MONROE CAPITAL Corp Q3 FY2022 Earnings Call

Welcome to Monroe Capital Corporation's Third Quarter 2022 Earnings Conference Call. Before we begin, I would like to take a moment to remind our listeners that remarks made during this call today may contain certain forward-looking statements, including statements regarding our goals, strategies, beliefs, future potential, operating results or cash flows, particularly in light of the COVID-19 pandemic. Although we believe these statements are reasonable based on management's estimates, assumptions and projections as of today, November 8, 2022, these statements are not guarantees of future performance. Further, time-sensitive information may no longer be accurate as of the time of any replay or listening. Actual results may differ materially as a result of risks, uncertainty or other factors, including, but not limited to, risk factors described from time to time in the company's filings with the SEC. Monroe Capital takes no obligation to update or revise these forward-looking statements. I will now turn the conference over to Ted Koenig, Chief Executive Officer of Monroe Capital Corporation.

Good morning, and thank you to everyone who has joined us on our call today. Welcome to our third quarter 2022 earnings conference call. I am joined by Mick Solimene, our CFO and Chief Investment Officer. Last evening, we issued our third quarter 2022 earnings press release and filed our 10-Q with the SEC. The M&A and financing markets maintained a cautious tone during the third quarter as concerns around slowing economic growth mounted in the face of inflationary and rising interest rate pressures. Since the end of the quarter, the Fed raised interest rates 225 basis points inclusive of the 75 basis point rate increase announced last week in response to an annualized inflation rate that now stands at 8.2%. According to Refinitiv, middle market financing value totaled almost $212 billion through the first nine months of the year, flat compared to nine months of last year. Middle market loan spreads and the LCD middle market index continued to widen, down approximately 27 basis points during the third quarter, but at a slower pace than during the second quarter when spreads widened by more than 100 basis points. Market volatility was much more pronounced in the public and leveraged financing markets, where transaction volumes dropped significantly. This created compelling opportunities for us in private credit to provide certainty of execution to our clients on more lender-friendly pricing and terms. We believe that the market dynamic will remain for the foreseeable future, and we are prepared to be a trusted financial partner to our clients. As a firm, we made over $3.7 billion of new investments through the first three quarters of 2022. The lower middle market remains active, and current market conditions are showing us somewhat lower leverage levels and better-priced investment opportunities across our platform than we experienced in the same period last year, which was a record-breaking year for M&A and finance activity. Turning now to third quarter results, we are pleased to report adjusted net investment income of $7.1 million or $0.33 per share, up from adjusted net investment income of $5.4 million or $0.25 per share for the second quarter. We also reported NAV of $226 million or $10.43 per share as of September 30, 2022, a decrease of $0.28 per share from NAV of $232.1 million or $10.71 per share as of June 30, 2022. The decline in NAV was substantially the result of unrealized losses due to fundamental performance in a couple of specific portfolio companies and the investment in MRCC Senior Loan Fund 1, which suffered unrealized mark-to-market losses that we refer to as the SLF. The decrease in value at SLF was driven by the unrealized mark-to-market losses on the SLF investments, which are loans to traditional upper middle market borrowers that have continued to experience higher volatility and valuations due to recent macroeconomic events. During the quarter, MRCC's debt to equity leverage decreased slightly from 1.38 times debt to equity to 1.33 times debt to equity. New origination activity at Monroe remains strong, and we expect a modest increase in leverage within our target leverage range of 1.3 to 1.4 times debt to equity. We believe that our existing portfolio companies will continue to navigate a somewhat higher interest rate environment as debt service coverage is generally solid across our portfolio, and the companies are well-positioned to manage the inflationary supply chain and geopolitical headwinds that they are facing. The strong dollar has not materially affected our borrowers, as unlike most large companies, most of the revenue generated by our lower middle market borrowers is from U.S. based sales. We closely monitor and assess those risks as part of our portfolio management process, which involves close and regular communication with our portfolio companies. New deals continue to undergo a comprehensive underwriting process that includes downside stress scenarios to assess performance volatility and cushion from rising interest rates, margin pressures, and an economic slowdown. We believe that the portfolio continues to be well-positioned to benefit from an increase in short-term interest rates, as all our borrowers were above their interest rate floors going into the fourth quarter. Therefore, any additional increases in interest rates should proportionately benefit our investment portfolio. MRCC enjoys a strong strategic advantage by being affiliated with a best-in-class middle market private credit asset management firm, with approximately $14.1 billion in assets under management and approximately 190 employees as of September 30th, 2022. Our dividend coverage is trending positively. We will continue to focus on generating adjusted net investment income that meets or exceeds our dividend and positive long-term NAV performance, despite some short-term macro market headwinds. I am now going to turn the call over to Mick, who is going to walk you through our financial results.

Thank you, Ted. As of September 30, 2022, our investment portfolio totaled $508 million, down $28 million from $536 million as of June 30, 2022. Our investment portfolio consisted of debt and equity investments in 98 portfolio companies on September 30, as compared to debt and equity investments in 98 portfolio companies at June 30. During the quarter, we made investments in five new portfolio companies with funding totaling $15.2 million. In addition, we had revolver, add-on, or delayed draft fundings to 25 existing portfolio companies totaling $36.2 million. During the quarter, we received five full payoffs totaling $45 million and had ordinary course loan repayments aggregating $28.5 million. We are well-positioned to redeploy this capital carefully into attractive assets that will benefit from increases in interest rates through participating in the substantial pipeline of opportunities generated at Monroe. At September 30, we had total borrowings of $301.2 million, including $171.2 million outstanding under our floating rate revolving credit facility and $130 million of our 4.75% fixed rate 2026 notes. Total borrowings outstanding decreased by $18.8 million during the quarter, as the revolving credit facility had $83.8 million of availability as of September 30, subject to borrowing base capacity. Now, turning to our results, for the quarter ended September 30, 2022, adjusted net investment income, a non-GAAP measure was $7.1 million, or $0.33 per share, compared to $5.4 million or $0.25 per share in the prior quarter. This increase in adjusted net investment income is primarily the result of the receipt of previously unaccrued interest income associated with repayment of an investment that had been on non-accrual status and advance of its repayment and the increase in the average portfolio yield during the quarter. When considering our target leverage, the rising interest rate environment, a favorable percentage of our fund leverage at a fixed rate, and the current credit performance of MRCC, we believe that on a run rate basis our adjusted NII will more than cover the current $0.25 per share quarterly dividend, all other things being equal. As of September 30, our net asset value was $226 million, which decreased from the $232.1 million in net asset value as of June 30. Our NAV per share decreased from $10.71 per share at September 30 to $10.43 per share, as of September 30. The $0.28 per share NAV decrease was substantially the result of unrealized losses due to fundamental performance on a couple of specific portfolio companies and the investment in MRCC Senior Loan Fund 1. The decrease in value at the SLF was driven by unrealized losses on the SLF investments, which are loans to traditional upper middle market borrowers and have continued to experience higher volatility and valuations. Looking to our statement of operations, total investment income was $15.9 million during the quarter, up from $13 million in the second quarter. The $2.9 million increase in investment income was primarily the result of a one-time benefit of $2 million representing previously unaccrued interest income from the repayment of our loan investment in Curion Holdings LLC during the quarter. Curion had previously been on non-accrual status, and during the quarter we received proceeds in excess of the cost basis of its investment as a result of the successful sale of the company. We also saw an increase in prepayment gains this quarter of approximately $400,000 and a decline in fee income this quarter of approximately $800,000. As we have previously discussed, these components of our interest income can be lumpy and based on specific transactions. In addition, during the quarter, we began to see the impact of increases in interest rates on our investment income substantially, although portfolio borrowers exceeded their benchmark interest rates at the end of the second quarter. At September 30, the effective yield on our debt and preferred equity portfolio was 9.9%, up from 8.5% at June 30. SOFR-like rates, which had been at historically low levels, rose during the quarter with one-month SOFR at approximately 314 basis points at September 30, versus approximately 179 basis points at June 30. All other things being equal, a rising interest rate environment will continue to improve the yield on our investment portfolio and increase net investment income. At September 30, we had four investments on non-accrual status, representing 0.7% of the portfolio at fair market value, compared to six investments on non-accrual status, representing 2% of the portfolio at fair market value at June 30. Our performance has steadily improved in this area as we have been working out the underperforming companies in our portfolio, as we said we would on previous calls. This is the direct result of the turnaround and workout capabilities of our external manager, Monroe Capital and the resources they have provided to us. During the quarter, we placed no additional borrowers on non-accrual status, and our investment portfolio risk rating distribution improved. Moving over to the expense side, total expenses increased from $8 million in the second quarter to $9.7 million in the third quarter, primarily driven by higher incentive fees net of associated fee waivers resulting from the increase in net investment income, higher interest and other debt financing expenses on our floating rate revolving credit facility due to the rising interest rate environment, and higher income tax expenses, primarily associated with blocker entities that hold certain of our equity investments. Net loss for the third quarter totaled $7 million, compared to a net loss of $12.4 million in the second quarter. Net realized and unrealized losses on investments were $7.9 million for the quarter. Other net gains totaling approximately $900,000 during the quarter related to foreign currency forward contracts used to hedge currency exposure on certain investments. As of September 30, the SLF had investments in 62 different borrowers aggregating $192.1 million at fair value with a weighted average interest rate of 8.3%. The SLFs underlying investments are loans to middle market borrowers that are generally larger and more sensitive to market spread movements than the rest of MRCC's portfolio, which is focused on lower middle market companies. The SLFs portfolio decreased in value by 1.2% during the quarter from 94.8% of the amortized cost as of June 30 to 93.6% of amortized cost as of September 30. During the quarter, MRCC received income distributions from SLF of $900,000, consistent with the second quarter. As of September 30, 2022, the SLF had borrowings under its non-recourse credit facility of $129.3 million and had $45.7 million of available capacity under its credit facility, subject to borrowing base availability. I will now turn the call back to Ted for some closing remarks before we open the line for questions.

Thank you, Mick. We feel that MRCC is well-positioned to deliver stable and consistent dividends for our shareholders, especially where our earnings and dividends would benefit from an increase in market interest rates. We have made substantial progress on portfolio matters over the past couple of years, including the most recent quarter where we achieved meaningful realization above our cost and carry. We witnessed our investment performance risk rating distribution improve. This has been a consistent pattern with our workout names in terms of recovery. We believe our purposely defensive portfolio strategy is well-positioned for potential economic volatility under the guidance of a seasoned senior leadership team that has managed credit through multiple economic and business cycles. Our external manager is a team of approximately 100 investment professionals for us to draw upon. Our investment strategy remains focused on providing well-protected and well-structured senior secured first lien loans to companies with defendable market positions, resilient business models, strong management teams, and reliable sponsors and owners. We will continue to selectively deploy capital in sectors resilient to economic cycles and headwinds, including technology, healthcare, business services, and opportunistic investments. Our overall Monroe Capital platform has a strong pipeline in excess of $2 billion of high-quality and selective investment opportunities for all funds at Monroe, including MRCC. We are excited about our investment portfolio and our prospects and continue to believe that Monroe Capital Corporation, which is affiliated with an award-winning best-in-class external manager, provides a very attractive opportunity for our shareholders and other investors. Thank you all for your time today. This now concludes our prepared remarks. I am going to ask the operator to open the call now for questions.

[Operator Instructions] Kevin Futz with JMP Securities, your line is open.

Hi, good afternoon, and thank you for taking my questions. I wanted to dig in a bit on portfolio company metrics. Just curious, you could talk about where weighted average EBITDA interest coverage and portfolio company leverage were at quarter end and how that's trended over the last few quarters.

So thanks for the question, Kevin. We don't disclose interest coverage metrics, and we don't disclose weighted average leverage. What I can say is that over the course of the quarter, from a performance perspective, we saw generally companies increase their top line. So revenues were up on both a unit basis and on a price basis. Margins were generally flat, year-to-date and quarter-over-quarter or slightly down in the context of a rising interest rate environment, where you can imagine, as we saw a slight decline in kind of interest coverage metrics among our borrowers. But when we underwrite our loans, and when we perform surveillance on our loans, we are very focused on ensuring that coverage cushions remain adequate and comfortable. As we look at the portfolio, we feel that our interest coverage ratios, or interest coverage cushions, are more than solid in this environment.

Okay, that's helpful color, Mick. And then my follow-up was on non-accrual that came off during the quarter. First, congratulations on the positive resolution of Curion. I felt that TJ came off non-accrual and it looks like the stub situations are written off prior to maturity, is that correct?

That is correct.

Okay, and then just one more quick one on amendment requests. Just curious, have you seen any pickup in amendment requests? And can you discuss your expectation for that to potentially pick up in the near term?

Sure. So, we've seen a modest increase or pickup in kind of amendment activity around financial covenants, especially when contrasting that with the COVID period of a couple of years ago, where it was significantly greater than it is today. But we have seen a modest pickup from our borrowers, with respect to amendment activity and requests regarding financial covenants.

Okay, I'll leave it there. Thank you for taking my questions. And congratulations on a nice quarter.

Thanks, Kevin.

Robert Dodd with Raymond James, your line is open.

Congratulations on the revolving non-accruals and Kevin done recovering that. On my follow-up on the amendment request, can you give us any color conceptually? Like what -- with financial covenants, maybe there's going to be a little bit more pressure on those as we go forward. What kind of brings the PE firm to -- because it's largely sponsor back transaction to the table? I mean, do they come early, do they wait until it's close? And obviously, it's not going to be a general problem in the portfolio. Is there only going to be a handful of borrowers maybe? So how much incremental information can you squeeze out of the sponsor when they come with an amendment request, just trying to get a real handle on whether this is just about interest rates, or is there something else going on?

I think I'll try that one, Robert. Thanks for the question. So here's how it works in practice. In our market, we have covenants in all of our transactions. The covenants we tend to have are relatively similar. We have debt service, we have leverage, and we generally have some EBITDA covenants. Let's assume that those three covenants, then they're each designed to protect us against different elements of potential deterioration in profitability, increased leverage, and the ability to service our debt. We monitor our borrowers generally on a monthly basis. So our portfolio management group is watching our clients monthly so that we can anticipate quarterly covenant initiatives. We set covenants on a quarterly basis, but we monitor on a monthly basis. Unlike public companies or large companies or large upper middle market companies that report quarterly, we receive information 10 days after the end of each month on a flash basis so that we can anticipate where we are on a quarterly basis. I can tell you that across the portfolio, we've seen no material covenant or amendment request activity yet. As of November 2022, I estimate that the overall economy will deteriorate somewhat in Q4 and Q1 as interest rates continue to rise. We believe we've done most everything we can do in our position to protect our portfolio by rotating out of highly cyclical industries, moving away from consumer-facing brand products, retail, restaurants—things that tend to be more consumer-driven or more immediately affected by a slowdown in the economy. We feel good about where the portfolio is. We've been monitoring things closely over the last several months with increasing interest rates, and we have not seen any pattern yet of company violations or amendment activities. Hopefully, we can say that again in the next call. Our leverage point comes in as we see any deterioration in any of these debt service coverage leverage or EBITDA covenants. We could be prepared in the quarter if there's a violation of a covenant to bring that sponsor to the table and discuss the situation with them. Unlike most of the market, we have the additional benefit that we can generally bring the sponsors to the table, whether it's one of the owners or the second or third-generation family members, to affect change. Sometimes, that involves putting in more money, sometimes it's about changing their operations with limiting CapEx, reducing dividends, or limiting compensation. Lower middle market companies can take actions that large companies cannot. We can implement relatively quick remedies to solve covenant problems. So I know that's a long-winded answer, but you gave me an open-ended question, and I tried to answer it to the best of my ability.

I really appreciate it. It was very helpful. Sorry it was a bit long. So I really appreciate that. Thank you. Flipping to the other side, if I can, quickly to follow up. I mean, you said you're probably going to take up leverage. You're seeing a lot of opportunities. I mean, what areas are particularly attractive right now for deploying new capital? Or do you expect that to mainly be follow-ons to existing portfolios? Are you talking about taking up leverage for new companies or just expanding the existing relationships?

Both ways. What we did purposely this quarter and the quarter before is stockpiling capacity. In an increasing interest rate environment, we've been doing this for 20 years at Monroe. I can give you some perspective on history in an increasing interest rate environment or coming out of a downturn. We did this after the financial crisis, after a couple of recessions, and after COVID. We try to stockpile a little bit of liquidity because the deals often improve. The new deals get better. We are always funding add-on opportunities, but those have already been priced. The opportunity to move the needle in our business is to do new transactions at lower leverage attachment points and at higher price spreads. All of the deals we are doing today are virtually being done at 50 to 100 basis points of current return higher than we were doing a couple of quarters ago. So when I talk about optimism for the future and for MRCC, I’m looking at what we’re doing today and the pipeline we have today—putting dollars to work at a 50 to 100 basis point higher interest rate margin than we were doing six months ago.

What that means from a sector perspective, Ted, is focused on technology and recurring revenue deals, healthcare services deals, and opportunistic deals that have more idiosyncratic characteristics. If you look at the deals we funded in the third quarter, they were in those sectors at greater spread levels.

Got it. Thank you.

[Operator Instructions] Christopher Nolan with Ladenburg Thalmann. Your line is open.

Hey guys, congratulations on Terry on. You guys are getting a good reputation for working through these trust pools. On that note, Vinci Brands, it's another large portfolio you had to farm. Can you give us any color on what your expectations are for resolution of that, please?

Sure, Chris. Good question. Vinci Brands, which was previously known as Incipio, is a borrower that is in the throes of consumer and some macroeconomic headwinds right now. They manufacture phone cases, particularly for iPhones. If you’ve been watching the news, you’re seeing what's happening with the iPhone launch—there's a demand-supply imbalance and Foxconn is having some issues in China supplying all the demand. The good news is that Apple is experiencing the highest level of demand for their new phones that they've ever seen. The problem is that COVID restrictions are causing local governments in China to close vast areas of manufacturing, which affects Foxconn's ability to satisfy that demand. We have a company doing about $140 million in revenue, so we have a real company making a real product, but it's currently facing some headwinds regarding iPhone production and some supply chain issues. We are continuing to work hard on this. I will tell you that this is a high-priority item for us, and we are doing everything we can on that credit. For now, there are factors beyond our control that we hope to navigate with time.

Great. Thanks for the detail. As a follow-up, given that you have a fair amount of adjustable-rate funding in terms of your bank facility, as interest rates go up, does that put a pricing disadvantage against other BDCs, which may have more fixed-rate funding?

Not really. If you look at the other BDCs that have fixed-rate funding today, it's generally a much higher fixed-rate funding. We still have, on a relative basis, because of how we've established our capital staff between fixed and floating, we're still floating off of some lower bank lines of credit rates, and there's still a positive arbitrage for us to do that. We're going to hold down that positive arbitrage until we see rates move back in our favor before we consider any type of fixed-rate debt.

Okay, that’s it for me. Thanks guys.

Thank you, Christopher.

Bryce Rowe with B Riley, your line is open.

Thanks, good afternoon, Mick and Ted. I was curious if maybe you could speak to the improvement in the portfolio's internal risk weightings. Is that more a function of non-accruals getting resolved, or were there some other factors at play?

Yes. Good question, actually, Bryce. There are two components that move and affect that. Number one is non-accruals getting resolved. If you look at our history over the last eight quarters, I think we've done a really good job at reducing non-accruals and cleaning up some historical portfolio companies and sponsors that have had some challenges. That's number one. The second way things move in risk ratings is through migration, both positive and negative. We have experienced some positive migration in companies, which means that we are effectively managing our portfolio and holding companies accountable. Mick, can you provide more specifics on the migration?

Absolutely correct. Those are the two components: non-accruals and net credit migration. We talked about the non-accrual topic with Curion being resolved during the course of the quarter, a very positive development. On the net migration front, we think about this in a couple of ways. First, it's about exiting transactions from our portfolio. During the quarter, we successfully migrated a credit that was in the risk rating category of three out of the portfolio—so we were happy with that. In terms of portfolio movements resulting from upgrades and downgrades, we had a net positive experience in that upgrade-downgrade activity during the third quarter. It was a good quarter in terms of credit quality.

Okay, that's helpful commentary. And then maybe a question on the SLF. The dividend coming into Monroe from the SLF has been stable here at $900,000. Just curious, with rates moving higher, is there an opportunity for income generated from the SLF to increase here in future quarters?

All things being equal, we'd expect the SLF to perform at higher bottom line net income levels. So by extension, we would expect performance of that portfolio to be accretive.

Got it. Thanks so much. That’s all for me. Appreciate the comments.

There are no further questions at this time. I'll now turn the call back over to the presenters for closing comments.

Okay. I just want to thank everybody for taking the time out today to catch up. It's an exciting time in our business, generally, from a firm standpoint, as we continued our firm's growth at the manager level. I think it’s very exciting for the BDC industry right now. Those managers that have the workout portfolio management or asset management capabilities can reap rewards as rates continue to increase, and that's certainly our intention to do here in the near term. Thank you all. We'll speak to you again next quarter. To the extent you have any questions on an interim basis, feel free to reach out to Mick Solimene or to myself at any time. Thank you all. Bye-bye.

This concludes today's call. We thank you for your participation. You may now disconnect.