Earnings Call Transcript - MFIC Q2 2023

Operator, Operator

Good afternoon, and welcome to the earnings conference call for the period ended September 30, 2022, for MidCap Financial Investment Corporation. 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 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 posted a supplemental financial information package on our website, which contains information about the portfolio as well as the company's financial performance. At this time, I'd like to turn the call over to our Chief Executive Officer, Tanner Powell.

Tanner Powell, CEO

Thank you, Elizabeth. Good afternoon, everyone, and thank you for joining us today. I will begin today's call with some comments about the market environment and why we believe our corporate lending portfolio is well positioned and well constructed for a challenging market environment. Next, I will highlight our results for the quarter and provide an update on Merx, and then I will discuss the increase to our quarterly dividend. Following my remarks, Ted will discuss our investment activity, including the meaningful cash paydowns we received from several investments we are seeking to reduce. Ted will also cover the portfolio's credit quality, including how our portfolio companies are performing in the current environment. Lastly, Greg will review our financial results in detail. We will then open the call to questions. Throughout today's call, we will refer to the company as MFIC or the BDC; and we refer to the Bethesda-based lender, which sources senior secured middle-market investment opportunities for Apollo managed capital, including the BDC, as MidCap Financial. Beginning with the current environment, the public credit markets remain volatile as the Fed reiterated its commitment to tighter financial conditions in order to combat inflation. The secondary price rally in the leveraged loan and high-yield markets in the first half of the quarter were all but erased in the second half as investor sentiment was dampened by the elevated interest rate environment and recessionary concerns. During the quarter, credit spreads continued to widen and U.S. leveraged loan issuance plummeted to the lowest level since the fourth quarter of 2009, driven by a pullback from CLO investors. Banks continue to struggle to offload financing commitments made prior to the current more volatile environment. Although deal activity has slowed, borrowers continue to turn to the private credit market which offers certainty of execution. In general, periods of economic stress and broader market volatility create better opportunities for direct lending. Amid this broader market volatility, we have seen improved lender terms and spreads for private direct lending, which continues to experience strong demand from financial sponsors and companies. We would expect terms to continue to tighten and spreads to widen should economic stress continue or worsen. For scaled capital providers like MidCap Financial, we believe that there are opportunities to lend to high-quality companies with attractive pricing and terms. MidCap Financial was relatively active during the September quarter with $3.3 billion of new originations. In the first nine months of 2022, MidCap Financial's new originations totaled $12.5 billion. Additionally, we expect a tougher environment; the tougher economic environment should lead to an increase in ABL opportunities, an area where MidCap Financial has a large and successful franchise. In the face of significant market volatility, our corporate lending portfolio continues to perform well, which we believe demonstrates the value of our senior secured investment strategy and the quality of our portfolio companies. Our underwriting process contemplates the potential for macroeconomic headwinds. As the macro environment continues to become more challenging, we believe the strength of our underwriting and the quality of our portfolio will become more apparent. We have constructed what we believe to be a well-diversified portfolio of true first-lien floating-rate corporate loans invested in less cyclical industries with granular position sizes. At the end of September, our corporate lending loans were 94% first lien with a weighted average attachment point of 0.2x, the metric which demonstrates that we are invested in the most senior part of the capital structure. Moving to our financial results. Net investment income was $0.35 per share for the quarter, which reflects an increase in interest income due to higher base rates as well as strong fee and prepayment income, partially offset by a slight decline in income from Merx as we continue to reduce the size of this investment. Amid the challenging market conditions, we generated considerable cash paydowns from several investments which we are seeking to exit, which Ted will discuss later during the call. Overall, given the volatile market environment, we recorded a net loss of $6.6 million on our portfolio. Given the total return feature in our incentive fee structure, incentive fees accrued during the quarter were below the full rate. We ended the period with net asset value per share of $15.45. Moving on. As discussed previously, we are focusing on reducing our investment in Merx, our aircraft leasing portfolio company, by selling aircraft and deemphasizing its servicing business. During the September quarter, Merx continued to make progress by selling two aircraft, reducing the number of planes in its own fleet from 62 to 60, which allowed Merx to prepay $14 million to MFIC. In conjunction with the paydown to MFIC and the aircraft sales, we converted $111 million of Merx's revolver into equity. Accordingly, at the end of September, our investment in Merx totaled $266 million, representing 11% of the total portfolio, consisting of a $150 million revolver with a 10% interest rate and $116 million of equity. The paydown and conversion of debt to equity will reduce the amount of interest that Merx pays to MFIC from approximately $6 million in the September quarter to approximately $3.8 million per quarter going forward. Despite the broader uncertain macroeconomic environment, there are no signs of slowdown in daily global flight activity, and we continue to focus on reducing our exposure. Now let me switch to our dividend policy. Given the impact of higher rates on our net interest income, the strong performance of our corporate lending portfolio and considering the upcoming reduction in our fee structure, we are pleased to announce that we are raising our regular quarterly base dividend by 15.6% from $0.32 per share to $0.37 per share, payable to shareholders of record as of December 19, 2022. As a reminder, on our last conference call, we made several important announcements, including the establishment of what we consider to be the industry-leading fee structure among listed BDCs. Recall that BDC's base management fee was permanently reduced to 1.75% on equity. Among listed BDCs, MFIC's management fee is the lowest and is the only one to charge management fees on equity. The incentive fee on income was permanently reduced from 20% to 17.5%. The changes to the fee structure will be effective for the period beginning January 1, 2023. We are raising the dividend to a level that we believe reflects the current earnings power of our portfolio, including some of the permanent benefits of our reduced fee structure, which is not yet reflected in our financial results. When the new fee structure becomes effective, we expect to significantly outearn this $0.37 base dividend, and we will reevaluate our dividend at that time. With that, I will turn the call over to Ted to discuss our investment activity.

Ted McNulty, President

Thank you, Tanner. Beginning with investment activity. Given our focus on reducing the fund's net leverage, MFIC's new investment activity was limited during the quarter. MFIC's new corporate lending commitments totaled $21 million across three companies for an average new commitment of $7 million. The new commitments were first-lien floating-rate loans with a weighted average spread of 639 basis points and a weighted average net leverage of 4.5x. Excluding revolvers, gross fundings for the quarter totaled $67 million, and sales and repayments totaled $154 million. Net revolver fundings were approximately $5 million. In aggregate, net repayments for the quarter totaled $83 million. Repayments for the quarter included $101 million from corporate lending positions, $14 million from Merx, and $39 million from other investments, including some shipping and oil and gas positions. Post-quarter end, we exchanged 50% of our non-income-generating investment in Carbonfree at our September 30 mark for $7.5 million cash and a $12.5 million interest-bearing note. Net leverage at the end of September was 1.4x. Given our visibility into additional repayments in the coming months, we are well positioned to make new commitments during what we believe will be an attractive vintage characterized by relatively wider spreads, lower leverage levels, and tighter documentation. Turning to the overall portfolio. Our investment portfolio had a fair value of $2.46 billion at the end of September across 136 companies in 26 different industries. Corporate loans and others represented 89% of the total portfolio, and Merx represented 11% of the portfolio at fair value. 94% of our corporate loans were first lien. The weighted average spread on our corporate loans was 613 basis points at the end of September. In general, despite an environment of heightened uncertainty, we see minimal negative impact in the fundamental performance of our corporate lending portfolio companies. While we're cognizant that borrowers will likely face increased challenges over the coming months due to inflationary pressures, higher interest rates, and potential headwinds from an economic slowdown, we believe we have designed our corporate lending portfolio to be defensive and perform well during periods of increased stress. We believe MFIC has one of the most senior secured portfolios among BDCs, as evidenced by our low attachment point of 0.2x. Our corporate lending portfolio consists of granular position sizes with our average position of $16.9 million. Our credit metrics remained relatively stable during the quarter. At the end of September, the weighted average net leverage of the corporate lending portfolio was 5.52x compared to 5.45x last quarter. The weighted average interest coverage ratio was 2.7x compared to 2.8x last quarter. These weighted average interest coverage ratios are based on company data from the last 12 months. Looking at the most recent quarter, we have observed some pressure on this metric, as expected. The weighted average interest coverage ratio was 2.2x based on company data from the June quarter. Our second-lien term loan in K&N, which had a fair value of $14.2 million at the end of September and which was originated in 2016, was placed on nonaccrual status during the quarter. At the end of September, investments on nonaccrual status totaled $23.6 million or 1% 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.

Gregory Hunt, CFO

Thank you, Ted, and good afternoon, everyone. Starting with our operational statement, total investment income was $58.9 million for the quarter, reflecting a 10.3% increase from the previous quarter. Recurring interest income increased due to higher base rates. We saw strong fee and prepayment income as well, with prepayment income rising to $2.9 million from $1.9 million last quarter, and fee income increasing to about $1.5 million from $500,000 last quarter. Dividend income remained largely unchanged from the previous quarter. The weighted average yield at cost on our lending portfolio was 8.9% at the end of September, up from 8% at the end of June, primarily driven by higher base rates. Total net expenses for the quarter were $36.2 million, up $6.3 million from the previous quarter due to increased interest expenses linked to our credit facility, which has a floating rate, and higher incentive fees. As a reminder, MFIC's incentive fee on income includes a total return hurdle with a rolling 12-quarter look-back period. In light of the net loss of $6.6 million for the quarter, incentive fees amounted to around $4 million, an increase from $1.4 million in the prior quarter. Net investment income per share for the quarter stood at $0.35. We recorded a net loss on the portfolio of $6.6 million, equating to $0.10 per share. Excluding the effects of Chyron and K&N, our corporate loan book showed slight declines as spreads began to widen during the quarter. On Page 16 of the earnings supplement, we shared our net gain or loss by strategy for the past five quarters. At the end of September, NAV per share was $15.45, marking a decrease of $0.07 or $0.05 from the previous quarter, primarily due to the $0.10 portfolio loss, somewhat countered by $0.03 from net investment income related to our dividend. Moving forward, we are maintaining a strong liquidity position, with undrawn revolver capacity significantly exceeding unfunded borrower commitments. We are well-positioned to take advantage of higher rates. To provide insight into potential near-term earnings effects, based on quarter-end rates, we estimate that a 100 basis point and a 200 basis point rise in reference rates could lead to incremental annual earnings of about $0.13 and $0.26, respectively. No stock was repurchased during the quarter. Lastly, I want to note that MFIC will change its fiscal year-end from March 31 to December 31, starting December 31, 2022. Consequently, MFIC will submit its annual report on Form 10-K for the fiscal year ended December 31, 2022, in late February 2023. This concludes our prepared remarks. Operator, please open the call to questions.

Operator, Operator

We will take our first question from Kenneth Lee with RBC Capital Markets.

Kenneth Lee, Analyst

Wondering if you could just talk a little bit about key drivers for the unrealized losses that you saw in the Merx business in the quarter.

Tanner Powell, CEO

Yes, of course. Thank you, Ken. When we assess Merx, we are examining each aircraft and its potential as we approach lease expirations. Specifically, the slight write-down we experienced this quarter relates to our outlook on the resolution of several planes as we navigate lease maturities. There's no broader implication; it's simply an adjustment to reflect our current perspective on these specific cases.

Kenneth Lee, Analyst

Got you. And one follow-up, if I may. In terms of the cash paydown you received from some of the investments, is there any visibility in the near term of any additional cash paydowns from other investments? And realizing it might be a little idiosyncratic, but what could be some key drivers there to see some additional cash paydowns in the future?

Tanner Powell, CEO

Yes, sure. And when we look across our granular portfolio of 130 obligors and with the obvious caveat, Kenneth, that things are somewhat volatile out there is our near-term visibility suggests more paydowns in the future against a backdrop of broadly declining M&A volumes. But if anything, our current forecast as we sit here today would suggest some modest further paydowns from here.

Operator, Operator

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

Finian O'Shea, Analyst

Back to Merx, Tanner, can you go back to the essence or driver of why so much was converted to equity? And then sort of to follow on Ken's question on the write-down, can you reconcile that to the proportionately steeper decline in the quarterly interest payment that we'll see from Merx, the $6 million in unrealized marks today versus the, I think, a couple of million a quarter, and correct me if I'm wrong there, on interest income?

Howard Widra, Executive Chairman

Okay. Yes, Fin, this is Howard. I think we should look at Merx. We're in the process of liquidating Merx, and we have a combined mark of around $250 million that we need to pay down. When we started this paydown, we believed it was better to reduce income from the combined position as we liquidate and expect to see additional cash coming in over the next quarters. So, we adjusted our approach. There was nothing fundamentally changing in the underlying value; we just thought that minimizing capital outflows would allow a greater portion to be returned to basis. Given our earnings potential, as we demonstrated with our dividend increase and anticipated earnings, we feel well positioned in this strategy. We do expect to receive further paydowns, though they may not be consistent. We are focused on this process and are actively working to ensure it succeeds. The adjustment we made was specifically aimed at maximizing the amount of capital returned to basis.

Finian O'Shea, Analyst

Okay. And just a small follow-on there. How much of an issue is sort of net investment income? Leases are maybe flat or stagnant, and LIBOR base rates are going up. Is that an item? Are you hedged there?

Howard Widra, Executive Chairman

Well, we have leases set. So they're not based off rates. They're sort of basically fixed, and the debt is fixed. Yes, we have a fixed-rate debt in our securitization. So we're not really impacted by that.

Operator, Operator

And we'll take our next question from Kyle Joseph with Jefferies.

Kyle Joseph, Analyst

I apologize for joining the call a bit late, and I'm sorry if this has already been discussed. It seems that originations were intentionally low to reduce the balance sheet. Could you provide an update on your pipeline and the spreads you're observing on new deals compared to the existing portfolio?

Tanner Powell, CEO

I'm happy to take that, Kyle. As you mentioned, there was some deleveraging in the particular quarter. In the current market environment, M&A activity has slowed down. We are fortunate to benefit from the wide funnel that MidCap Financial provides us. Looking ahead, as we noted in our prepared remarks, we see increasing opportunities, particularly in the ABL sector. Our overall outlook indicates lower M&A activity, but there are still good opportunities available. While the rapid changes and adjusted valuation expectations are limiting M&A opportunities on the sponsor side, we continue to see a strong pipeline of add-on acquisitions. This includes funding our existing delayed draws as well as new commitments to current borrowers, as these smaller add-ons are more feasible in the current market, presenting another opportunity for us.

Kyle Joseph, Analyst

Yes. And then...

Tanner Powell, CEO

I apologize, Kyle, I didn't get the spread right. If we look at spreads and set aside the impact of the base rate, comparing now to the beginning of the year, we observe spreads that are 100 to 200 basis points wider. This isn’t just about the spread; a year ago, the average deal was around 575, but now we're seeing figures between 650 and 675. Additionally, we are noticing increased convexity due to a higher original issue discount, dropping from around 98 to at least 97 or even lower in some instances. So, the spread has widened by 100 to 150 basis points, not factoring in the rise of the base rate or LIBOR/SOFR.

Kyle Joseph, Analyst

Got it. In terms of shifting to credit, we noticed your leverage statistics and added one investment to nonaccrual. Have you experienced greater demand or an increase in amendment activity? Additionally, how would you assess the health of your portfolio as companies face higher interest expenses, ongoing inflation, and other factors?

Tanner Powell, CEO

Yes, absolutely. Not yet. The key point to emphasize, which we have been presenting for many years, is that over 95% of our borrowers within our corporate book have financial covenants. The good news is we have a seat at the table. There is a normal level of activity that occurs anyway, whether it’s opening a document for an add-on acquisition or for various other reasons. Regarding credit weakening amendments, we have not observed an increase. It's important to remember that these metrics are evaluated on a backward-looking basis. For instance, the figures currently being assessed are from June 30. We would expect it to naturally increase in this type of environment, but up to this point, we have seen very limited levels of excessive or above-normal amendment activity.

Operator, Operator

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

Melissa Wedel, Analyst

Most of my questions have been asked already. But I thought it would be helpful just to quickly review how you're thinking about portfolio leverage right now and where you'd ideally like to operate given how things are evolving from a macro perspective.

Tanner Powell, CEO

Yes, thanks, Melissa. As we mentioned in our prepared remarks, we are currently at 1.42x, which is at the lower end of our previously stated range. In response to Kenneth's question, we expect to maintain or operate below that level in the near term, partly due to some insight regarding our payments. Historically, we believe that our first-lien strategy and granular position sizes enable us to sustain that higher leverage level. That's our current position, based on our visibility on near-term payments.

Operator, Operator

And we'll go next to Paul Johnson with KBW.

Paul Johnson, Analyst

Real quick on just the interest coverage ratio that you mentioned, the decline in this most recent quarter, I guess, with most sort of updated financials that you have dropping from 2.9 to 2.2x. It sounds like a big drop, obviously, also a fairly significant increase in rates over that time period as well. But I was wondering if you could just kind of comment on that and, I guess, if you had any sort of commentary around EBITDA performance of your portfolio companies if that at all is reflected in that number as well.

Tanner Powell, CEO

Yes, sure. But go on, Greg.

Gregory Hunt, CFO

Yes. Yes, sure. Yes, no, thanks for the question. Just to clarify, the LTM interest coverage ratio went from 2.8 to 2.7, so only a modest downward revision on an LTM basis as of June. We did quote a 2.2 number, which was a sensitivity looking at the company data only for the June quarter, and that kind of made sense as rates were starting to rise. And as we look forward, we certainly do expect there to be more pressure as rates continue to rise. I think one of the ways we think about it is we're starting from a good point. We've got a significant amount of sponsor equity behind the majority of the loans that we make. We're starting in the high 2s, as we mentioned, 2.7 on an LTM basis. So we have an equity cushion. We've got true first-lien positions, and we've got covenants to get us to the table if we do see EBITDA start to deteriorate. So I think from an EBITDA standpoint, to get to the next part of your question, we saw EBITDA growth. EBITDA, still being in a growth mode at 6/30, in the low to mid-single digits, which has tapered off from what we saw in prior quarters, but still in positive territory. And so we'll continue to watch this closely, obviously, and as will everyone in the credit markets.

Paul Johnson, Analyst

Got it. And I appreciate the correction there. It makes sense. And then just on the dividend increase, I imagine this was obviously with kind of your house view on forward rates and the new fee structure coming on. I'm just curious if that's the case or if there's any, I guess, room for potential increase from that level.

Ted McNulty, President

We believe we can significantly outearn the stated dividend. Our fees will not begin until the first quarter of next year, and as we start to generate more than the dividend, we will have options to either raise our dividend or issue special dividends. At a minimum, we expect to make special dividends. The extent of these actions will depend on interest rate movements, but even at current rates, we feel confident about covering the $0.37 dividend. We wanted to establish a point of comfort, and we expect to outearn it by a solid margin.

Operator, Operator

And there are no questions at this time. I will now turn the call back over to the management team for closing remarks.

Tanner Powell, CEO

Thank you, operator, and 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 questions. And everyone, have a good weekend and evening.

Operator, Operator

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