Earnings Call Transcript - MFIC Q2 2024

Operator, Operator

Good morning, and welcome to the Earnings Conference Call for the period ended June 30, 2024 for MidCap Financial Investment Corporation. At this time, all participants have been placed in listen-only mode. The call will be opened for a question-and-answer session following the speakers' prepared remarks. I will now turn the call over to Elizabeth Besen, Investor Relations Manager for MidCap Financial Investment Corporation.

Elizabeth Besen, Investor Relations Manager

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 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 website at www.sec.gov or our website at www.midcapfinancialic.com. At this time, I would like to turn the call over to Tanner Powell, MFIC's Chief Executive Officer.

Tanner Powell, CEO

Thank you, Elizabeth, and thank you to everyone who has joined today's call, especially those of you who may be newer to MFIC. I will begin today's call with an update on the successful completion of our mergers with our previously affiliated funds, Apollo Senior Floating Rate Fund Inc. and Apollo Tactical Income Fund Inc., which we will refer to as AFT and AIF or the CEFs throughout today's call. I will then provide an overview of MFIC's second quarter results and will also provide our perspective on the current environment. Ted will then discuss our investment activity and provide an update on the investment portfolio. He will also review the assets that we acquired in connection with the mergers. Greg will then review our financial results in greater detail and will also review some of the accounting aspects of the mergers. Beginning with the mergers, we are pleased to announce that on July 22, MFIC successfully closed its mergers with AFT and AIF, two listed closed-end funds managed by Apollo. We believe these mergers mark an important step in MFIC's evolution to becoming a leading pure-play middle-market BDC. We remain enthusiastic about realizing the potential benefits that we highlighted when we announced the mergers last November. Let me remind you of some of these key benefits. First, we expect these mergers will be both ROE and NII per share accretive for all shareholders as we rotate the CEF's lower-yielding investments in the ordinary course into higher-yielding directly originated loans that align with MFIC's investment strategy. Second, the mergers are expected to enhance MFIC's portfolio diversification and improve certain portfolio metrics. Third, we expect to be able to realize operational synergies from the elimination of certain duplicative expenses from the mergers. And lastly, we believe that the larger market capitalization for the combined company may broaden the universe of potential investors, which could result in greater stock liquidity. As Ted will discuss, we are currently focused on deploying the capital and rotating certain assets acquired in the mergers and have already made good progress in that regard. As a reminder, Apollo provided significant financial support for these mergers by reimbursing all merger-related expenses for all three funds and by making a one-time special cash payment to the CEF shareholders. As a result of the mergers, MFIC's net assets have increased by approximately 44%. With $1.45 billion in net assets, MFIC has significant investment capacity. As a result of this deleveraging, MFIC is well positioned to deploy capital into true first lien senior secured loans sourced by MidCap Financial, a leading middle-market lender managed by Apollo. Moving to our results for the June quarter, as previously announced when the mergers closed, MFIC's net investment income per share for the June quarter was $0.45, which corresponds to an annualized return on equity, or ROE, of 11.8%. Results for the quarter reflect solid recurring interest income from our predominantly floating rate portfolio and strong fee and prepayment income. GAAP EPS for the June quarter was $0.35. NAV per share was $15.38 at the end of June, down $0.04 from the end of March. Beginning with the macro environment regarding rates, Apollo's Chief Economist believes that the Fed will cut rates by 25 basis points in September, but still expects a soft landing. He notes a continuing strength in a broad set of weekly indicators such as TSA data for air travel, restaurant bookings, retail sales, and hotel occupancy rates that suggest the economy will be able to avoid recession. With regard to markets, the credit market continued to be very strong and well-bid throughout Q2 and into the start of Q3 2024. M&A and LBO activity increased in Q2 from very low levels, though has lagged expectations, and thus issuers and sponsors have taken advantage of limited new supply, tapping the market for dividends and repricings. Auction activity has seen a meaningful pickup in the latter part of Q2 and into Q3, and we expect to see an increase in new deployment opportunities for direct lenders in the back half of the year. As you know, MFIC is squarely focused on investing in first lien loans to middle-market companies sourced by MidCap Financial, a leading middle-market lender with one of the largest direct lending teams in the US, with close to 200 investment professionals. MidCap Financial was founded in 2009, has a long track record, which includes closing on over $118 billion of lending commitments since 2013. This origination track record provides us with a very large dataset of middle-market company financial information across all industries, and we believe it 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 short, 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. Despite the heightened level of competition, we are pleased to report that MidCap Financial was active during the June quarter, closing approximately $4.4 billion in new commitments or $9.6 billion in the first half of 2024. Next, let's turn to dividends. First, as previously announced, in connection with the mergers on July 21, our Board of Directors declared a one-time special cash distribution of $0.20 per share to shareholders of record as of August 5, 2024, payable on August 15, 2024. As a reminder, this special $0.20 dividend is being paid to all shareholders as of the record date, including former AFT and AIF shareholders. In addition, on August 6, 2024, our Board declared a quarterly dividend of $0.38 per share consistent with our prior quarterly dividend to shareholders of record as of September 10, 2024, payable on September 26, 2024. With that, I will now turn the call over to Ted.

Ted McNulty, President

Thank you, Tanner. Good morning, everyone. I will spend a few minutes reviewing our second quarter investment activity and our investment portfolio. I will then review the investments we acquired via the mergers with the closed-end funds. During the June quarter, MFIC's new investment commitments totaled $285 million across 28 different borrowers for an average new commitment of $10.2 million, as we continue to focus on diversification by borrower. 23% of new commitments were made to existing portfolio companies. Despite spread compression, we believe the risk-return profile on these new commitments remains compelling. The weighted average spread on our new commitments in the June quarter was 559 basis points. Net leverage on new commitments was 3.3 times, down from 3.9 times last quarter. The weighted average OID for new commitments was approximately 157 basis points. This spread in OID translates into a very attractive unlevered asset yield of over 11%, assuming a 5% base rate. In terms of funded investment activity for the quarter, gross fundings for the corporate lending portfolio, excluding revolvers, totaled $214 million. Sales and repayments totaled $131 million. Net corporate lending revolver fundings were positive $10 million, and we received a $3 million paydown from Merx. In aggregate, net fundings for the quarter totaled $90 million. Turning to our investment portfolio. We've built what we believe is a well-diversified senior corporate lending book. At the end of June, prior to the close of the mergers with the closed-end funds, our portfolio had a fair value of $2.4 billion and was invested in 165 companies across 23 different industries. Corporate lending and other represented over 92% of the total portfolio, and Merx accounted for less than 8% of total portfolio on a fair value basis. 97% of the corporate lending portfolio was first lien, and over 99% of our corporate lending debt portfolio had one or more financial covenants, with 88% of our corporate lending portfolio backed by financial sponsors who we know well and with whom MidCap has longstanding financial relationships. The average funded corporate lending position was $14.1 million or approximately 0.6% of the total corporate and other lending portfolio. The weighted average yield at cost of our corporate lending portfolio was 12% on average for the June quarter, down slightly from 12.1% in the March quarter. At the end of June, the weighted average spread on the corporate lending portfolio was 601 basis points, down 20 basis points compared to the end of March. Turning to credit quality, our focus on true first lien top-of-the-capital-structure middle-market loans has resulted in what we consider to be stable credit quality. Overall, we feel good about the health and quality of our corporate lending portfolio, as our underlying borrowers have largely been able to handle higher borrowing costs. We have not seen a significant increase in the amendment requests, and the requests we have seen are generally accompanied with good sponsor support. Our portfolio companies are generally maintaining performance, continuing the trend of solid fundamentals demonstrated in 2023 and into early 2024. On a median basis for the March quarter, portfolio company revenue and EBITDA both increased by mid-single digits year-over-year. This has been achieved despite a downturn in acquisition activity, indicating that much of the growth demonstrated has been organic. At the end of June, the weighted average net leverage of our corporate lending portfolio was 5.38 times, up very slightly from 5.36 times last quarter. At the end of June, the weighted average interest coverage ratio remained 1.9 times, unchanged quarter-over-quarter, with four companies below 1 times. We are closely monitoring these situations and believe they are manageable as the companies have strong current liquidity, good underlying business performance, or have strong financial sponsor support. The median EBITDA of MFIC's corporate lending portfolio companies was approximately $46 million. Our underwriting on MidCap-sourced 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 is around 3 basis points on loans sourced by MidCap Financial. We think this performance data shows how well the strategy has performed. As of the closing of the mergers, investments on non-accrual were 1.8% of the total portfolio at fair value, or 2.3% at amortized cost across 11 names, including six companies acquired from the closed-end fund portfolio, two of which we have exited near cost in the secondary market. We wanted to take a few minutes to highlight some metrics that we think can provide insight into how we assess the risk of the portfolios of BDCs. Lenders have a number of ways they can mask liquidity challenges with their underlying borrowers. First, lenders increase the use of PIK interest. Whether at origination or as part of the restructuring, PIK income is a proxy for borrowers who cannot currently service their debt. In this regard, MFIC's PIK income remains very low compared to the BDC industry average. Second, lenders allow revolving loan senior to their cash flow term debt while still categorizing their cash flow loan as first lien. We focus on what we often refer to as true first lien or top of the capital structure, meaning there's no debt senior to our position as evidenced by our attachment point of 0.04 times. Third, some lenders provide covenant-lite loans or even draws on the revolvers that do not spring a covenant, effectively making the whole revolver available for payment of interest, regardless of the state of the company. As a reminder, over 99% of MFIC's corporate lending portfolio has at least one financial covenant, and any covenant-lite loans we may hold would have a spring covenant when the revolver is drawn above certain levels. And fourth, some lenders have added structures where they increase their debt to pay their own interest, sometimes referred to as synthetic PIK. Although hard to account for the myriad structures lenders can use to achieve these results, we generally do not advance credit to borrowers to cover interest. Importantly, MFIC benefits from MidCap Financial's large, dedicated portfolio management team, which helps identify and address issues early. It's also important to note that MidCap Financial leads and serves as administrative agent on the vast majority of our deals, which provides meaningful downside protection. As agent, we are in active dialogue with the borrower and have enhanced information flow, which allows us to be proactive in resolving problem credits. Moving on 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. The blended yield across our total investment in Merx is less than 4%, and the continued rotation of capital from Merx has the potential to have a meaningful beneficial impact on income. As of June 30, 2024, our investment in Merx totaled $187 million, representing 7.7% of the total portfolio at fair value. During the June quarter, Merx paid MFIC $4.7 million, including $1.7 million of interest and a $3 million return of capital. Since the end of June, MFIC's investment in Merx has decreased to approximately 5.8% of the total portfolio due to a combination of the growth in the portfolio from the mergers, as well as an additional $7.5 million paydown from Merx, which occurred in July. Turning to the mergers with AFT and AIF, to echo Tanner's comments, we're excited about the long-term benefits that we believe this transaction will create. I'd like to take a few minutes to discuss the assets we acquired as part of our mergers with AFT and AIF. We onboarded approximately $596 million of investments from the closed-end funds, increasing the size of MFIC's portfolio to approximately $3.1 billion as of the closing date. Of the $596 million of onboarded assets, approximately $207 million, or 35% of these assets were directly originated loans across 37 obligors with a weighted average spread of 564 basis points. The remaining $389 million of these assets consists of broadly syndicated loans, high-yield bonds, and structured credit positions. As Tanner mentioned, we are currently in the process of selling the non-directly originated assets and redeploying those proceeds into assets that are more consistent with MFIC's investment strategy. The good news is that these non-directly originated assets are held throughout the Apollo platform, which facilitates risk monitoring while on our books, as well as the selling process. Since the closing of the mergers on June 22, and through yesterday, we have sold approximately $125 million of these assets near our cost basis. We are very much on track with our plan to sell these assets, which we expect to complete over the next few quarters. In addition, the mergers were a significant deleveraging event for MFIC and created investment capacity of approximately $386 million, assuming a net leverage ratio of 1.4 times. Taking into account the $389 million of non-directly originated assets that we intend to sell, plus the $386 million of additional investment capacity, we have approximately $775 million of capital to deploy. Given the significant deal flow generated by MidCap, we are confident that we can deploy this capital in attractive opportunities. As Tanner mentioned earlier, MidCap closed on $9.6 billion of commitments in the first half of 2024. We expect to reach our target leverage in the next two to three quarters and see no impediment to doing so. We want to emphasize that we will remain committed to our disciplined approach to portfolio construction as we deploy this capital.

Greg Hunt, CFO

Thank you, Ted, and good morning, everyone. Beginning with our financial results, net investment income per share for the June quarter was $0.45, which reflects solid recurring interest income as well as strong fee and prepayment income. For the quarter, prepayment income was $3.2 million and fee income was approximately $900,000. PIK income remains low, representing approximately 3.6% of total investment income for the quarter. GAAP net income per share for the quarter was $0.35. Results for the quarter correspond to an annualized return on equity, or ROE, based on net investment income of 11.8%, and an annualized ROE based on net income of 9%. Results for the latest 12-month period correspond to an annualized ROE based on net investment income of 11.6% and an annualized ROE based on net income of 11.1%. MFIC NAV per share at the end of June was $15.38, down $0.04 quarter-over-quarter, which reflected net investment income of $0.45, which is $0.07 above the $0.38 distribution and a $0.11 per share net loss in the portfolio. As Ted mentioned, the vast majority of our corporate lending portfolio continues to have strong fundamental performance. MFIC's net assets increased by $450 million from the mergers. Both the NAV per share of $15.38 and the $450 million increase in net assets exclude the impact of the one-time special distribution of $0.20 or $18.8 million made in connection with the mergers. Net expenses for the quarter were $39.6 million, down slightly compared to the prior quarter, primarily due to lower incentive fees and lower administrative expenses, offset by higher interest expense given the increase in the size of the portfolio. The weighted average interest rate on our debt for the quarter was approximately 7%. We intend to continue to evaluate and monitor capital raising transactions going forward. Management fees totaled $4.4 million for the June quarter, essentially flat compared to the prior quarter. As a reminder, MFIC's base management fee was reduced to 1.75% on equity and is one of the only listed BDCs to charge management fees on equity, which we believe provides greater shareholder alignment and focus on net asset value. Incentive fees totaled $5.6 million for the June quarter. As a reminder, our incentive fee on income is 17.5%, and includes a total return hurdle with a rolling 12-quarter look back, the effective incentive fee rate for the June quarter was 15.9%, impacted by the net loss recorded during the quarter and the impact of the lookback feature. Moving to our balance sheet. MFIC's net leverage was 1.45 times at the end of June compared to 1.35 times at the end of March, reflecting the $90 million of net fundings during the quarter. MFIC's net leverage as of the closing of the mergers was 1.13 times. I'd like to take a few minutes to cover some of the accounting aspects of the mergers. Mergers are being accounted for in accordance with the asset acquisition method of accounting under ASC 805-50. As a reminder, AFT and AIF merged into MFIC in stock-for-stock transactions, with shares being exchanged on a NAV-for-NAV basis. The exchange ratios for the mergers were based on the fund's NAV per share as of July 19, 2024. Accordingly, MFIC issued 0.9547 shares of its common stock for each AFT share and 0.9441 shares of its common stock for each AIF share. In total, MFIC issued approximately 28.5 million shares of MFIC to the closed-end fund shareholders, resulting in 93.8 million MFIC outstanding shares following the merger. At the time of the merger, MFIC was trading at a slight discount to its current NAV. In connection with the merger, an affiliate of Apollo made a $0.25 per share special cash payment to each AFT and AIF shareholder for a total payment of $7.5 million. In accordance with the accounting guidance, a portion of this cash payment was deemed to be merger consideration, which resulted in the fair value of the consideration paid to both AFT and AIF shareholders being equal to the fair value of the assets acquired, resulting in no purchase discount or premium. As a result, there will be 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 fund assets at close became MFIC's cost basis in these assets without any adjustment. This concludes our prepared remarks. Operator, please open the call to questions.

Operator, Operator

We'll take our first question from Kenneth Lee of RBC Capital Markets.

Kenneth Lee, Analyst

Hey, good morning. Thanks for taking my question. Just in terms of the portfolio rotation over the next few quarters, the non-directly originated assets being sold, I assume you're talking about the BSLs, the structured credit and the high-yield bonds from the closed-end funds. Granted that the BSL market is fairly liquid, but just want to get a better understanding of any kind of key constraints around the pace of sales, for example, like the structured credit, the high-yield bonds? Thanks.

Tanner Powell, CEO

Thank you for the question. Since closing the mergers on July 22, we've made solid progress, raising approximately $125 million. Your question touches on a crucial aspect of our future plans. Of the $400 million in our investment categories, we anticipate holding a number of securities or loans that may not be very liquid. Our approach to this program and rotation strategy does not rely on selling every single broadly syndicated loan or high-yield bond. Some of these securities or loans may not have the same liquidity and could necessitate accepting a discount to fair market value, which we aim to avoid. Therefore, while we plan to continue making progress on this front, you shouldn't expect us to sell out all $400 million. Additionally, it's important to take into account the reinvestment yield and the possible discounts required for transacting those bonds and loans.

Kenneth Lee, Analyst

Great. Very helpful there. And just one follow-up, if I may. Any updated outlook on potential ROE or ROE accretion just going forward? Thanks.

Tanner Powell, CEO

No, we are not going to update that guidance. Obviously, we're looking at the potential for lower base rates, but as we outlined in our prepared remarks and as mentioned in our November materials, we see significant synergies to improve both ROI and NII.

Operator, Operator

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

Melissa Wedel, Analyst

Good morning. Thank you for taking my questions. I'm trying to understand the mathematics behind the rotation strategy you described and the goal of increasing leverage in the portfolio back to target levels. It seems there is considerable rotation and natural turnover that we should anticipate in the portfolio, but it also appears that the timeframe to return to the target is quite short, within about two quarters. I hope you can help clarify this and also confirm the target range you have in mind for this environment. Thank you.

Tanner Powell, CEO

Thank you, Melissa. Starting with the lower end of our guided leverage range at 1.4 times and the pro forma leverage we previously reported at 1.13 times, reaching that 1.4 times would give us an investment capacity of nearly $400 million, specifically $386 million. This reflects growth, net of any sell-offs. Regarding Ken's question, I acknowledge that our goal isn't to sell every bond and loan; we aim to be selective to avoid sacrificing fair market value while managing risk. However, if we did decide to divest all $389 million of non-directly originated assets from the mergers, our total investment capacity would approximate $775 million. From this perspective, we have $389 million to sell, of which we've already sold $125 million, noting that we don't intend to sell all of it. Market conditions will influence this over the next couple of quarters. Importantly, we've achieved over $3 billion in assets, which constitutes just about one-tenth of the assets in the MidCap Financial ecosystem, a business exceeding $30 billion. Therefore, we have had no issues with deployment or access to assets. This additional capital allows us to engage in more deals or take on larger deals, which is supported by the extensive MidCap Financial origination platform we are fortunate to utilize.

Operator, Operator

We'll take our next question from Finian O'Shea of Wells Fargo Securities.

Finian O'Shea, Analyst

Hey, everyone. Good morning. Higher-level question. With Howard moving over to Apollo and taking on what seems to be building out the direct origination effort and marrying that with MidCap's, can you outline the sort of firm-wide direct lending setup such as how do you collaborate and maybe compete? Do you split up sponsors? Do you go by deal size on who leads? Anything that you think would be important for the MidCap investor? Thank you.

Howard Widra, Executive Chairman

Yes, I can address that, Fin. This is Howard. To reiterate for the market, we have a single offering, which is the combined Apollo-MidCap menu of direct lending options. We are actively reaching out to sponsors, leveraging the resources at Apollo and MidCap, which I oversee, to convey that we are available to meet their capital needs. These needs include direct lending loans that support both the larger Apollo market and the MidCap initiatives. Additionally, we offer sponsors other services such as NAV loans, GP capital, rediscount loans when they have financing capacity, equipment loans, and so on. We are presenting our array of capabilities to the market. When a deal arises, we employ two overlapping strategies that are pertinent to your question. For instance, if there's a core middle-market deal, say with $40 million to $50 million of EBITDA at a 5 times multiple, MidCap typically executes that. Often, parts of the Apollo ecosystem will participate in such loans to align with 40 Act requirements as transactions develop. Conversely, for larger companies, such as those with $300 million in EBITDA engaged in a $1.5 billion private credit deal, usually involving multiple parties, Apollo generally leads in that context. While we have the option for MFIC to engage with these larger deals, we typically do not participate, although we might occasionally do so. Additionally, the closed-end funds are part of that AGS ecosystem and have recently engaged in some of these loans. Some of the loans that have transitioned from the closed-end funds are now included in our corporate portfolio, indicating long-term retention. Regarding how we manage risk and decision-making within MFIC, because we are integrated and I oversee sponsor origination, we have full visibility on all deals. We understand which projects we've acquired through closed-end fund loans and which ones are available to us. This relates back to what Melissa mentioned about generating flow. It's not only about the MidCap assets but also about selective opportunities within larger assets that fit our criteria. I believe MidCap shareholders should view our strategy as centered on the core middle market, defined as having $20 million to $100 million in EBITDA, while being connected to a global platform that serves numerous sponsors, enhancing our relevance and access to ample deal flow. Most importantly, our strategy is a key component of Apollo's market approach and value proposition. Clare Bailhe, who leads MidCap sponsor initiatives, and I are driving this effort across Apollo.

Finian O'Shea, Analyst

Thank you for the detailed insights. I have a follow-up question. Now that the mergers are finalized, congratulations on that achievement, what is your strategy moving forward? I assume you might aim to become one of these $5 billion BDCs, but I’d like to know your thoughts. Some of your peers are converting large private entities to public ones, and there’s a trend of secondary-style growth in public markets. How do you view these options, and what should we expect in the near future?

Howard Widra, Executive Chairman

We believe the size of the BDC is not the primary goal; rather, it is a consequence of conducting business properly. Our focus remains on generating attractive risk-adjusted returns, and we anticipate the ability to grow under normal circumstances, ideally by performing well enough to attract more investments. The core objective is to continue executing effectively, and if we do this, we will be rewarded and can expand. Regarding other potential growth opportunities, our priority is to ensure that anything we pursue benefits our shareholders. We are not interested in growth that compromises shareholder value. We'll explore all avenues that can add value to our current shareholders. However, the industry has not seen significant mergers or new contracts recently, making it difficult to foresee such developments. We are open to any capital-raising strategies that are beneficial to our shareholder base. I'll pause here to see if Greg or Tanner has additional comments.

Greg Hunt, CFO

No, and I think that's well stated.

Finian O'Shea, Analyst

All right. Thanks so much, everybody.

Operator, Operator

And there are no further questions at this time. I'd be happy to return the call to our host for any concluding remarks.

Tanner Powell, CEO

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 day.

Operator, Operator

This does conclude the MidCap Investment Corporation for the period ended June 30, 2024 earnings call. You may now disconnect your lines and everyone have a great day.