MidCap Financial Investment Corp Q3 FY2024 Earnings Call

Good morning and welcome to the Earnings Conference Call for the period ending September 30, 2024 for MidCap Financial Investment Corporation. At this time, all participants have been placed in a listen-only mode and the call will be open for your questions and answers session following the speakers' prepared remarks. I would now like to turn the call over to Elizabeth Besen, Investor Relations Manager for MidCap Financial Investment Corporation. Please go ahead.

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. Our Executive Chairman, Howard Widra, is 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 on 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 either the SEC's website at www.sec.gov or 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 our call over to Tanner Powell, MFIC's Chief Executive Officer.

Thank you, Elizabeth. Good morning, everyone, and thank you for joining MFIC's call. I'll start today's call by discussing the successful completion of our mergers with Apollo Senior Floating Rate Fund, or AFT, and Apollo Tactical Income Fund, or AIF, closed-end funds previously managed by Apollo. I will then provide an overview of MFIC's third quarter results and share our perspective on the current market environment. I will turn it over to Ted, who will discuss our investment activity and provide an update on the investment portfolio, including the progress we've made rotating certain of the assets acquired in the mergers, results, and capital position in more detail. Let me start with a brief update on the closing of our mergers, which we view as a significant and transformational event. As I mentioned, MFIC successfully closed its mergers with AFT and AIF during the quarter. We believe these mergers offer significant financial benefits. We are excited about the long-term benefits that we believe this transaction will create. More importantly, we expect these mergers will be beneficial for all shareholders. As a result of the mergers, MFIC's net assets increased by over 40%, generating significant investment capacity. Last quarter, we onboarded approximately $600 million of investments, with approximately one-third in directly-originated loans, which are considered to be core and intend to retain. The remaining two-thirds were non-directly-originated loans consisting of broadly syndicated loans and high-yield assets. We started rotating the non-directly-originated assets when the mergers closed, prioritizing the lower-yielding assets. As Ted will elaborate, the non-directly-originated assets are progressing well, and we are on track to complete these sales over the next few quarters. We're focused on prudently deploying funds for these sales and the additional investment capacity created from the mergers. Based on our target leverage ratio of 1.4x and the remaining assets to reposition, we have approximately $600 million of capital to deploy into directly-originated middle-market loans. We are fortunate to have access to the necessary origination to deploy this capital, given the significant volume of commitments originated by MidCap Financial. Over the past four quarters, MidCap has closed $18.7 billion of commitments, including $5.1 billion in the third quarter. We are committed to deploying this capital in a steady and measured manner, while maintaining discipline in avant-garde and vintage exposure. We have a clear and straightforward plan to gradually increase leverage over the coming quarters, and we believe MFIC's future results are well-positioned to benefit as we relever back to our target level. We expect to be able to reach our target leverage in the next couple of quarters. Turning to our results for the September quarter, please note that the mergers closed on July 22. Consequently, results for the quarter include approximately 10 weeks of combined company revenue and income. MFIC's net investment income per share for the September quarter was $0.44, which corresponds to an annualized return on equity, or ROE, of 11.5%, and reflects a partial incentive fee. Results for the quarter reflect strong recurring interest income from our predominantly floating-rate portfolio. We recorded a modest net loss on our portfolio. GAAP EPS for the quarter was $0.31. NAV per share was $15.10 at the end of September, down $0.08, or approximately 0.5% from the end of June, excluding the impact of the one-time special cash distribution paid during the quarter in connection with the mergers. These mergers were a deleveraging event for MFIC. And at the end of September, MFIC's net leverage was 1.16 compared to 1.45 at the end of June. The current market environment continues to benefit from a solid economic backdrop. Economic growth continues at a healthy rate, and we've witnessed continued strength in the consumer, strong wage growth, high stock prices and strong credit markets. In terms of credit markets, we've seen an increase in activity levels. The volume in the year-to-date period has been more concentrated in opportunistic refinancings and repricings, lowering spreads, extending maturities, and improving capital structures. More recently, we have seen a pickup in new money transactions, particularly sponsor M&A, following the September rate cuts, and are cautiously optimistic that activity levels will increase in the back half of Q4 and into 2025. Additionally, the dynamics with financial sponsors seeking liquidity events for fundraising, and the pressure to return capital as hold periods have continued to stretch, in addition to significant dry powder, may also serve to increase M&A volumes into 2025. As you know, MFIC is focused on investing in first lien loans to middle-market companies sourced by MidCap Financial, a leading middle-market lender with a large direct lending team in the U.S. MidCap Financial was founded in 2009 and has a long track record, which includes closing on approximately $124 billion of lending commitments since 2013. This origination track record provides us with a large data set of middle-market company financial information across all industries, which we believe makes MidCap Financial one of the most informed and experienced middle-market lenders in the market. Apollo Global's affiliation with MidCap Financial provides MFIC and the broader Apollo platform with significant deal flow. In summary, we believe the core middle market offers attractive investment opportunities across cycles and does not compete directly with either the broadly syndicated loan market or the high-yield market. Turning to our dividend, during the September quarter, in addition to our regular quarterly dividend of $0.38, we paid a special $0.20 one-time dividend to shareholders in connection with the mergers. On November 4, 2024, our Board declared a quarterly dividend of $0.38 per share for shareholders of record as of December 10, 2024, payable on December 26, 2024. With that, I will now turn the call over to Ted.

Thank you, Tanner. Good morning, everyone. I'll spend a few minutes reviewing our third quarter investment activity and then provide details on our portfolio. In the September quarter, we started actively deploying the capital from the mergers. MFIC's new commitments in the September quarter totaled $371 million, up 30% from the prior quarter, and were across 27 different borrowers for an average new commitment of $13.7 million. All new commitments were first lien. The weighted average spread on our new commitments in the September quarter was 533 basis points. Net leverage on new commitments was 4.7 times. For the quarter, gross funding totaled $288 million, excluding revolvers and assets from the mergers. Net revolver fundings were $13 million, and we received a $7.5 million paydown from Merx. In total, net fundings were $222 million, excluding assets from the mergers. As mentioned on last quarter's call, we onboarded $596 million in assets from the closed-end funds, of which $207 million, or 35%, were directly-originated loans, and $389 million, or 65%, were non-directly-originated loans. We sold, or were repaid on, $234 million of these assets, including two positions that were on non-accrual status. In aggregate, net fundings for the quarter totaled $585 million, including assets from the mergers. With respect to the non-directly-originated loans acquired in the mergers, these assets are held throughout the Apollo platform, which facilitates both credit monitoring and the sales process. Turning to our investment portfolio, at the end of September, our portfolio had a fair value of $3.03 billion and was invested in 250 companies across 26 industries. Direct origination and other, including the directly-originated loans acquired from the closed-end funds, represents 88% of the total portfolio. The non-directly-originated loans acquired from the closed-end funds represented 6%, and Merx also accounted for approximately 6% of the total portfolio on a fair value basis. As you can see on Page 6 in the earnings supplement, we've added a row to break out the non-directly-originated assets we acquired from the mergers. Taking into account the remaining non-directly-originated loans that we intend to sell, plus the additional investment capacity based on a target leverage of 1.4 times, we have approximately $600 million of capital to deploy in directly-originated middle-market loans. We continue to monetize the non-directly-originated assets, although the pace may vary as we remain committed to deploying the capital in a steady and measured manner. At the end of September, 98% of our directly-originated portfolio was first lien at fair value. Approximately 99% of our direct origination portfolio on a cost basis had one or more financial covenants, and 91% of our direct origination portfolio is backed by financial sponsors we know well, and with whom MidCap has long-standing relationships. The average funded direct origination debt position was $13 million. The weighted average yield at cost of our directly-originated lending portfolio was 11.6% on average for the September quarter, down from 12% last quarter. The decline in the weighted average yield was mostly due to the decline in base rates and, to a lesser extent, the decline in the spread on assets. At the end of September, the weighted average spread on the directly-originated corporate lending portfolio was 577 basis points, down 24 basis points compared to the end of June. The decline in the yield on the direct origination portfolio was not materially impacted by the closed-end fund assets. In terms of credit quality, we believe the overall credit quality of MFIC's direct origination portfolio remains healthy. The financial sponsors and management teams of our borrowers have been effectively managing their liquidity. In a handful of more challenged situations, we're seeing good financial sponsor support. We have not seen a significant increase in amendment requests related to covenants or liquidity, and the requests we have seen are generally accompanied by equity infusions. At the end of September, the weighted average net leverage of our direct origination portfolio increased slightly to 4.3 times, up from 4.38 times last quarter. At the end of September, the weighted average interest coverage ratio was 1.9 times, flat compared to last quarter. The median EBITDA of MFIC's origination portfolio companies was approximately $52 million. We believe the stable level of revolver utilization we are seeing from our portfolio companies is also an indicator of portfolio health. At the end of September, approximately 31% of our leverage lending revolver commitments were drawn, which is consistent quarter-over-quarter. We believe a steady revolver utilization rate can indicate greater financial stability. Our underwriting on mid-cap source loans has proven to be sound. Based on data since mid-2016, which is the approximate date upon which we began utilizing our co-investment order, our annualized net realized and unrealized loss rate is around four basis points on loans sourced by MidCap Financial. We believe this performance data shows how well the strategy has performed. No investments were added to non-accrual status during the quarter. We exited two investments from the acquired closed-end fund portfolios that were on non-accrual status. At the end of September, investments on non-accrual were 1.8% of the total portfolio at fair value, or 2.3% at cost. When assessing a BDC's credit quality, we think it is important to look at investments on non-accrual status in combination with the BDC's level of PIK income. We believe allowing borrowers to PIK can make non-accrual levels appear artificially low as the financial stress of borrowers is not fully reflected in the non-accrual statistics and potentially masks underlying issues. We do recognize that it makes sense to allow borrowers to opt to PIK in certain circumstances. MFIC's PIK income remains low, representing approximately 3.6% of total investment income from the quarter, well below the BDC average. Moving to Merx, as we've discussed in the past, we're focused on reducing our investment in our aircraft leasing and servicing business. While we don't expect paydowns to occur evenly, we believe aircraft sales and servicing income should allow for the paydown of third-party debt and MFIC's investment in Merx over time. During the September quarter, Merx paid $9.1 million, including $1.6 million of interest and a $7.5 million return of capital. At the end of September, MFIC's investment in Merx totaled $183 million, representing 6% of the total portfolio at fair value. The blended yield across our total investment in Merx was approximately 3.3% at fair value. We expect MFIC's exposure to Merx to decline in the coming quarters, driven by additional paydowns and the continued growth in the investment portfolio as we deploy the capital acquired in the mergers. We believe the current environment for selling aircraft is very attractive due to limited availability and strong demand, and we expect to make meaningful progress reducing our exposure in the near future. With that, I will now turn the call over to Greg to discuss our financial results in detail.

Thank you, Ted, and good morning, everyone. Beginning with our results, as previously mentioned, the mergers closed on July 22. Consequently, results for the September quarter include approximately 10 weeks of combined company revenue and income. Net investment income per share for the September quarter was $0.44, and GAAP EPS was $0.31. This reflects a $0.13 per share net loss. Results for the quarter correspond to an annualized return on equity, or ROE, based on net investment income of 11.5% and annualized ROE based on net income of 8.1%. I will now discuss several factors that impacted MFIC's results for the September quarter. First, as previously noted, the mergers were a deleveraging event for MFIC. Accordingly, results for the September quarter reflect below target leverage, as we sold certain assets acquired in the mergers and deployed capital into directly originated loans. We ended the September quarter with a net leverage of 1.16 times, below our target. As Tanner mentioned, we intend to prudently increase leverage over the coming quarters, and we see no impediment to doing so. Second, prepayment and fee income were below normal levels. For the September quarter, prepayment income was approximately $900,000, down from $3.2 million in the prior quarter. Fee income was approximately $1 million, up slightly from last quarter. Third, MFIC's base management fee was $4.4 million, unchanged from the previous quarter. Our base fee is calculated as $1.75 on net assets as of the beginning of the quarter. Consequently, the increase in net assets from the merger did not impact the management fee in the September quarter. In the December quarter, the base management fee would be approximately $6.2 million. Fourth, results for the quarter include a net loss of $11.4 million, or $0.13 per share. MFIC's incentive fee for the quarter was approximately $4.6 million. We are focused on deploying the capital from the mergers and repositioning the remaining non-directly originated loans to increase MFIC's earnings power. Taking all of this into account, at the end of September, MFIC's NAV per share was $15.10, down $0.08 quarter over quarter, approximately 0.5%, excluding the one-time special dividend paid in connection with the mergers. The $0.08 decline was driven by a $0.13 per share net loss, partially offset by net income in excess of our regular dividend. Moving to capital, MFIC issued 28.5 million shares at NAV during the quarter as part of the merger consideration. As a result, MFIC now has approximately 93.8 million shares outstanding. In accordance with IAS 33, MFIC's NII and EPS denominators were based on the weighted average shares outstanding during the quarter. Since 28.5 million shares were issued approximately three weeks into the quarter, the EPS denominator for the September quarter was approximately 87.3 million. In terms of recent debt capital activity, as previously disclosed, in October we were pleased to extend the maturity of our Senior Secured Revolving Credit Facility by approximately 18 months, pushing the maturity to October 2029. We maintained existing pricing and terms. Total lender commitments under the facility were increased by $110 million to $1.6 billion, increasing the number of lenders to 18. We announced MFIC's merger with the closed-end funds and highlighted improved access to capital as a key potential benefit, and we are pleased to see this benefit materialize. We successfully added a new lender to the facility who was previously a credit provider to the closed-end funds. I would like to review the accounting aspects of the mergers. Mergers are being accounted for in accordance with the Asset Acquisition Method of Accounting under ASC 805-AFT. As a reminder, AFT and AIF merged with and into MFIC in two stock-for-stock transactions, with shares exchanged on a NAV-for-NAV basis. The exchange ratios for the mergers were based on each fund's NAV per share as of July 19, 2024. Accordingly, MFIC issued 0.9547 shares of common stock for each AFT share and 0.9441 shares of common stock for each AIF share. In total, MFIC issued 28.5 million shares of MFIC to the closed-end funds, resulting in 93.8 million MFIC outstanding shares following the merger. At the time of the merger closing, MFIC was trading at a slight discount to its current NAV. In connection with the mergers, an affiliate of Apollo paid a $0.25 per share special cash payment to the closed-end fund shareholders for a total payment of $7.5 million. In accordance with accounting guidance, a portion of this cash payment was due to the merger consideration, resulting in the fair value of the consideration paid to both the closed-end funds being equal to the fair value of the acquired assets, resulting in no purchase discount or premium. Consequently, there is no impact on the cost basis of the acquired assets, and therefore no impact on our financial statements. The fair value of the closed-end assets at close became MFIC's cost basis without any adjustments. This concludes our prepared remarks. Please open the call to questions.

Certainly. We will take our first question from Kenneth Lee with RBC Capital Partners Markets. Please go ahead.

Hey, good morning, and thanks for taking my question. Just one on the fee income there. Could you just remind us again if MFIC is more levered to prepayments for fee income, and therefore as prepayments pick up, you should see a little bit more of a pickup there? Thanks.

Thanks, Ken, and good morning. So, the loan asset class doesn't typically have a ton of call protection, and particularly in markets like this, you start to see that become less robust in any event, and it's rarely ever more than 102 or 101. Our practice is to take OID and amortize it over time, and so prepayments will create a pull forward of that OID, if you will, if the loan is redeemed prior to maturity. But outside of, and the one exception within our portfolio is in our Life Sciences vertical, where we typically will have call protection. So, notwithstanding, you've got a dynamic where, yes, there is a pickup when you do see prepayments, but outside of life sciences, it's not too dramatic on any given loan.

Got you. Very helpful there. And just one follow-up, if I may, in terms of the ongoing rotation for the non-directly originated assets and you mentioned during the prepared remarks that the pace could vary over the next few quarters. Any updated outlook in terms of what factors could drive the pace there? Is it based on macro or pricing or rates? Just any kind of color on that?

Yes, sure, Ken. It's a little bit of all of those things. We want to manage our deployment appropriately and we don't want to over-index to one particular quarter in terms of vintage. As we noted, the mergers were a deleveraging event. And so as we look to redeploy capital, build back to our target leverage and thus full earnings capacity, we want to balance the market risk of the closed-end funds to also redeployment capacity as well as just exposure. So, I think that's kind of generally the overall sentiment. We started to sell these assets by initially focusing on the lowest-yielding assets. So, we were able to move those quickly and efficiently. What we have in the book now has a better earnings capacity than the overall portfolio and we will continue to manage risk and earnings as we move forward over the next few quarters.

I'd make one quick addition to that, Ken, and at the risk of stating the obvious, within the pool of loans that came over, not surprisingly, certain of those loans that were loans or high-yield bonds had varying degrees of liquidity. Obviously, as we're evaluating the framework that Ted just alluded to, a lot of emphasis is given to the level of liquidity in the underlying loan to ensuring that selling that loan or bond would not catalyze a loss. We're trying to be very deliberate in that regard as well.

Gotcha. Very helpful there. Thanks again.

Thank you. We will take our next question from Mark Hughes with Truist. Please go ahead.

Yes, thank you. Good morning. Just looking at the direct origination commitments, I guess this is eight on the presentation. The average commitment size has been moving up the last few quarters. And I think you pointed out the net leverage for the loans this quarter is a little bit higher. Anything to see there? I know you're trying to kind of make that shift in assets expeditiously. Is that contributing to that evolution?

Yes, I'd say really quickly that we had knowledge of the merger closing and knowing it was going to be a direct origination deleveraging event, we obviously tried to over-index into the origination. And as you know or as we alluded to on the call, we were at 1.45 leverage going into this quarter. Furthermore, what we saw was in Q2 and early Q3 was very healthy in terms of M&A or relatively healthy from the beginning of the year. There were also additional opportunities there. We've seen somewhat a reduced level of activity, perhaps in anticipation of the election. We expect auction activity to pick up post-election, as evidenced by the number of NDAs that we're signing, aided by the rate cut we saw in September. While we're optimistic about the growing pipeline, it could drive deployment in the latter part of this quarter and into 2025. So overall, strong origination had to do with good market, healthy M&A volumes in the Q2 and early Q3 period, and we remain optimistic.

And how about the spread on the field this quarter relative to last quarter? How do you see the competitive environment?

Yes, I think overall, the market has become more borrower-friendly. If you look at where CLOs are pricing these days and see all the money that private capital is raising, and then on the other hand you see a slowdown in M&A activity. As Tanner mentioned ahead of the election and anticipating rate cuts, the supply-demand imbalance is tilting in the borrower's favor. We've definitely seen spread compression starting last December. The spreads were high relative to historical norms in 2023 and they’ve been tightening. Similarly, leverage in 2023 in early 2024 was well below historical norms. Thus, the market is indeed becoming more borrower-friendly, and while loans aren't as attractive as they were in 2023, they still remain attractive on a historical basis. Considering where we sit competitively with the universe of borrowers we have and the backing of our capabilities, we feel like we're in a good spot.

Appreciate that. Thank you.

Thank you. We will take our next question from Matthew Hewitt with Jefferies. Please go ahead.

Hi, guys. Congrats on the quarter and the close of the mergers. Can you not ask me to be an expert on politics or policy, but can you just talk about maybe your high-level thoughts about what the election could mean for your business or portfolio companies at this point?

Yes, this is Howard. I think you've seen the forward curve move up. So that is probably the most obvious indication of where the market thinks it's going, with a more benign regulatory environment and potentially a more inflationary environment, which is why they think interest rates are going up. That generally can cut both ways but obviously creates a more growth backdrop for companies. The other part is just regulatory oversight. A change at the FTC likely changes people's view of mergers or the practical implications of merging. One would expect deals to increase. Those are probably the first-order effects. The second, third, and fourth-order effects are harder to predict. Specific companies will have specific issues that arise as policies change.

And just to add on to that, and much has been made of this, it is highly likely that tariffs will go up. When we think about our borrowers, and by statute, we have to be U.S.-based, so it's less about the markets that they're selling into. However, we are critically examining the supply chains of our underlying borrowers to integrate that into our underwriting framework as we evaluate risk on our books and look for new investment opportunities.

Okay, thanks. That's great context. And then can I just ask, the $0.10 unrealized and realized loss per share for the quarter, can you maybe give some color on which portfolio companies drove that?

Sure. We think about the portfolio in a couple of different ways. One is what we acquired from the closed-end funds. Those were largely flat. We did take small loss on exiting some of the non-accrual status names, which was offset by gains and other sales. Our biggest loss was on a restructuring name where we transitioned from preferred equity into a second lien. Overall, we felt going from non-current income to current income and moving up the capital stack is beneficial. However, we had to realize a loss on exiting the preferred equity security. Many other loans showed movements as they are on our watch list or undergoing a sales process. We marked them down slightly to highlight the uncertainty of the outcomes.

Thanks very much.

Thank you. We will take our next question from Paul Johnson with KBW. Please go ahead.

Yeah. Good morning. Thanks for taking my questions. My only question is just kind of, given the weakness in the stock during the quarter, post-closing the merger, a market that's been pretty competitive, weighted average spread on investments around 570 basis points, and your leverage is about as low as it's been in a while, obviously due to the closing of the merger. So can you just expand on maybe your thoughts around the buyback? When would you look to potentially repurchase shares, if that's an option? And why not consider that here in this scenario with leverage you're looking to increase in a tight market?

First of all, it's ironic because prior to the merger, the questions were why is your leverage so high? But we have always said we will buy back stock when it's accretive versus other uses of capital. The guideline we had given previously was around 0.8 price analysis. We believe that even as the stock price has traded down versus peers since the merger, as people who can hold this stock have cleared out, we think it's an ongoing concern. Lastly, whatever you saw in the last quarter isn't necessarily indicative of our strategy going forward. We're not open to sort of trading, and that's been the case. The window wasn't open for a large number of trading days during the quarter. So the answer is the same as before. We don't see it changing based on our leverage status. We assess our available capital and weigh our options, but believe that having available capital is a strength.

Got it. Does the relationship change to where you would potentially look to buy back? I mean, how does that change in relation to just overall market returns, putting that into context of the spread compression we've seen this year?

Yes, look, obviously, there are many inputs. The cost of debt is going down, so many factors play into it. If, in the long-term, we believe all senior loans will settle at 400 over, that would be a different calculus. Expectations for ROE across the whole market also play a role. The balance would change, but remember there's been a 150 basis points decline in spreads, following a similar increase just prior. Therefore, we shouldn't react based solely on current spreads; it’s more about where we forecast them over the entire cycle.

I appreciate that. That's all the questions for me. Congrats on a good quarter, guys. Thanks.

Thank you. And there are no further questions at this time. I'll turn the call to management for any 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, and have a good day.

Thank you. This does conclude today's program. Thank you for your participation. You may disconnect at any time.