MidCap Financial Investment Corp Q3 FY2022 Earnings Call

Good afternoon, and welcome to Apollo Investment Corporation's earnings conference call for the period ended December 31, 2021. I will now turn the call over to Elizabeth Besen, Investor Relations Manager for Apollo Investment Corporation. Please proceed.

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 customary 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 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 for joining us today. I'll begin my remarks with an overview of the quarter, and we'll then provide some additional business highlights. 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'll then open the call for questions. Over the last several years, we have built a well-diversified portfolio of true first lien floating rate corporate loans invested in less cyclical industries with granular position sizes. Our ability to co-invest with other funds and entities managed by Apollo, including MidCap, allows AINV to participate in larger deals while maintaining relatively small hold sizes on our balance sheet. As you know, MidCap is the hub of Apollo's middle market direct origination business and is on par with any lender in the marketplace. The overall MidCap direct origination platform was very active during the period, closing approximately $7.7 billion in new commitments during the quarter and $19.6 billion in commitments in 2021. The MidCap platform provides AINV with access to a wide funnel of opportunities, which allows us to be selective and find attractive investments. After market close today, we reported net investment income for the December quarter of $0.35 per share. Results for the quarter benefited from strong fee and prepayment income and reflect operating with average net leverage in the middle of our target leverage range. We ended the period with net asset value per share of $16.08, up $0.01 per share. Our corporate lending portfolio, Merx, had net gains during the quarter. The corporate lending portfolio continues to improve, which Tanner will discuss later during the call. Results for December also reflect the benefit from the monetization of non-earning and under-earning assets and redeploying those proceeds into our core strategies. We have consistently generated cash from our non-core assets, and we are focused on executing some more significant progress in the coming quarters. During the December quarter, we received repayments of approximately $10 million from 3 of our non-core positions, 2 of which were non-earning, which included $4 million from 1 position without any reduction in NAV and $2 million from 1 investment which was $2 million above fair value. We also received approximately $29 million from the repayment of second lien position. Post-quarter end, Dynamic Product Tankers, one of our shipping investments, closed on the sale of 3 ships, which will be generating an additional $18 million in cash proceeds at our December 31st NAV in the March quarter. We have visibility into additional monetizations from our non-core portfolio in the coming quarters, and we look forward to reporting our continued progress. Pro forma for the Dynamic sale, non-core assets represent only 6% of AINV's total investment portfolio. Second liens represented only 5% of the corporate lending portfolio at the end of December. Lastly, we repurchased stock during the period, a meaningful discount to NAV, which was accretive to NAV per share and moderately accretive to net income per share. Moving on to other business highlights. Our Board has increased our share repurchase authorization by $25 million, having nearly completed our existing authorization. We obviously hope opportunities to repurchase our shares at a meaningful discount to NAV do not occur. But when they do, this authorization will allow us to create value for our shareholders. 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 April 7, 2022, to shareholders of record as of March 21, 2022. As a reminder, the dividends being declared today are the last of the dividends that we previously indicated would be maintained at $0.31 for the base distribution and $0.05 for the supplemental distribution. One of our objectives is to provide greater visibility for our shareholders with respect to the distribution. So for the next 2 quarters, we intend to declare a base dividend of $0.31 per share plus a supplemental dividend in an amount such that the base and supplemental combined will equal the prior quarter's net investment income per share. This means that next quarter, we expect to declare a base dividend of $0.31 plus a supplemental dividend of $0.04 or $0.35 in total, which is equivalent to the NII per share for the December quarter. We expect to have greater clarity in the coming quarters regarding the timing of the embedded upside in our portfolio and the impact of interest rates on our earnings. With that, I'll turn the call over to Tanner to discuss the market environment and our investment activity.

Thank you, Howard. The broader market environment is mixed as economic expansion, good corporate earnings growth and increased valuation are being balanced by inflationary pressures, the emergence of COVID-19 variants, ongoing supply chain issues and a more hawkish posture by the Federal Reserve. Specific to our business during this pandemic, non-bank financial institutions have become an even more important source of financing for corporates than banks. Private equity firms were extremely active in 2021 and continue to raise more capital resulting in significant dry powder. As this dry powder is deployed, the demand for financing is expected to result in considerable investment opportunities for lenders like MidCap and AINV. Moving to AINV's investment activity. New corporate lending commitments for the quarter totaled $271 million across 24 companies for an average new commitment of $11.3 million. Seventy-one percent of new commitments were leveraged lending, 13% asset-based, 10% life sciences, and 6% franchise finance. Consistent with our strategy, all new commitments were first lien loans with a weighted average spread of 639 basis points and a weighted average net leverage of 4.7x, and 96% were made pursuant to our co-investment order. Elevated repayments offset strong gross fundings resulting in net repayments for the quarter. Gross fundings for the quarter totaled $234 million, excluding revolvers. Sales and repayments totaled $287 million, excluding revolvers. As Howard mentioned, repayments included $29 million of corporate second liens and $10 million of non-core assets. Net funding for revolvers was $30 million, totaling $23 million in net repayments for the quarter. Regarding our aircraft leasing portfolio company, we believe Merx has successfully navigated this challenging period. During the December quarter, the fair value of AINV's investment in Merx increased by $3.4 million, or 1.1%, as aircraft leasing fundamentals are showing minor improvements. Turning to the overall AINV portfolio. Our investment portfolio had a fair value of $2.59 billion at the end of December across 139 companies in 26 different industries. We ended the quarter with core assets representing 93% of the portfolio and non-core assets representing 7%. First lien assets represented 93% of the corporate lending portfolio. At the end of December, the weighted average spread on the corporate lending portfolio was 605 basis points. We are closely monitoring the impact of cost inflation within our portfolio and its impact on profitability. We believe our portfolio is generally weighted towards industries that are less likely to be impacted by inflation and supply chain issues. We continue to see improvement in our credit metrics as we reduce our exposure to second lien positions. The weighted average net leverage of our corporate lending portfolio declined to 5.03x, down from 5.1x last quarter. The weighted average attachment point declined to 0.2x, down from 0.3x last quarter. Our low attachment point is a clear indication of the seniority of our corporate lending portfolio compared to loans which are classified as senior but have much deeper attachment points. The weighted average interest coverage improved to 3.1x, up from 3x last quarter. Investments made pursuant to our co-investment order represented 85% of the corporate lending portfolio at the end of the quarter. No investments were placed on non-accrual status during the quarter. At the end of December, investments on non-accrual status totaled $14 million or 0.5% of the total portfolio at fair value, down from $28 million or 1.1% last quarter. The quarter-over-quarter decline was attributable to the restructuring of our investment in sequential brands during the quarter. With that, I will now turn the call over to Greg, who will discuss the financial performance for the quarter.

Thanks, Tanner, and good afternoon, everyone. Beginning with AINV's statement of operations. Total investment income was $55 million for the quarter, up 3.9% quarter-over-quarter, reflecting higher fee income and prepayment income as well as higher interest income, partially offset by lower dividends. Prepayment income was $4 million, up $700,000 for the quarter. Fee income was $1.6 million, up $600,000 for the quarter. The increase in interest income was attributable to a larger average investment portfolio. Dividend income was $500,000 for the quarter, a decrease of $2.3 million compared to the September quarter. We received a $2.7 million cash distribution from MC, one of our shipping investments, which was recorded as a return of capital during the period. The weighted average yield at cost on our corporate lending portfolio was 7.6% at the end of December, unchanged quarter-over-quarter. The weighted average spread of our corporate lending portfolio was 605 basis points compared to 602 basis points last quarter. Expenses for the quarter were $32.5 million, up $800,000 for the quarter and included an incentive fee of $5.4 million. The increase in interest expense reflects the growth in the portfolio. Net investment income per share for the December quarter was $0.35. Net leverage at the end of December was 1.52x, up slightly from last quarter, as the average net leverage for the December quarter was 1.51x compared to 1.46x for the September quarter. On Page 16 in the earnings supplement, we disclosed the net gain and loss by strategy over the past 5 quarters. During the current quarter, our corporate lending portfolio had a net gain of $3.7 million or $0.06 per share. Merx had a net gain of $3.4 million or $0.05 per share. Non-core and legacy assets had a loss of $9.1 million or $0.14 per share, driven by losses on our shipping investments. The loss on shipping primarily relates to the sale of the 3 ships that closed in January. NAV per share at the end of December was $16.08, a $0.01 increase quarter-over-quarter. The $0.01 increase was attributable to a $0.05 per share accretive impact from stock buybacks, partially offset by the $0.03 per share net loss on the portfolio and the $0.01 from distribution relative to net investment income. Moving to stock buybacks. During the quarter, AINV purchased approximately 955,000 shares at an average price of $12.99, including commissions, for a total cost of $12.4 million. Since the end of the quarter and through yesterday, AINV had purchased an additional 61,000 shares at an average price of $12.70 for a total cost of approximately $800,000, leaving us with $5.8 million available under the previous authorization. As Howard mentioned, our Board has increased our share repurchase authorization by $25 million, which increases the amount available for future stock repurchases of just over $30 million. This concludes our prepared remarks, and please open the call to questions.

We will now begin the question-and-answer session. Our first question comes from Kyle Joseph with Jefferies.

Just refresh us, if you don't mind, given what's going on with the Fed, what percentage of your debt portfolio has floors and where those floors are versus rates at this time?

Yes, Kyle, thank you for your question. Elizabeth is getting the specific number. However, it's in the 90% range, mostly at 1%. On the life sciences side or in some specialty areas, we occasionally see slightly higher floors. Nearly everything on the corporate side is at 1%, and, as you might expect, in cases where a company is close to the syndicated market, we might see something just under 1% at around 75 basis points, but that is very rare. Now, she has the data for me, and it shows that 91% have a floor of 1% or higher, while only 3% have no floor at all.

Got it. Very helpful. And then I was just going to ask 1 follow-up, probably also for Tanner. Obviously, your credit performance has been very sound. But can you just give us an update in terms of your portfolio of companies about what they're seeing in terms of inflation, whether it be on the wage side or the raw material side? And any sort of impacts you've seen in terms of EBITDA margins or growth?

Yes, definitely. It's widespread. The question is really about how significantly the companies are experiencing it, whether it's in terms of wages or supply chain issues. We monitor revenue and EBITDA growth closely. We make adjustments for companies that are very active in acquisitions. This quarter, EBITDA growth was still positive but not as robust as revenue growth, highlighting the underlying trend you mentioned. We maintain that our position at the top level of the structure will insulate our ultimate credit performance from these pressures. I can’t comment on whether these pressures will lessen in the coming months, but given our focus on building these companies and our underwriting approach, I believe they can manage a certain degree of cost pressure before we see a significant change in our loss expenses.

We'll take our next question from Kenneth Lee with RBC Capital Markets.

Wondering if you could elaborate on the visibility that you have into additional monetizations from the non-core portfolio over the near term. And perhaps just talk about what could be driving that potential activity there.

Yes, we are focusing on the sales processes for a couple of significant positions and hope to see at least one of them come to fruition soon. Additionally, we are generating cash from a few of our positions, with Glacier being a notable contributor. We expect Glacier to continue producing cash, and even if the net asset value doesn't decrease this quarter due to oil prices and overall performance, there could still be potential for upside. The company clearly has the capability to generate more cash. Strategically, while the DPT transaction is off the books, the MC transaction has historically brought in some cash, which can be allocated towards expenses or earnings, making it a positive cash generator. So, the emphasis is on Spotted Hawk and MC to extract significant cash from those in the near future.

Got you. Very helpful. And wondering, one follow-up, if I may. Wondering if you could share with us your thoughts around potential originations activity this year, especially in comparison to what you saw last year?

Yes. I mean, obviously, we had a record year of origination, I think, as did a lot of our peers. That was the result, I think, of 2 things: a lot of private equity activity and dry powder. There's still a lot of dry powder; maybe the activity probably doesn't go up. And then as importantly, the continually increased market share of private credit versus both banks and the broadly syndicated market. That trend we expect to continue. So if you assume the pie is getting bigger, which I think is the right assumption, we would expect origination volumes to be lower than the run rate of the fourth quarter, but at least as good as it was for the full year next year. There continues to be an advantage for people who have the ability to speak for larger commitments and have size and multiple pockets of capital, which Apollo falls into that category. So that's obviously important. And it's like an arms race in some regards, so you gotta just keep working on that. If you look at origination activity through the first 5 weeks of the year, it is strong, and it's on a run rate as good as that. But frankly, that's some carryover from the end of last year. So you'd have to sort of look forward to the pipeline over the next 2 or 3 months to corroborate what I just said. But I feel like our full-year origination should be close to what our full-year origination was this year, which would be a reasonably conservative estimate.

And I might add to that quickly, Ken. As you'll know well, the lion's share of the originations for us and our peers will and always likely be from the sponsor part of our business. We continue, as we called out in our prepared remarks, to see good flow that meets our yield perspective and our other verticals such as life sciences and ABL, and that's a nice addition to AINV's opportunity set this year and beyond.

We'll take our next question from Casey Alexander with Compass Point.

Yes. First of all, I'd like to applaud you for moving to a variable dividend structure. I think that is going to be the trend for many BDCs going forward. I'm wondering if the Board considered setting the next quarter's dividend at somewhere around between 96% and 98% of the previous quarter's NII, just so that you could retain some of that income for NAV growth and to put away a sort of rainy day fund for when there may be credit losses at some point in time in the future?

Yes, 98% is less than a penny. That's a very good question. Our focus is on providing visibility into our earnings capabilities while we work on reducing our core assets. Changes in interest rates will also have an impact. We intend to keep it variable based on our earnings and provide clear visibility moving forward, expecting it to be a growing dividend base. Once we have a clearer understanding, we will consider setting the dividend slightly below our core earnings power for the reasons mentioned. However, we believe we are still in a transition period, which includes reducing our concentration in Merx, a process that was ongoing before COVID and is now reemerging. Does that clarify things?

Yes, I definitely want to inquire about the share repurchase program. Shareholders seem to appreciate the aggressive approach towards it. However, with a leverage ratio over 1.5x, buying back shares will increase that leverage ratio further. What are your thoughts on the share repurchase program? Are you looking at using proceeds from non-core assets to buy back shares? I'm interested in your perspective, as pursuing the share repurchase program without raising new equity will push the leverage ratio closer to the upper limit of your target range.

Well, we think about it like this quarter, we did $200-plus million of new origination and we had net neutral growth. So this is just some of that origination, right? The return on this investment is at $0.80 of NAV, which is better than a new loan. On the other hand, it does shrink stuff, and it's permanent, right? It's something that got paid off and rolled. So it has to be pretty accretive. If you asked us how we think about it, we don't think about it as 'Oh, we're using non-core money.' It's viewed as an investment that is beneficial for the shareholders. It's effectively a higher return than a loan with no credit risk and no fee against it. So you have to consider it in the full package of things, especially while you're repositioning everything. You're definitely right that higher leverage means the higher premium you have to get to make that the right choice.

First one for me on the dividend income line. So I know there's a little noise there with the return of capital from MC. Howard, I think you said last quarter we could expect about a $1 million run rate in that line item from MC going ahead. Does that still hold today?

Yes, I believe it generates those types of returns and cash. We would expect to produce that level of cash. Whether it's classified as income or a return of capital really hinges on the valuation. It can be either income or a return on capital. However, if the asset's value is declining, we believe it wouldn't be suitable to classify income from something that should be attributed to the basis. The correct perspective is that it does generate that income, which serves as its average return over time. We sold one ship last quarter, which influenced the valuation more than what would typically occur based on shipping rates.

Got it. Makes sense. Maybe next one for me is pivoting in the non-core book to maybe more so oil and gas. It sounds like the shipping activity is pretty healthy. Does recent strength in the oil and gas market speed up the timeline at which you think you can dispose of Glacier and Spotted Hawk?

Yes. Well, yes, Spotted Hawk, I mean, I think it definitely speeds it up. There's more interest in it, and we're focused on sort of having a process as we have a number of interested parties who have much more capabilities now. That has always been sort of an exploration play as opposed to oil coming out of the ground, so its valuation has always had a broader range. But there’s definitely more interest because more people are building up assets. Glacier is actually more interesting, because we basically invested a little bit of money to reopen some wells, and we're benefiting from that from a cash perspective. So, I don't know if it was clear in the remarks, but like in Glacier, we realized $4 million of cash out of there, and the mark didn't go down at all. Because effectively, there’s a $4 million increase in value in Glacier and oil has only gone up since then, and it's continuing to produce well. We believe that there's more likely to be buyers out there, and we will look to that, but we're also pretty comfortable with the cash it's producing in real-time.

Got it. Fair enough. And last one for me on the follow-up regarding share repurchases. If you were to get visibility on the slow down of repurchases, given where you sit above the midpoint of your leverage range, if you got more into a net growth position, would you expect the pace of share repurchases to slow down?

Yes, if we achieved net growth and continued at the current leverage level with the same stock price, it's reasonable to expect some slowdown. However, if we see significant monetization that reduces our leverage substantially, then it's more likely that the pace would increase. Overall, it has been an active quarter.

We'll take our next question from Ryan Lynch with KBW.

Can you guys go over your comments regarding Dynamic Product Tankers? I didn't quite follow it all the way. It looks like you guys had about a $12 million loss or write-down this quarter in your shipping book, but then you talked about the closing of the 3 ships, and I thought I heard maybe $18 million of unrealized gains in the March quarter. So can you just recap all that? I want to make sure I have all the details correct.

Yes, I'm happy to. Thanks for the question, Ryan. So the 3 of the 4 ships within our Prime dynamic tanker investment were monetized in this quarter. We negotiated those sales as of the end of last quarter. So the write-down reflected the monetization of those positions. The $18 million, which has largely been received to date, subject to some normal closing conditions and the closing process, was the return of capital and not a gain in this particular quarter. We're very focused on looking to monetize the fourth ship as well.

Okay. So the $18 million that you mentioned is just cash coming back in from the monetization as it will be recorded as return of capital, with no impact on your income statement, correct?

Correct.

Thanks for the clarification on that. And then you mentioned Merx is sort of, you think, down to the worst of it regarding the COVID downturn. What specifically this quarter drove the increase in the valuation of Merx?

Yes, sure. As you can probably imagine, it's a portfolio across 75 planes, and there are normal puts and takes. But on the margin, there were more positives than negatives as we continue to work through our COVID-related challenges with respect to our underlying lessees. Another driver this particular quarter is the dynamic we've talked about at length regarding the fact that we have other pools of capital at Apollo for which we serve as the exclusive servicer for those assets. As we get those opportunities, we get the benefit of the servicing revenues without stretching the AINV balance sheet. Some of that gain we saw in the particular quarter was owing to the stabilization that Howard and myself alluded to augmented by this dynamic as we continue to invest capital away from AINV and benefitting our servicing revenue.

We'll take our next question from Melissa Wedel at JPMorgan.

I wanted to touch on the yield on debt investments. It's been quite stable and resilient over the last few quarters, despite some spread compression in the market. I was hoping you could kind of go over the drivers of that stability and whether you think that can persist through this year?

Yes. It's been stable because of our origination at MidCap this quarter, which was $7.7 billion. We are choosing the assets here that fit our criteria regarding the right credit components and hitting the yield profile. If we had to originate 6 times as much, you would have seen more yield compression because there’s certainly yield compression across all businesses. However, due to the breadth of the pipeline, we're able to select what fits, including, as Tanner said, assets that aren't necessarily all leveraged loans but in some of the more bespoke asset classes. The stability results from the selectivity of AINV versus the entire available pool.

At the risk of overemphasizing, you often see people trying to complete deals before year-end. I wouldn't interpret it as a spread widening, but sometimes the sheer volume of deals in the market gives some pricing power to lenders on the margin. I wouldn’t read too much into it, but it did help augment what we were able to achieve from a spread perspective in Q4.

So as a follow-up to that, given the strength of the credit profile of companies right now, is that something that you're willing to use, the benign credit environment, to subsidize the spread when it comes to new investments?

I don't know if I understand the question. Just to make sure, what do you mean?

Sure. To the extent that losses could be lower, with the terms to borrowers quite friendly, it could speak to a supportive credit environment, especially with macro tailwinds for companies despite recent inflationary pressures. I guess I'm wondering if your outlook is for continued solid credit performance from portfolio companies, does that make you willing to dip down a little bit more on spread than you otherwise might?

No. I think there are certain levels of returns we want to deliver to shareholders that we feel we can achieve at these yields while maintaining our target leverage. Unless something changes in those measures or if the macro environment restricts access to those assets, things won't change. If we believed the risk was excessively high, we would need to adjust our approach, but I don’t see that as an issue at this time. It’s not about our willingness to pursue deals at the current yield or the size of our holdings being limited due to leverage. Diversity is also crucial for us, which aids in our strategy. We often opt for multiple assets instead of larger holdings. Regardless of the macro environment being favorable or not, we always underwrite with the understanding that it might not remain favorable. Our evaluations must be robust enough to handle pressures. There are some macro challenges affecting companies universally.

And we'll take our next question from Finian O'Shea with Wells Fargo Securities.

Can you remind us or touch on the interaction with Apollo's broader platform with the newer non-traded BDC up and running now?

Sure. The non-traded BDC has a different focus. Its strategy is basically larger deals that are originated through relationships with larger sponsors. They expect to have a portfolio that's 75% not in the range of assets AINV views as core to its strategy. They do expect to do 20% of their portfolio in assets that fit a part that's core to AINV strategy in leveraged loans, so not the other asset class we do in leveraged loans. Those deals will be in the higher end of the middle market that we do so, say, companies in the $60 million to $70 million EBITDA range where there's effectively plenty of loan to go around. Those are $300 million underwrites, and there are lots of vehicles at Apollo that are taking part in it, including this non-traded BDC. We view the non-traded BDC as very complementary to our overall approach to the market because it just gives us a lot more capabilities to underwrite deals in the higher end of the middle market and then obviously also in the larger market for them. That's where it falls. We've seen this in the first quarter now in closing some of the bigger deals where both AINV and ABS are involved.

Sure. That's very helpful. Just to recap, so I have it right. About 20% overlap with sort of a core mid-cap asset, 60%, 70% of EBITDA, and then 75% of it, the bulk of their assets are issuers that are much too large or up-market for you. Is that right?

Well, either broadly syndicated or large, right? They have something that says 20% to 30% middle market lending. So I said like a quarter. Obviously, as they build their portfolio and the market has more large origination opportunities, their percentage will fluctuate, but that will be right directionally sort of as it grows. They expect to have 50% to 70% of their assets in larger corporate loans that are originated, 20% to 30% in middle market in 20%, and the rest in broadly syndicated. Obviously, we're not doing broadly syndicated anymore, and the larger loans we're not doing as well.

And there are no further questions on the line at this time. I'll turn the program back to our speakers for any continued or closing remarks.

Thanks. Thank you, everybody, for listening to today's call and for your questions on behalf of the team. Thank you for your time, and feel free to reach out with us if you have any other questions. Have a good day.

This does conclude today's program. Thank you for your participation, and you may now disconnect.