 78% of the corporate lending portfolio at the end of September. We continue to remain focused on preserving liquidity. And accordingly, no stock repurchases were made during the quarter. As our leverage and liquidity continue to improve, we will continue to evaluate repurchasing our securities as appropriate. This concludes our prepared remarks, operator, and please open the call to questions.

Your first question comes from the line of Kenneth Lee with RBC Capital Markets.

Just wondering whether you could just provide any further details behind the visibility into additional repayments for the December quarter? And whether you could see any additional gross paydowns beyond the ones that were mentioned in the release?

Yes. Well, so gross paydowns, we have visibility of deals that we know are in the process of being sold or paying down of about another $100 million, whether any of those creep over to the new year, we don't know. But about another $100 million, that's gross paydowns. We do expect to do, as I mentioned, some new business. And so our leverage, Greg said, at 1.47x today and probably below 1.45x in the next week or so based on stuff that's paying off in the near term and then probably starting to tread water around there on the lower side of our range.

Great. Very helpful. And just one follow-up, if I may. Wondering if you could just provide any update on thinking around potential funding mix changes in the near term.

We are not planning to make any changes in the near term. We have a strong support from a group of over 24 banks, and we are continuously monitoring the market. At some point, we will make changes, but not at this time.

Your next question comes from the line of Kyle Joseph with Jefferies.

Apologies, I was on mute. Anyway, I'll get right on the questions. So deployments have been light, not surprisingly, over the last few quarters as you guys have focused on delevering, but I think it sounds like you've gotten to a point where you're comfortable at evaluating new transactions. Tanner, I think, can you give us a sense for how the pipeline looks in terms of size? And then, in terms of terms, how it looks versus kind of pre-COVID deals?

Yes, thank you for the question. You're absolutely correct; our focus has been on returning to our targeted leverage level, and we saw some movement in the September quarter, which I expect will increase in December. Regarding the pipeline, we’ve emphasized this in the past, and I want to reiterate it. The good news is that our middle market platform, including MidCap, continues to see strong origination, and our ability to provide solutions to clients is not solely dependent on how many deployments we make. Even though our deployment numbers have been light, deals are still progressing. As we move further from the impact of COVID, we are seeing increased activity, which is not surprising. Additionally, there's a clearer distinction in the sectors that are affected and those that are not, with M&A activity shifting towards the more resilient sectors. Concerning terms, as mentioned in our prepared remarks, we are observing an increase compared to pre-COVID times. Continued strong competition in private capital and debt markets has led to some compression in spreads. Generally speaking, spreads are about 50 basis points wider and overall terms may be a little better than what we experienced during COVID. Documentation has also improved, with less availability of delayed draw and revolver facilities, as borrowers are proactively addressing unfunded commitments that arose during COVID. In summary, conditions have improved, tightening relative to previous experience, and with our successful deleveraging, we anticipate participating more in origination through the MidCap and broader Apollo platforms.

Got it. That's very helpful. In terms of the portfolio yields in the quarter, there's a bit of pressure compared to last quarter. I don't believe it's driven by rates. Is this more about a shift in the mix of assets being paid down?

Yes, I'll mention that there is a dynamic where the investments with the highest yields are naturally the ones that borrowers target for repayment. Additionally, some of this situation is due to LIBOR contracts being established prior to the period. As LIBOR rates dropped significantly earlier in the year, it takes time for some of those contracts to expire, contributing, albeit to a lesser extent, to the changes in yield you observed.

Got it. For my last question, this is for Greg. Considering the losses from earlier in the year, if we assume there are no further losses or gains, when do you anticipate the incentive fee will be paid out again so I can check my calculations?

Yes. I think based on your assumptions, it would be December of '21.

Your next question comes from the line of Matt Tjaden with Raymond James.

Tanner, maybe first one for you. I know you said last quarter on the call that through July, cash flows at Merx were tracking at or above expected levels. Did that hold throughout the entirety of calendar third quarter? And any commentary you can give on what you're seeing thus far through November?

Yes, sure. Happy to. So that was what we were seeing through July, I would say that, that held through September. That forecast is based on the deferrals granted and what we had expected to kind of come back online. You had a dynamic where, obviously, while unfortunately, this has affected all parts of the world, it hasn't necessarily been equal. And so in Asia, you've obviously seen a return or a greater return or pickup in air travel. And then also in the U.S., while air traffic still remains very, very challenged, obviously, capital markets and the government support had been very, very robust. And so in general, we are still seeing a modest outperformance relative to our expectations in terms of lease cash flows. I would caution, and I think we remain appropriately cautious as if you think about a lot of those deferrals that were granted, Matt, they were in that April to June period, and were typically 6 to 9 months. And so it is during this period we're kind of real-time on those coming back online. And so while we are encouraged by kind of relative to expectations, what we've seen to date, we remain cautious, inasmuch as not all of those borrowers, not all of those lessees have been scheduled to come back online as of now.

Great. That's helpful. And then last one for me, just a quick one. I know you said a 40% drop in amendments during the quarter. Any commentary you can give on the seriousness of those amendments compared to the prior quarter?

Yes, I think you were right to note that during the pandemic, a lot of borrowers proactively reached out for assistance. As that activity subsided, we entered a phase where we provided support for transactions that required it. Activity was down by 40%. We recorded about 8 to 9 amendments in the quarter, with roughly half considered substantive, many of which included equity contributions from the sponsors. The remaining half were more strategic and less impactful. In response to your question, those substantive amendments primarily addressed issues related to underperformance or COVID-19 effects. Overall, as mentioned in our prepared remarks, there was definitely less activity. It's worth noting that for those names more affected by COVID-19, we observed strong support from sponsors in their amendments.

Your next question is from the line of Finian O'Shea with Wells Fargo.

Tanner, I appreciate your insights on Merx this quarter. I have a two-part question. First, regarding the valuation decrease of 1.8%, you mentioned an offset between the collateral value and the servicing contract. Were the swings significant or were they relatively modest, especially considering the overall modest net impact? Secondly, regarding the growth of your servicing business, what was the level of collateral or assets that the business needed to service for Apollo? This could relate to the number of airplanes or capital invested, depending on how you prefer to answer. That's my first question.

Yes, of course. Greg may have the specific numbers, but I'll start with my response. The fluctuations are relatively modest. The net decrease is $5.9 million in collateral value compared to servicing. Regarding your other question about the servicing platform, we mentioned in our August call that we executed a significant transaction for Delta. The pipeline remains quite strong, with additional opportunities, and the servicing platform benefits as transactions are completed. I can't provide an exact figure related to what caused the increase, but we have successfully established a dedicated fund that still has available capital for these transactions. We also benefit from the broader Apollo platform and their potential demand for aircraft leasing transactions. I’m not sure if Greg has the specific numbers, but overall, they are fairly modest in their fluctuations.

I believe the overall figures indicate a total write-down of 5. The servicing platform's value increased in the medium single digits, likely between 5 and 10. As a result, the collateral part decreased by 10 to 12. This change is attributed to the increase in transactions on the platform and some explicit fees generated that are now receivables from claims disposition. This represents even more direct value as it will lead to cash inflow.

Right. And Fin, the other directional thing that you can get is the metal, the way that we look at it, has been written down, and these are based on cash flows, residuals and all that, over 18%, okay? So that's kind of the magnitude that we have written down, the metal side of it. And that's pretty reflected in kind of, if you look at market comps and stuff.

And that's from March, right? Or as we...

Yes, that's from March through the September quarter. Yes.

That's helpful. Regarding the topic we discussed, many of these aircraft are linked to government contracts or major airlines globally, and some were being renegotiated. I assume you have worked through most of that now. What kind of overall top line impacts did Merx experience for the business? And how far along are you in that process?

Yes, we've worked through and have initial agreements with all of the airlines. They need to adhere to those terms going forward. If other challenges arise, that could impact things, but we believe we have a good understanding of the cash flows ahead. Before this situation, the cash flows from Merx were typically in the range of $40 million to $45 million each quarter, accounting for debt payments and dividends paid to AINV. Currently, it's down to $20 million from interest. If the parties fulfill their obligations under these leases, we're expecting to generate significantly more cash flow than the current $20 million per quarter. However, in the short term, there's some catch-up needed in the securitization structures. The cash produced initially is being used to pay down debt, but with the new lease contracts, we anticipate cash flow that exceeds the income we recognize from Merx each quarter. This will provide us additional cushion in terms of our value and servicing platform.

Yes, very helpful.

And that's how we view the situation. The main point is maintaining these leases. We now know what to anticipate. It's not as favorable as it was previously, but when you consider AINV, you are essentially covering this through the reduced return from Merx. We have structured our dividend based on those lower returns from Merx. Additionally, we believe we have the potential to exceed expectations by generating liquidity from some of our planes, whether they are cargo planes or have strategic relevance, which will help reduce our costs over the next two quarters. Our objective is to further minimize the impact of this gap on our cash flows and provide a clearer sense of valuation and stability.

We have no further questions at this time. I would like to turn it back over to management for closing remarks.

That's me. Thanks, everybody, for listening today. And on behalf of our team we thank you again for taking the time and supporting us through this challenging environment. Feel free to reach out to any of us with any questions, and we hope everybody has a nice day.

Thank you. This concludes today's conference call. You may now disconnect.