MidCap Financial Investment Corp Q4 FY2021 Earnings Call

Good afternoon, and welcome to Apollo Investment Corporation’s Earnings Conference Call for the Period Ended March 31, 2021. At this time, all participants have been placed in a listen-only mode. The call will be opened for a question-and-answer session following the speakers’ prepared remarks. I’ll now turn the call over to Elizabeth Besen, Investor Relations Manager for Apollo Investment Corporation.

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.

Thanks, Elizabeth. Good afternoon. Thank you everybody for joining today. I’ll begin today’s call with a few thoughts about how AINV has performed throughout the pandemic, followed by an overview of our results for the quarter. Following my remarks, Tanner will discuss the market environment, review our investment activity for the quarter, and provide an update on credit quality. Greg will then review our financial results in greater detail and provide an update on our liquidity position. We’ll then open up 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. Given that it’s a little over a year since the initial volatility from the pandemic, I’d like to begin today’s call with a few thoughts about how AINV has successfully navigated this challenging period. First, our corporate lending portfolio continued to perform well and has recovered the vast majority of the unrealized losses recorded during the March 2020 quarter. Given the stable credit metrics of our portfolio companies, we believe there is potential for some additional recovery in our corporate lending portfolio. We believe this strong performance validates our investment strategy and our ability to underwrite as well as improved market conditions.

Thanks, Howard. Beginning with the market environment, the U.S. economy continues to strengthen due to significant fiscal and monetary relief and the continued rollout of the vaccine. Specific to the direct lending market, given the improved economic backdrop, we are seeing a pickup in sponsor activity. With that said, competition for attractive new investments remains elevated due to robust repayment activity and a strong syndicated loan market, which is offering borrowers, including the upper end of the middle market, attractive financing. As a result, pricing, leverage, and terms have generally returned to pre-pandemic levels, particularly for companies with little to no impact from the COVID-19 pandemic. Moving to AINV’s investment activity, new corporate lending commitments for the quarter were $106 million across 11 companies for an average new commitment of $9.6 million. Consistent with our strategy, all of these new commitments were first lien floating rate loans with a weighted average spread of 690 basis points, and a weighted average net leverage of 4.2 times. All of these new commitments include LIBOR floors, and 91% were made pursuant to our co-investment order. Gross fundings for the quarter totaled $116 million, excluding revolvers and Merx. Repayments totaled $172 million, excluding revolvers and Merx. Net fundings for revolvers totaled $13 million, and Merx repaid $9.5 million to AINV on a net basis. Repayments included our $22 million second lien position in Hayward. Net repayments were $53 million in total. I will now provide an update on our post-quarter-end investment activity. From April 1st to May 18th, we’ve made new commitments of approximately $193 million, all of which were first lien corporate loans. Gross fundings have totaled $157 million; sales and repayments have totaled $149 million, including $57 million of second lien corporate lending positions. Moving to Merx. While there are still many challenges facing the aviation industry, we continue to see a slow but steady recovery in air traffic in many regions. We are optimistic that demand for air travel will continue to grow with the ongoing rollout of the vaccine and lifting of travel restrictions. Notwithstanding the current challenges, we believe the aircraft leasing market will continue to be an important and growing percentage of the world fleet as airlines increasingly look at third-party balance sheets to finance their operating assets. Merx has remarketed most of its aircraft that have come off-lease in 2021, either via extensions with existing lessees or re-leasing to other airlines on long-term leases. Of the 7 aircraft leases that are maturing in 2021, extensions for 4 have already been executed; 1 is in the process of being finalized, and 1 is currently under negotiation for extension or sale. Merx is actively remarketing the remaining aircraft. In addition, during the quarter, 1 aircraft in Merx’s owned fleet was sold above its carrying value. During the period, Merx paid $14.3 million to AINV, consisting of $4.8 million in interest payment and a $9.5 million return of capital.

Thank you, Tanner, and good afternoon, everyone. Before I begin, I’d like to remind everyone that Merx financial statements are included as an exhibit to our 10-K that we filed today. Beginning with AINV’s statement of operations, total investment income was $50.8 million for the quarter, reflecting lower interest income, lower dividend income, and lower fee income, partially offset by greater prepayment income. The sequential decline in the interest income was attributable somewhat to certain nonrecurring items in the December quarter, as well as a smaller average portfolio due to deleveraging. Fee income declined to approximately $700,000 for the quarter, down from $1.2 million. Prepayment income was $3.3 million compared to $2.4 million last quarter. Dividend income was $300,000 compared to $1.1 million last quarter.

Hey. Good afternoon. And thanks for having me on. First question, I think, Greg, you talked about dividend income and it was a little light. Any one-time issues there, or is that a fair run rate going forward?

Yes. I think the run rate is between there and $1 million. It’s a function of our shipping investments at this point and just the cash flow that’s coming out of those. So, I would say the run rate will be closer to $1 million going forward.

Got it. Helpful. Thanks. And then for Tanner on portfolio performance, obviously, non-accruals were stable in the quarter. But just give us a sense for revenue and EBITDA growth and how that’s been trending, particularly as we start to compare against COVID-impacted months?

Yes. Absolutely, Kyle. So, first of all, what’s in the LTM, so to speak, does not have those easy comparisons yet. And then, one caveat is, not surprisingly, given the focus on acquisitions and roll-ups within the sponsor community, comparisons are somewhat difficult. But whether looking at what we’re seeing real-time as well as also what we experienced in kind of fourth-quarter numbers, which form the basis for the valuations as of March 31, the outlook has been very encouraging on an organic basis in the mid-single digits very easily. We haven’t started seeing much effect on the margin side, which has certainly received a lot of press. And even more impactfully, if you look at – and I think this has also been broadcast more broadly is confidence, CEO confidence, management team confidence and willingness to spend has seen a noticeable uptick in recent months. And I think that will bear out in continued outperformance from an operating standpoint.

Hi. Good afternoon. I have a couple of questions. One is in relation to – this is a couple of questions in relation to Merx. How many of the planes, if any, are currently off lease? And how many lease expirations do you have in 2021? And how does the market look for re-leasing of those assets? And then, secondly, the acquisition of FLY Leasing during this last quarter, how did that improve in any way the price discovery of the market for commercial aircraft or inform you as to the demand for commercial aircraft?

Yes, sure. I’ll take a first stab at that. And, apologies if I went pretty quickly in my prepared remarks. We tried to give some of that detail, and let me try to go back to it. And then, Casey, of course, please correct me if I haven’t hit everything that you asked there. In terms of 2021 and the lease expirations, that news is good. Of the 7 that were maturing in 2021, we’ve already executed 4 extensions. 1 is in the process, and 1’s in negotiation, and then we’re actively remarketing the remaining 1. In terms of strictly off lease, we have 2 planes that are off lease. And then, we have a handful that are in bankruptcy proceedings or are currently affected by broader restructuring. But what I would say on that account is – and again, going back to the prepared remarks, to a certain extent, we’ve definitely seen stabilization in our ability to deal with those lease maturities as reflective of kind of growing confidence and improving conditions in the market environment. And then, the second part of your question, Casey, is FLY Leasing, which broadly speaking, when you see things transact, that usually is a good thing in terms of people’s outlook on the future and liquidity in the market. FLY Leasing and our portfolio, there are limited comparisons available. Obviously, FLY Leasing was a public company, and the multiple is tough to get at from the outside without the benefit of what was exactly in book value. FLY Leasing also skewed – even though it’s a similar size to Merx in terms of total planes, it skews a little bit more heavily to widebody, which we’ve talked a lot about. We think that Merx outperforms peers in as much as a much lower widebody concentration. So, I think it’s good that you’re starting to see things transact, even more so than the FLY Leasing transaction, the ability for the sale-leaseback market to get up and running, and then the hard data with TSA hitting highs in terms of passenger volumes, as well as the vaccine rollout corroborating an improving marketplace. So, sorry, I want to make sure I hit – go ahead.

No. You got them all; and we would agree with you that it’s extremely difficult to evaluate commercial aircraft, looking at it from the outside, because that’s what we’re trying to do as well. My next question is, Greg, thank you for the update on the partial resumption of the incentive fee, because it looks like that’s moved up a quarter with this quarter’s gains. And I’m just kind of curious about your statement that you’re going to maintain the $0.31 per share and the $0.05 per share for the next four quarters is interesting in that the math of it suggests that when you fully resume the incentive fee, your net investment income based upon the weighted average yield of the portfolio would be somewhat below $0.36 a share. So is your statement about the distribution plus the supplemental, how do you come about covering that? Is it by getting back up into the target leverage ratio? Is it some asset mix shift? I’m just curious because currently, looking at the math, it’s not quite there.

So, yes. Casey, I’ll take a shot at that. So basically, our model and goal for the business is to be in our target leverage range, which portfolio that is vastly in the assets that we targeted with maybe just occasional exceptions, little sort of equity tagalongs we do or some other opportunistic things we think are accretive. But having a portfolio in our target leverage range produces enough money to cover both the dividend and the supplemental if we are able to recover the cash from our non-core assets over time. And frankly, even with the non-core assets generating about a 4% or 5% return currently. So as we generate cash off those assets and redeploy them into our current yield and we get Merx back to a level of producing income, not to the level it was before, but to a new moderated level, we can generate enough income after the incentive fee to cover that dividend. And so, the reason why we wanted to clarify this $0.31 and $0.05 in the next four quarters is that the timing of that redeployment, whether it’s getting to our target leverage, which we have more control over, or it’s getting some of that redeployment done, or starting to generate the equity returns off Merx that we did historically, may not match to the timing of the incentive fee. So, I think you’re right. It doesn’t show that it works, but it isn’t product mix. It isn’t all of a sudden going to a barbell approach and doing higher yielding stuff. It’s just the continuing all these drivers that are incrementally getting us to the level that we can – the model works. Does that make sense?

Yes, it does. And just to clarify, when I was talking about changing the asset mix, I was thinking more out of equity into interest-earning assets than thinking about moving into greater risk investment.

Well, that is right. Because the equity we have are these non-core assets, right? Like other than little cats and dogs, the big equity positions are the non-core assets that aren’t producing something. So that’s correct.

Hi, everyone. Good afternoon. I guess, a couple of follow-ons there. Tanner, first, with the lease renegotiations that you’re going through. I think you said there are 7 or so, and they’re going well. How do the rates that you are negotiating compare to the portfolio and your newly constructed return from Merx?

So, a couple of things there. So, when you’re undertaking a lease negotiation, there are a number of different factors other than just the headline rate. And furthermore, when we are re-leasing, there’s, in all cases, a reduction from what that initial rate would otherwise be. Think of it in terms of when a lease is first signed when the plane’s brand new; it’s not the lease rate that it will command at the first lease maturity 10 years hence. And so, if I understood your question, what we’re able to realize now is in line with our modified expectations within our valuation, but clearly, at a level lower than what we would have otherwise seen, if we had all been so fortunate as to never have seen COVID.

Let me jump in for a moment. Of the seven we discussed, four are already re-leased and two are in advanced negotiation. So, it's not a total of seven that haven't been addressed. These assets have been re-leased, so we have a good understanding of the situation. As Tanner mentioned, the value of each asset depends on the current lease and the plane's value at the end of the lease term. When we re-lease a plane, it typically doesn't command as high a rate as it did five years ago when the previous lease was signed. However, a new lease does carry value; that cash flow stream is valuable, and it defers the residual value to the end. So, what Tanner is indicating is that these re-leasings have helped maintain the values we have on those planes after the overall decline in value we experienced in March during the Merx write-down. Essentially, it supports those asset valuations, which is why we see a certain level of stability. Regarding cash flow, historically, Merx generated between $10 million to $12 million per quarter over the past three to five years before COVID. Currently, our income is around $5 million per quarter due to capital returns. For our earnings model to function correctly, we need to see earnings fall between those two figures moving forward. We don't need it to return to past levels but to reach the projections we anticipate when the leases start generating cash. While they are currently paying, they are primarily servicing debt in our securitization. Therefore, as of now, the leases we've re-signed uphold the valuations we established following the recent correction. This situation could change, but so far, things are on track. Tanner, did I miss anything?

No, no, no.

Hi, guys. One quick housekeeping one, if I can. On maintaining the $0.05 per quarter for the next four quarters, does that include the one that you announced today? So, it’s three after this, or it’s four into the future?

No, it’s four, including the one that we announced today.

Okay, fair enough. Got it. Then just on to Merx again, but not lease renewals, if I can. I mean, looking at the financials of Merx, it seems like revenue was barely down year-over-year. The expenses were the problem, and those were mainly noncash, right? I mean, it was asset impairment and allowance for credit losses. So, would it be fair to say that you don’t expect those items? Certainly, at the level they did, to recur at any kind of scale. And if that doesn’t happen, Merx looks like they’re going to be profitable very soon, and cash flow doesn’t seem to be a problem. So could we expect dividends sooner rather than later?

Yes. I’m happy to take a stab at part of that and then open it up to Greg’s comment as well. So first, in terms of thinking about valuations and at the risk of stating the obvious, these are not bonds and our return and principal is not written on a piece of paper. And so, where we’ve written the metal down to is to a level that we’re comfortable with in terms of our discounted cash flow analysis, wherein we do assume a residual in the future. But it’s not – you can’t think about it the same way that you would where you mark down a security, but you still have a par claim. We do feel better about – as I mentioned, with some of the stabilization that we’re seeing in the market that’s giving us more confidence. But we are owners of that asset, and the volatility and ultimate asset prices are going to be borne by us as the equity holders of those particular assets. And I don’t know if, Greg, you wanted to make another comment more broadly about the asset impairment?

Yes. I think you’re right to ask the question because you can only provide dividends to the extent that you have earnings. And when you do look at the results for this year, you had $80 million worth of asset impairment and $32 million worth of allowance for credit losses. We don’t expect that type of impairment and credit losses going forward as the aviation sector is stabilized and our portfolio is stabilized. So, I think you’re absolutely right. But I think just a couple of other notes, when you do go through Merx financial statements. Merx for the year paid down, inclusive of our joint ventures, over $140 million worth of debt year-over-year. So, I think that’s a really important factor. We impaired the assets by 79. If you look at our external value, we wrote down the metal by over 25%, which is very close to the GAAP write-down, even though they’re not – they’re apples and oranges. So, there’s some real good that has kind of settled down at Merx. And I think we’re in a good position today going forward.

The way...

I just want to quickly interject. That’s essentially my point. The numbers seem positive to me, even though I'm only looking at the financials. You seem more cautious in your comments and prepared remarks than what the numbers indicate. It appears that things may be in better shape. You've reduced debt, and cash flow has increased.

So Robert, I think I can bridge that gap. So the reason why there is more hesitancy is because the cash flows, the revenue that you’re seeing that are coming through are currently being used to continue to pay down debt until our securitizations are caught up. And so, from a GAAP basis, there is real income there. And it’s making the equity more valuable, if you will, by paying down the debt, but it’s not cash that’s available to be paid. And so, the equity dividends that Merx may decide to declare may lag its earnings power. But you’re right in that it is – if we are right about our valuation and it is stable, it is producing enough income to begin paying dividends in the near future. Whether it’s producing that cash or that drags it a little bit or it’s paying down excessive debt remains to be seen, just in terms of timing, depending on when people catch up payments when leases happen. And so, that’s why there’s a little hesitancy with regard to the exact timing of when the dividends pick up. But again, it goes back to what we were talking to Casey about is that we feel like there’s more earnings power than you’re seeing at the moment, and that will run through the dividend line. The timing of that will depend somewhat on the cash flow as opposed to the earnings because we may be paying down more debt than you would have otherwise thought we would, which again, is why we want to give sort of people some – the timing of that is sort of irrelevant to long-term value of Merx. It’s just – but it is relevant to the quarterly predictability for investors.

And there are no further questions in queue at this time. I’ll turn the call back over to management for closing remarks.

All right. Thank you, operator, and thank you, everybody, for listening and your questions. On behalf of the whole team, we thank you for the time today. And obviously, please feel free to reach out with any questions you have. Have a good day.

This concludes today’s conference call. Thank you for participating. You may now disconnect.