MidCap Financial Investment Corp Q3 FY2023 Earnings Call

Good afternoon, and welcome to the earnings conference call for the period ended December 31, 2022, for MidCap Financial Investment Corporation. I will now turn the call over to Elizabeth Besen, Investor Relations Manager for MidCap Financial Investment Corporation.

Thank you, operator, and thank you, everyone, for joining us today. Speaking on today's call are Tanner Powell, Chief Executive Officer; Ted McNulty, President; and Greg Hunt, Chief Financial Officer. Howard Widra, Executive Chairman as well as additional members of the management team are on the call and available for the Q&A portion of today's call. I'd like to advise everyone that today's call and webcast are being recorded. Please note that they are the property of MidCap Financial 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 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.midcapfinancialic.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. Throughout today's call, we will refer to MidCap Financial Investment Corporation as either MFIC or the BDC and we will use MidCap Financial to refer to the lender headquartered in Bethesda, Maryland. At this time, I'd like to turn the call over to our Chief Executive Officer, Tanner Powell.

Thank you, Elizabeth. Good afternoon, everyone, and thank you for joining us today. I'd like to begin today's call by highlighting our results for the quarter, followed by a review of our investment strategy, including some performance data, which we believe shows why we're so confident in our strategy. I will then provide an update on some of the good progress we have made reducing our investment in Merx and will conclude with the increase to our quarterly dividend. Following my remarks, Ted will review our investment activity and provide an update on portfolio credit quality. Lastly, Greg will review our financial results in detail and provide some additional comments on Merx. We will then open the call to questions. Beginning with our financial results after market closed today, we reported net investment income per share of $0.43, which benefited from the positive impact of higher base rates. As a reminder, there's generally some lag before we see the full impact of higher base rates due to the timing of loan resets. At the end of December, net asset value per share was $15.10, a decline of 2.3% quarter-over-quarter, mostly due to losses outside of our first lien corporate lending strategy. Regarding investment activity, new commitments continue to focus on first lien corporate loans sourced by MidCap Financial. We have also made significant progress reducing our exposures outside of our core strategy. Sales and repayments during the quarter included nearly all of our remaining oil and gas exposure, which is now less than $1 million at fair value. In addition, post quarter end, we received a significant pay down from Merx, reducing our position by roughly 24%. Pro forma for this pay down Merx represents approximately 8.3% of the portfolio at fair value. Shifting to a review of our investment strategy. As you may recall, in August, we made several key announcements which underscored Apollo Global Management's commitment to being at the forefront of the democratization of finance. These announcements included the establishment of a new and industry-leading fee structure for MFIC and equity investment into the BDC by MidCap Financial and a change in the company's name. These announcements reinforce MFIC's position as a pure-play senior secured middle-market BDC providing public shareholder access to institutional quality private credit at a best-in-class fee structure among listed BDCs. As you have heard us discuss on our previous calls, over the last several years, we have shifted the BDC's portfolio into first lien corporate loans, primarily sourced by the MidCap Financial, one of the world's leading middle-market lenders with a proven track record. MidCap Financial has one of the largest direct lending teams in the United States with close to 200 investment professionals. We believe the scale of MidCap Financial, combined with other Apollo-managed capital mix MFIC part of one of the largest market participants in middle-market lending. For reference, in 2022, MidCap Financial closed approximately $16.4 billion in new commitments, including $4 billion in the December quarter. The BDC is fortunate to be in a unique position to have access to loans sourced by MidCap Financial given the strategic relationship between MidCap Financial and Apollo Global. In mid-2016, concurrent with the receipt of our co-investment order, MFIC shifted its strategic focus to leverage Apollo Global's relationship with MidCap Financial. I wanted to take a moment to provide some historical performance data, which we think shows how well the strategy has performed. As of June 2016, which is approximately the date upon which we began utilizing our co-investment order, our first lien corporate lending portfolio totaled approximately $300 million. At the end of December 2022, our first lien corporate lending portfolio had grown to nearly $2 billion at fair value over that 6.5 year period; we funded approximately $5.7 billion of new first lien corporate loans sourced by MidCap Financial. Total losses on those first lien corporate loans during that period have been approximately $7 million, or 12 basis points on a cumulative basis. On a cumulative basis, our 2 basis points annually. We are highlighting this track record because we do not believe the market has fully appreciated how these assets have performed over an extended period of time and because we believe it may help to inform how our first lien corporate lending portfolio should perform going forward. It is also worth noting that today's first lien corporate lending portfolio is not only well diversified by borrowing industry but also across 5 distinct product groups: leverage lending, asset-based lending, lender finance, life science lending, and franchise finance. Moving to Merx, consistent with our strategic focus on being a pure-play senior secured middle market BDC, we remain focused on accelerating the reduction of our investment in Merx. We are pleased to report that we have made significant progress in this regard. At the end of December, MFIC's investment in Merx had a fair value of $261 million, representing 10.9% of the total portfolio at fair value. Post quarter end, Merx executed a significant transaction by selling its interest in a joint venture and repaid roughly $62 million to MFIC, which was applied to the revolver, reducing the size of MFIC's investment in Merx to approximately $199 million or 8.3% of the portfolio at fair value. We remain focused on continuing to reduce our investment in Merx, and while we don't expect paydowns to occur evenly, we do expect to see additional paydowns in 2023, subject to market conditions. Greg will provide some additional color on the reduction in Merx later during the call. Moving to our quarterly dividend. Given the benefit we are seeing from higher base rates, the exit of lower yielding and non-earning legacy assets, and the expected benefit from our new fee structure, which became effective on January 1, 2023, our Board has increased MFIC's regular quarterly dividend by $0.01 from $0.37 to $0.38, which equates to a 10% dividend yield based on December NAV. This dividend increase marks the third consecutive increase in our quarterly base dividend. At current base rates, we are well positioned to generate net investment income in excess of this new dividend level. The forward curve indicates that there will be additional rate increases and rates will remain elevated for some time. As the operating environment continues to evolve, our Board will continue to evaluate whether to retain additional earnings, increase the base dividend, or declare supplemental dividends. With that, I will turn the call over to Ted.

Thank you, Tanner. Beginning with a few thoughts on the current evolving macroeconomic environment. Volatility in the leverage finance and equity capital markets continued during the period as the Federal Reserve continued to raise interest rates to curb inflation amid ongoing concerns around slowing economic growth. In 2022, the Federal Reserve increased rates by 425 basis points and has increased rates by an additional 25 basis points so far this year with more rate increases expected, albeit at a slower pace. More recently, we have seen some signs of easing inflation, however, and Fed hawkishness is expected to keep markets volatile in the near term. As a result, primary new issuance in the leveraged loan and high-yield markets continues to be negatively impacted. We believe it will take time for the Federal Reserve's actions to be fully absorbed by the economy, and therefore, M&A transaction volumes will remain slower in the near term. We believe that the increased volatility in the public markets has created more attractive investment opportunities for direct lenders as more companies turn to the private debt markets. We're seeing wider spreads, lower leverage, and tighter documentation across our origination platform and continue to be selective, seeking to finance companies with defensible market share and resilient balance sheets. For example, credit spreads are at least 100 to 150 basis points higher than last year across our origination platform. With this as the market backdrop, we thought it would be worthwhile to remind everyone how we have constructed our corporate lending investment portfolio. We believe MFIC has one of the most senior secured portfolios among BDCs. Our corporate lending portfolio is focused on floating rate investments at the top of the capital structure, which we believe positions us well going into a weaker economic environment. In order to understand the stability and safety of our portfolio, we think it is important to focus on attachment points. At the end of December, the weighted average attachment point of our corporate lending portfolio was 0.2x, which underscores that we are invested in the most senior part of the capital structure for what we refer to as true first lien. By focusing on the top of the capital structure, we believe we will be able to mitigate some of the credit risks that could arise in a more challenging operating environment. Despite the more uncertain macroeconomic landscape, our borrowers have generally been able to navigate the current environment well, as evidenced by their fundamental performance. Our portfolio companies experienced positive year-over-year revenue growth in the most recent quarter and sound with slightly lower EBITDA growth. We believe our portfolio companies are generally entering 2023 with solid fundamentals and will be able to weather potentially more challenging conditions. To date, we have not seen any meaningful increase in either amendment activity or revolver drawdowns beyond the normal levels. That said, we acknowledge that some companies will have challenges in a slower economic environment, and we could see a pickup in amendment activity in the coming quarters. Importantly, MFIC benefits from MidCap Financial's dedicated portfolio management team of nearly 60 investment professionals which helps identify and address issues early to maximize value. Moving to investment activity. We believe the middle market is generating attractive investment opportunities. As mentioned earlier, MidCap Financial was active during the December quarter closing approximately $4 billion in new commitments. In the December quarter, MFIC's new corporate lending commitments totaled $73 million across 9 companies for an average new commitment of $8.1 million. These new commitments were all first lien floating rate loans with a weighted average spread of 680 basis points, up 41 basis points compared to commitments made in the prior quarter. The higher spread on new commitments is another earnings tailwind we continue to see. The weighted average net leverage of new commitments made during the quarter was 4.8x, which is 0.7x below the 5.5x average of our portfolio. Excluding revolvers, gross fundings for the quarter totaled $105 million, and sales and repayments totaled $141 million. Net repayments for revolvers totaled $11 million. In aggregate, net repayments for the quarter totaled $48 million. Especially notable, sales and repayments included roughly $21 million from our remaining oil and gas exposure, which is now less than $1 million at fair value. In 2022, we sold all of our ships and oil and gas assets as we continue to accelerate the execution of our true first lien strategy. Turning to the overall portfolio. Our investment portfolio had a fair value of $2.4 billion at the end of December across 135 companies in 26 different industries. Corporate Lending and other represented 89% of the total portfolio and Merx represented 11% of the portfolio at fair value. As Tanner mentioned, post quarter end, Merx has been reduced to approximately 8% of the total portfolio at fair value. At the end of December, 94% of our corporate lending portfolio was first lien with a weighted average spread of 610 basis points. Our portfolio company credit metrics remained relatively stable during the quarter. At the end of December, the weighted average net leverage of the corporate lending portfolio was 5.49x down from 5.52x last quarter. The weighted average interest coverage ratio was 2.5x, down from 2.7x last quarter. These weighted average interest coverage ratios are based on company data for the last 12 months through September. The weighted average interest coverage ratio was 1.9x based on an annualized interest expense for the September quarter and using the last 12 months of EBITDA. Given the significant and rapid increase in base rates, we're focused on current and future interest coverage and fixed charge coverage ratios across the portfolio as a component of an active risk monitoring process. No investments were placed on non-accrual status during the quarter. At the end of December, investments on non-accrual status totaled $10 million or 0.4% of the total portfolio at fair value. With that, I will now turn the call over to Greg to discuss our financial results in detail.

Thank you, Ted, and good afternoon, everyone. Before discussing our results, I wanted to remind everyone that MFIC has changed its fiscal year-end from March 31 to December 31. The change in fiscal year was done to better align MFIC's reporting calendar with other Apollo Global entities. The transition report on Form 10-K, which was filed today, includes a 9-month period from April 1, 2022, through December 31, 2022. MFIC's next fiscal year will cover the period from January 1, 2023, to December 31, 2023. You can see the year-over-year results in the 10-K that we filed today. Shifting to our results. Net investment income per share for the December quarter was $0.43 compared to $0.35 for the September quarter and $0.35 in the year-ago quarter. Net investment income for the December quarter continued to benefit from higher base rates on our floating rate assets, solid fee and prepayment income, as well as a lower incentive fee compared to the comparable periods. Prepayment income was $2.8 million, down slightly from last quarter, and fee income was approximately $700,000 compared to $1.5 million last quarter. Dividend income was essentially flat quarter-over-quarter. The yielded cost on our corporate lending portfolio was 10.3% on average for the quarter, an increase of 140 basis points from last quarter, driven by the increase in base rates. This yield figure is an average of the beginning and the end of the quarter. At the end of December, the yield of the corporate lending portfolio was approximately 11% compared to 9.6% at the end of September. NAV per share at the end of December was $15.10, a 2.3% decrease quarter-over-quarter, primarily driven by losses outside of our first lien lending book. In that regard, and as previously indicated, our corporate lending portfolio of $2.1 billion is made up of 94% first liens. Losses are less than 10% of our losses or $2.3 million were attributed to our first lien corporate lending book and were primarily due to mark-to-market adjustments from spread widening as opposed to fundamental credit losses. Additional details on the net losses are shown on Page 16 in the earnings supplement. MFIC's incentive fee on income includes a total return hurdle with a rolling 12-month, 12-quarter look back. Given the net loss on the portfolio, incentive fees in the December quarter were significantly reduced. As a reminder, beginning on January 1, 2023, MFIC's base management fee was permanently reduced to 1.75% on equity. Among listed BDCs, MFIC's management fee is now the lowest and is the only listed BDC to charge management fees on equity, which we believe provides a greater alignment and focus on net asset value. The incentive fee rate on income was also permanently reduced from 20% to 17.5%, and we retained the total return feature. Moving on, from our balance sheet perspective, our net leverage stood at 1.4x at the end of December within our target range. We intend to amend and extend our revolving credit facility in the next few months. Although no stock was purchased during the quarter, we believe MFIC's trading discount to NAV implies a loss rate significantly higher than our first lien corporate lending portfolio has experienced over the last 6.5 years. Moving to Merx, as Tanner mentioned, in January, Merx sold its 50% interest in a joint venture, reducing Merx' fleet from 57 aircraft to 43 today. Proceeds from this sale were applied to the MFIC, reducing our investment in Merx to approximately 8.3% of the portfolio at fair value. This sale in combination with other steps taken in connection with the reduction of our exposure to Merx resulted in a nominal write-down on our investment during the quarter. Turning to our outlook, we believe we are well positioned to grow earnings in the coming quarters due to the rising interest rate environment. For perspective, based on quarter-end rates, we estimate that a 50 basis point and 100 basis point increase in base rates would result in incremental annual earnings of approximately $0.06 and $0.13, respectively. We have provided additional information on the sensitivity in our 10-K. As we enter 2023, we feel very constructive about the outlook for MFIC, given the diversity of our corporate lending portfolio which we believe is designed to weather a more challenging economic environment. This concludes our prepared remarks, and operator, please open up the call to questions.

And our first question will come from Mark Hughes with Truist.

For Merx, I think you talked about the opportunity for more paydown in 2023. Are transactions required in order to generate that? Or can they pay down just from operating cash flow?

Yes, thanks, Mark. The answer is that big wholesale transactions are not necessary. As Greg mentioned, we currently have 43 planes in our portfolio. It's important to note that these are not CUSIP securities and cannot be traded on the wire. The sales process for these assets is lengthy and involves tax considerations. We do have a yield on the portfolio right now, but to see significant reductions in our exposure, we would need to sell assets either individually or in larger groups.

Within the portfolio, the high-tech industry is about 17%, I think. Any impact there has been some volatility in the tech on the job front. Are you seeing any of that within your portfolio?

No. In high tech, this was a distinction made back in '06 when the fund was founded and it encompasses a lot of areas, including software, which is something that the broader market has experienced quite a bit. When we consider the exposure there, the good news from a software perspective is that the different companies are often targeting various underlying markets with distinct fundamentals. Additionally, those deals typically have lower loan-to-value ratios than our average loan-to-value across our leveraged lending portfolio, which is roughly 50%. Therefore, there is significant cushion in any case. However, as you rightly mentioned, there are some broader challenges in the tech space.

Our next question will come from Robert Dodd with Raymond James.

I have one more question. In your prepared remarks, you mentioned that spreads have widened significantly, by 100 to 150 basis points, and others have noted the same trend. However, when I examine your new commitments, they were 680 this quarter compared to 639 last quarter and also 639 a year ago. This indicates an increase of about 40 basis points in widening, and the leverage remains similar. Have you had the chance to adopt a more cautious approach regarding the assets, possibly in response to the visibility of spread expansion in new commitments? Any insights you could share on this would be appreciated.

Yes, thanks, Robert. I believe that's absolutely the case. When we discuss those numbers, we're looking at our various business segments, particularly our middle market lending platform and our activities at MidCap. It's important to highlight that this is one of the factors that led us to reduce our cost structure, which allows us to engage in a larger share of the opportunities that MidCap is bringing in. While we aimed to remain in the 600s when possible, in the most recent quarter, we deployed approximately $75 million at the 680 level, which we believe reflects the current market conditions. As you noted, this indicates that we're being a bit more conservative while also preparing for the broader market changes, allowing us to participate in a larger percentage of the deals as our cost of capital decreases.

I appreciate that. Regarding the energy exits, I assume this has been in the works for a while rather than just a decision made this quarter. We were aware of some realized losses, but could you provide more insight on why there were multiple exits in such an active manner? What really drove that, or did everything just happen to align at once?

Yes. Sure, Robert. Happy to address that. So several years ago, we began the process of migrating towards the broader strategy. And starting in 2020 and then in 2021, we took the opportunity to work with the management teams and restructure the business and get those businesses ready to go to market and then did so in 2022. In some cases, hiring advisors, running processes, and this is across oil and gas as well as the shipping assets that we sold last year. And it just so it turns out that for both of the assets, they ended up closing in the quarter, the 2 oil and gas assets. So they have been worked on for operationally, financially for a couple of years and then in terms of actual M&A process over the course of the year.

Our next question will come from Ryan Lynch with KBW.

My first question is about the nature of the write-down from the NAV this quarter. I understand you mentioned they were primarily due to spread widening. However, wasn't the largest markdown actually related to your corporate lending portfolio, specifically driven by the debt-to-equity restructuring of K&N, which seems more like a credit markdown? I'm a bit confused unless I'm misunderstanding why the markdowns this quarter were mostly described as spread widening rather than credit.

Yes, thank you for your comments. To clarify, there was indeed one part of the write-down that was related to the second lien, specifically the K&N investment which underwent a restructuring that was finalized after the quarter ended. Additionally, in the prepared comments, the write-down in the first lien credit book was attributed to the mark-to-market adjustments. Therefore, there are really two distinct components involved.

Yes. The prepared remarks emphasized that the significant decline occurred outside of the first lien strategy, and you are correct that this was largely due to the K&N write-down.

And within the corporate strategy, it was a mark-to-market.

Got you. And then you guys gave some statistics on weighted average interest coverage, 2.5x on trailing 12 months, 1.9x in September annualized. Have you guys done any sort of analysis that looks at what that interest coverage is going to look like in calendar 2023 when kind of LIBOR SOFR kind of peak out? And then obviously, the weighted average interest coverage is kind of the mostly quoted statistic, but from a credit standpoint, I don't think most investors are sort of worried about the average borrower default and I think it's more likely in the risk or more in the tailwinds of potential borrowers having issues. So have you guys done any sort of analysis on, at what interest coverage would look like on a forward basis and what percentage of your portfolio would fall below that 1x interest coverage level?

I understand that these numbers may seem somewhat historical. We've conducted an analysis and found that based on the current LIBOR, approximately five names fall below the 1x coverage threshold. When we account for a stress scenario of an additional 100 basis points, which is slightly higher than market expectations for LIBOR/SOFR rate increases, only a few more names are added to that list. Therefore, even considering SOFR rates around 5.75% to 6%, we still have fewer than 10 names under the 1:1 coverage ratio, and this is without factoring in the year's benefits to help offset the increase in the underlying companies.

Yes, we anticipate a somewhat stepwise progression, which may have its inconsistencies, but likely not as marked as what we experienced this quarter. There are certain groups of assets that are clearly interrelated, like those from the same lessor, that we expect to divest. Therefore, while we foresee this happening more on a plane-by-plane basis rather than as entire entities, it won’t simply occur one by one. I realize this may not be a complete answer, but that is our outlook.

And our next question will come from Melissa Wedel with JPMorgan.

I was hoping you could discuss portfolio leverage and your thoughts on the current levels. I would assume that since you're currently around 1.4x on a net basis and still in a bit of a capital recycling mode as repayments and exits occur, that would be a fair assumption. Are you approaching things differently?

I think that's a fair assumption. That is the 1.41x where we came out this quarter, is at the bottom of our range. We did provide guidance last quarter that we would expect to operate in and around that range. And to your point, redeploying what comes back to us. I would note, and hopefully, it's obvious from some of the other comments and questions is we do believe that further economic volatility notwithstanding, this will be a good vintage for credit lenders on account of good spread, improving documentation and lower all-in leverage. And so we do want to participate in this market and make sure we are properly indexed to what we believe is a good market for private credit and make sure MFIC is the beneficiary of that.

Okay. I appreciate that. And I think as a follow-up on some of the outstanding commitments, and I'm looking at Slide 18 in your deck specifically. As you think about sort of the commitments available to be drawn down on, I think I'm looking about $193 million, kind of rounding $193 million. As you think about the potential for a more challenging operating environment, are you expecting to see that number start being drawn upon by existing portfolio companies? And if that's the case, I assume that the terms have already been set, so they're not sort of dictated by the current environment, but by the terms that were agreed upon when that commitment was made. Could you just kind of elaborate on that process a little and how you're thinking about it?

Yes, sure, Melissa, very good question. And so the first point is we have not seen a tick up in revolver utilization across MFIC or our broader business. And I think on this account, good news, bad news is, the bad news is we went through COVID. But the good news is in having gone through COVID, and experienced those instances wherein there was the preemptive drawing down of the revolvers, we had the opportunity, both in new loans as well as also in existing loans to put in the type of terms to protect on the margin against such as anti-cash hoarding and eliminating netting in terms of covenant compliance. And so while, if stresses are more acute than we expect or are continuing at the level, obviously, cash flows may become challenging. You would expect a higher utilization, but we haven't seen and at a minimum, on account of what we've been able to do from a documentation standpoint, think that that risk of excessive drawdowns within our revolvers to be much less risk than what we've seen historically.

And then on the term loans, those have defined use of proceeds as well. So they're primarily in place to support sponsors, going to make acquisitions to grow their portfolio of companies. And so the delayed draw term loans, which is I think what you were pointing out on the slide, those can't be drawn down just for liquidity purposes.

Thank you. And at this time, we have no further questions in the queue, so I would like to turn it back over to management for any additional or closing remarks.

Thank you, operator. Thank you, everyone, for listening to today's call. On behalf of the entire team, we thank you for your time today. Please feel free to reach out to us if you have any other questions. Have a good evening.

Thank you, ladies and gentlemen. This does conclude today's conference call, and we appreciate your participation. You may disconnect at any time.