MidCap Financial Investment Corp Q1 FY2022 Earnings Call

Good afternoon, and welcome to Apollo Investment Corporation’s Earnings Conference Call for the Period Ended June 30, 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. 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 press 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. 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. I'll begin today's call by providing an update on our ongoing progress, repositioning the portfolio, followed by a review 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. 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. Beginning with an update on our portfolio repositioning, we continue to make good progress increasing our exposure to first lien floating rate corporate loans while reducing our exposure to junior capital and non-core positions. From a volume standpoint, our Direct Origination platform was very active, closing $4.6 billion in new commitments during the June quarter. AINV’s new investment commitments were strong, totaling $332 million in all-in first lien floating rate loans. We believe we have constructed a granular and diversified portfolio of high-quality senior corporate loans. We believe Merx has successfully navigated this challenging period, and we expect AINV will be able to generate higher revenue from Merx in the coming quarters. We also continue to make progress reducing our exposure to non-core and junior capital investments. Repayments during the quarter included exits to second lien investments, as well as a small partial pay down from one of our shipping investments. We remain focused on reducing our exposure to the remaining non-core assets while ensuring an optimal outcome for our shareholders. Moving to financial results, we delivered solid results for the quarter. Net investment income for the June quarter was $0.39. We ended the quarter with net asset value per share of $16.02, up 14% or 0.9%. The increase was driven by our corporate lending portfolio, which continues to perform well. The investment portfolio grew modestly, as solid fundings were mostly offset by prepayment activity. Gross fundings for the quarter were $230 million excluding revolver fundings, while net fundings totaled $29 million. Net leverage increased to 1.39 times at the end of June, up from 1.36 times last quarter and slightly below our target leverage range of 1.4 to 1.6 times. As we look ahead, we are confident in our ability to grow our portfolio and operate within our target leverage range, given the tremendous need for creative and flexible private capital and the unique and robust nature of the Apollo mid-cap platform. With that said, as Tanner will discuss later, the current market environment is very competitive, and we will continue to focus on first lien assets and will remain disciplined in our credit selection process. Turning to our distribution. For the quarter, the board has declared a base distribution of $0.31 per share and a supplemental distribution of $0.05 per share. Both distributions are payable on October 8, 2021, to shareholders of record as of September 21, 2021. With that, I'll turn the call over to Tanner to discuss the market environment and our investment decision.

Thanks, Howard. Beginning with the market environment, the US economy continues to recover on the back of more vaccinations, supportive fiscal and monetary policy, high stock prices, tight credit spreads, and significant excess savings in both the household and corporate sectors. Daily data for travel credit card usage and restaurant bookings continue to approach or exceed pre-pandemic levels. While there may be a slower reopening in some parts of the country, the ongoing improvements in GDP, employment, and earnings are likely to continue. The reopening of the economy has been associated with a significant spike in inflation as prices of cars, flights, and dining services have recovered; we generally believe that the growth backdrop will serve as an offset to the inflationary pressures that our portfolio companies face. Based on the data from LCD, new issue loan volume in the June quarter reached $145.8 billion, the second highest quarterly total in the last four years. Amid strong supply, the market continues to see strong demand from both CLOs and retail investors. Secondary loan prices have also continued to move higher. Specific to our business, the middle market lending environment has generally returned to pre-pandemic conditions due to several factors including a growing number of private credit providers, a strong syndicated loan market, and a strong economic backdrop, all of which have contributed to the return of borrower-friendly pricing and terms. Private Equity M&A activity is robust as sponsors continue to deploy capital. As a result of these favorable conditions, more companies, including the upper end of the middle market, are seeking syndicated solutions. Moving to AINV’s investment activity, new corporate lending commitments for the quarter total $332 million across 24 companies for an average new commitment of $13.8 million. By strategy, 82% of new commitments were leveraged lending, 12% were in life sciences, and 6% were asset-based. Consistent with our strategy, all these new commitments were first lien floating-rate loans, with a weighted average spread of 620 basis points and a weighted average net leverage of 5.2 times. All of these new commitments include LIBOR floors; 92% were made pursuant to our co-investment order. Gross fundings for the quarter totaled $230 million, excluding revolvers and Merx. Due to the strength in the overall market, repayments were also strong, totaling $189 million, excluding revolvers and Merx. The strength in the loan market has enabled us to continue to reduce our exposure to second liens. During the quarter, repayments included $57 million from the exit of two second lien positions, and over the past four quarters, second lien repayments have totaled $133 million. We also received $4 million repayment during the quarter from MC, one of our shipping investments, from the sale of one of its vessels. Net repayments for revolvers totaled $12 million. In total, net fundings were $29 million. Moving to Merx and beginning with the overall market, we are optimistic that the demand for air travel will continue to improve with the ongoing rollout of the vaccine and the lifting of travel restrictions. Additionally, we expect to see the aircraft leasing market continue to be an important and growing percentage of the world fleet, as airlines will need to increasingly look to third-party balance sheets to finance their operating assets. As the aircraft sector continues to recover, we have seen a notable pickup in sale-leaseback transactions and in the ABS market, an important source of financing for aircraft lessors. Specific to our investment, we believe Merx has successfully navigated this challenging period. The level of lease revenue generated from our fleet has stabilized. We have worked through our exposure to airlines that have undergone restructurings. We've been able to remarket aircraft during this period with long-term leases or sales. Our current lease maturity schedule is well staggered. Additionally, Merx continues to benefit from a growing servicing business, which has increased in value over time. We believe Merx's portfolio compares favorably to other lessors in terms of asset, geography, age, maturity, and lessee diversification. Merx's portfolio is skewed towards the most widely used aircraft types, which means demand for Merx's fleet is anticipated to be resilient. Merx's fleet primarily consists of narrow-body aircraft serving both U.S. and foreign markets. At the end of June, Merx's own portfolio consisted of 78 aircraft across 10 aircraft types, 39 lessees in 25 countries with an average aircraft age of 11.5 years, and an average lease maturity of 4.3 years. Merx's fleet includes 75 narrow-body aircraft, two wide-body aircraft, and one stryder. The Apollo aviation platform will continue to seek to opportunistically deploy capital. To be clear, Merx is focused on its existing portfolio and is not seeking to materially grow its own balance sheet portfolio. However, growth in the overall Apollo aviation platform will nurture the benefit of Merx as the exclusive servicer for aircraft owned by other platforms. Turning to the overall AINV portfolio, our investment portfolio had a fair value of $2.49 billion at the end of June across 140 companies in 25 different industries. We ended the quarter with core assets representing 92% of the portfolio and non-core assets representing 8%. First lien assets represented 90% of the corporate lending portfolio, up from 87% last quarter. At the end of June, the weighted average spread on the corporate lending portfolio was 616 basis points. As a reminder, the weighted average LIBOR floor on our floating rate assets is approximately 1%, well above today's current LIBOR. The weighted average net leverage of our corporate lending portfolio declined to 5.22 times from 5.34 times last quarter. The weighted average attachment point declined to 0.4 times, down from 0.6 times last quarter. The decline in these metrics, both for the quarter and over the past few years reflects the continued improvement in the credit quality of the portfolio. Investments made to our co-investment order represented 81% of the corporate lending portfolio at the end of the quarter. Amendment activity remained modest this quarter with no material amendments. No investments were placed on or removed from non-accrual status during the quarter. At the end of June, investments on non-accrual status represented $27 million or 1.1% of the portfolio at fair value. With that, I will now turn the call over to Greg, who will discuss the financial performance for the quarter.

Thank you, Tanner. Beginning with AINV's statement of operations, total investment income was $50.5 million for the quarter, reflecting lower interest income, partially offset by higher prepayment and fee income. The quarter-over-quarter decline in interest income was attributable to the pace of the investment activity and a relatively higher yield on repayments versus fundings. Fee income was $1.1 million, up from $700,000 last quarter. Prepayment income was $4 million, up from $3.3 million last quarter. Dividend income was essentially flat for the quarter. The weighted average yield at cost on our corporate lending portfolio was 7.7% at the end of June, down from 7.8% last quarter. Expenses for the quarter were $25.2 million, essentially flat quarter-over-quarter, and there was no incentive fee paid during the quarter. Net investment income per share for the quarter was $0.39. Net leverage at the end of June was 1.39 times, up from 1.36 times at the end of March. On page 16 in the earnings supplement, we disclose the net gain or loss by strategy over the past six quarters. As Howard mentioned, our corporate lending portfolio continues to perform well. During the quarter, our corporate lending portfolio had a gain of $6 million or $0.09 per share. Merx had a slight loss of $1.2 million or $0.02 per share, and our non-core and legacy assets had a net gain of $2 million or $0.03 per share. The net gain on non-core and legacy included a $9.8 million gain on Carbon Free, a legacy investment partially offset by losses on oil and gas and shipping. As a reminder, our investment in Carbon Free consists of investments in the company's proprietary carbon capture technologies and an investment in the company's chemical plant. Carbon Free is benefiting from the strong interest in carbon capture utilization and storage. The increase in valuation is a result of a recent third-party capital raise at Carbon Free. NAV per share at the end of June was $16.02 or a $0.14 increase or 9.9% quarter-over-quarter. The $0.14 increase was attributable to $0.10 of net share gain on the portfolio and net investment income per share of $0.03. Regarding liquidity, given the continued improvement in the quality of our investment portfolio, our liquidity position continues to strengthen. Both quarter-end and in July, we issued $125 million in 4.5% unsecured notes due on July 26. Despite the dilutive impact of these notes, we believe it was prudent to diversify and extend the maturity of our funding sources. In addition, we were pleased to have affirmed our investment grade rating and revise the outlook to stable from negative in July. Regarding stock buybacks during the quarter, AINV purchased 145,500 shares at an average price of $13.92 for a total cost of $2 million. From July 1 to August 4, 2021, we purchased an additional 44,000 shares at an average price of $13.46 for a total cost of $600,000, leaving approximately $24 million authorized for future purchases under the Board's current authorization. Before opening the call to questions, we wanted to briefly remind everyone that given the total return hurdle feature in our fee structure and the recovery in our portfolio over the last several quarters, we expect to begin to pay a partial incentive fee in the quarter ending September 2021. The exact timing and amount will vary based on future gains and losses, if any, as well as the level of net investment income for the quarter. As we said on last quarter's call, we believe AINV's net investment income may fluctuate over the next few quarters as we begin to pay incentive fees. That said, we expect to generate higher revenue from certain investments, including Merx, which will help offset the impact from incentive fees. We remain confident in the trajectory of our earnings and our long-term plan. As mentioned last quarter, we intend to declare a quarterly base dividend distribution of $0.31 per share and a quarterly supplemental distribution of $0.05 per share for at least the next two quarters. To be clear, this would be in addition to the distribution declared today. This concludes our prepared remarks, operator, and please open the call to questions.

And we will take our first question from Finian O’Shea with Wells Fargo. Please go ahead. Your line is open.

Hi, everyone. Good afternoon. Just a question, I guess, for Howard on the rebound and origination outlook and so forth. Can you give us, I guess, your high-level thoughts on how much? A lot of this is, you know, pent-up demand versus, of course, a sustainable shift in the demand for private credit?

Sure. I believe that the activity has been very strong compared to historical levels. It's difficult to determine if this is a permanent increase. However, there are some underlying trends suggesting that this elevated activity may persist for a while. One factor is the significant amount of available capital for equity firms to pursue deals, which is likely to maintain this elevated level. Additionally, the ongoing shift toward the private credit market, stemming from high-end deals in the syndicated market and what banks are offering to different companies, indicates that we can expect more activity. There is also some pent-up demand. Therefore, we anticipate that activity in the industry, as evidenced by many other BDCs, will remain strong, at least through this quarter, and we expect this trend to continue in the near and medium term.

Thank you. Can you provide an update on the direct lending and middle-market activities at Apollo, including details about MidCap and the relevant funds we are co-investing in at this time?

Sure. We have seen a lot of transaction volume and large pipelines across our Apollo direct origination business and a full range of products. This includes lender finance and our real estate business, which can be viewed as asset-based lending. There is significant activity, and there has also been considerable capital creation at Apollo to support our clients. One key aspect of our execution has been our ability to participate in transactions of various sizes. We have been creating capital through separate managed accounts, significant capital raises from MidCap in both debt and equity, and ongoing allocations from our insurance balance sheets. Overall, we have experienced significant growth in capital at Apollo to finance these different strategies. Additionally, the market is demanding more credit, which may be driven by both secular and cyclical factors. We are currently in a favorable credit environment as growth is accompanied by sufficient capital and minimal credit issues across most sectors, supported by overall economic growth and liquidity. This creates a favorable backdrop for our operations.

Very well. Appreciate the color. That's all for me. Thank you.

We'll take our next question from Kyle Joseph with Jefferies. Please go ahead. Your line is open.

Hi. Good afternoon, guys. Thanks for taking my questions. I guess, first one for Tanner really sounds like Merx is kind of kind of out of the woods. You've talked about growing revenues AI and Big going forward. Can you give us any sort of recognizing there's a lot of uncertainty remaining, but give us a sense for the potential magnitude and also the form, whether it be dividend or interest income?

Let me take a shot at addressing that. Last quarter, we discussed the earnings potential of Merx, which is currently estimated to be around the low 30 million range for the entire investment, excluding interest or dividends. Recently, this cash flow has accumulated as we manage leases, and it has also been utilized to pay down debt in order to realign our debt facilities. The expectation is that a significant portion of this will be available for distribution rather than being reserved for cash accumulation. Currently, we have $190 million of our investment in debt, which has been yielding returns in the low fours per quarter. The remainder is anticipated to come from dividend income. That's the current situation. There is a possibility of restructuring to shift more toward debt rather than equity if it makes sense for other reasons. However, as we've consistently stated, the income from Merx should not be seen as vastly different. The income generated is quite predictable. Historically, this has maintained a steady flow for the debt component, which is contractual. We expect that it will transition from generating about 4.5 million per quarter to most of the net income being produced in the near to medium term. I can't provide an exact prediction as it will depend on how we decide to allocate our capital.

No. That's really helpful. I appreciate it. And then, in terms of credit performance, I know non-accruals were stable. It looked like leverage came down a bit in the portfolio or recognize 2021 is the unique year in terms of comps, in terms of revenue and EBITDA growth. And I'm sure it's all over the board depending on the company. But can you just give us a sense for how you're evaluating portfolio company performance that you factoring in 2019 levels of performance and how you see portfolio growth evolving, as we kind of lapse some of the COVID comps?

Yeah. Sure. And I assume, Kyle, you're really getting at the underlying economic fundamentals. Keep in mind that these valuations are by and large the March quarter in 2021. And so you're clearly competing against only a portion that was COVID-affected. In that respect, you in this quarter actually had probably the first time where sort of the rubber meets the road in terms of really getting a feel for just the level of stabilization because you're comparing against a non-COVID quarter, right. And I think what we've seen is economic strength. There is obviously a very large debate in the market, concerning just how whether inflationary pressures will be transitory or not? We've certainly seen it in certain of our businesses. The way we think about that part of the equation is if we've done our job right, and we are indeed creating risk, first lien risk at roughly 60% LTV. The hope is that, what ultimately drives the ability to repay is not going to be infringed by some inflationary pressures. So, we're not as concerned on that side. But to your larger question, we're definitely seeing some fundamental strength, a lot of fundamental strength, consistent with what you hear about the broader economy. Our overall leverage went down, just over $0.1 across to roughly $2 billion corporate book speaks to sort of that underlying strength and deleveraging within the portfolio due to strong economic performance.

Got it. That's really helpful answer. Thanks a lot.

And we'll take our next question from Matt Tjaden with Raymond James. Please go ahead.

Hey, all, afternoon. I appreciate you taking my questions. First one for me, following up on Merx. Has the rise in COVID cases in the US and the Delta variant, has it slowed the recovery of Merx versus kind of where we sat maybe three months ago?

Yeah. I would say the recovery was never going to be linear. Obviously, the Delta variant is something that everyone is looking at and scrutinizing very, very heavily. It is still too early to judge whether that's a meaningful change. Certainly, on the margin, people are very cognizant of it, but I wouldn't say it's changed the outlook. We did mention that, and this is not exactly to your question there, Matt. But one of the things we made mention of in our prepared remarks, is that one of the things that has helped the market has been the reemergence of financing markets and that's something that has contributed to the strength alongside an increase in sale leaseback activity, that's helped to provide some backing to the market. So to your specific question, I think the Delta variant, it's still too early to say. We were cognizant that this was never going to be linear in any case. And that's not certainly how we’d manage the business or what we anticipated. We are encouraged by the level of sale leaseback activity and the repairing or reemergence of the financial markets, notably the ABS market as a very good sign for the industry.

Got it. That's helpful. Last one, for me, kind of a more high-level one. From the perspective of shareholder returns, how does AINV balance higher target leverage versus peers to your cost of unsecured debt currently?

How do we balance taking on this debt at this cost, considering the returns we aim to generate? We believe this offering was well priced for investors, though potentially overpriced compared to the relative risk of our peers. There was significant interest expressed from our constituencies, including equity holders and senior debt holders, asking when we would issue again. It feels like a good time to lower our cost of debt. Therefore, we executed a small issuance to reestablish our brand. We concentrated on attracting high-quality, long-term investors who have a strong interest in this sector, allowing them to better understand our portfolio's performance and help reduce our cost to a level aligned with achieving our desired ROEs of around 9%. This is a valid question and one of the most relevant this quarter. We felt this was the right strategic move, as it offers us both strategic benefits and flexibility. The amount is $125 million or 4.5%, which does result in a financial loss since we are paying down lower-interest revolver debt, but it extends our timeline beyond the existing bonds, which will be more costly when redeemed. While this is a future consideration, we are focused on long-term strategies to reduce our cost of debt, and we believe this step was necessary.

That's it for me, I appreciate the time.

That appears to be no further questions. I will now turn the call back to management for any closing remarks.

Thank you, and thanks, everybody for calling in today on behalf of all of us. We thank you for your time today and feel free to reach out to any of us if you have any questions. Have a good day.

Thank you. And this concludes today's program. Thank you for your participation. You may disconnect at any time.