Earnings Call Transcript - NMFC Q4 2021

Rob Hamwee, CEO

Thank you, and good morning, everyone. And welcome to New Mountain Finance Corporation's Fourth Quarter Earnings Call for 2021. On the line with me here today are Steve Klinsky, Chairman of NMFC and CEO of New Mountain Capital; John Kline, President of NMFC; Shiraz Kajee, CFO of NMFC; and Laura Holson, COO of NMFC. Laura was promoted to COO effective February 15 and has been a core member of the credit team for over 10 years. Steve is going to make some introductory remarks, but before he does, I'd like to ask Shiraz to make some important statements regarding today's call.

Shiraz Kajee, CFO

Thanks, Rob. Good morning, everyone. Before we get into the presentation, I would like to advise everyone that today's call and webcast are being recorded. Please note that they are the property of New Mountain Finance Corporation and that any unauthorized broadcast in any form is strictly prohibited. Information about the audio replay of this call is available in our February 28 earnings press release. I would also like to call your attention to the customary safe harbor disclosure in our press release and on Page 2 of the slide presentation regarding forward-looking statements. Today's conference call and webcast may include forward-looking statements and projections, and we ask you to refer to our most recent filings with the SEC for important factors that could cause actual results to differ materially from those statements and projections. We do not undertake to update our forward-looking statements or projections unless required to by law. To obtain copies of our latest SEC filings and to access the slide presentation that we will be referencing throughout this call, please visit our website at www.newmountainfinance.com. At this time, I'd like to turn the call over to Steve Klinsky, NMFC's Chairman, who will give some highlights beginning on Page 5 of the slide presentation.

Steve Klinsky, Chairman & CEO

Thanks, Shiraz. It's great to be able to address all of you today as both the Chairman of NMFC and as a major fellow shareholder. I'll start by covering the highlights of the fourth quarter. Net investment income for the quarter was approximately $0.31 per share, fully covering our dividend of $0.30 per share that was paid in cash on December 30 and above our prior guidance. Our net asset value was $13.49 per share, a 1.7% increase from last quarter's net asset value, primarily driven by continued appreciation in our Edmentum and REIT equity positions. The regular dividend for Q1 2022 was again set at $0.30 per share based on estimated net investment income of $0.30 per share. As we discussed on our previous earnings calls, risk control and downside protection have always been part of New Mountain's founding mission. Our firm as a whole now manages over $35 billion in total assets with a team of over 190 people. We have never had a bankruptcy or missed an interest payment in the history of our private equity work. We have applied that same team strength and focus on downside protection to NMFC and our credit efforts. The great bulk of NMFC's loans are in acyclical sectors with secular tailwinds, such as enterprise software, tech-enabled business services and health care services and technology. These are the types of defensive growth industries that we think are the right ones in all times and particularly attractive in difficult times. We believe our portfolio continues to be well positioned due to this defensive growth investment strategy and is evidenced by an average net default loss of only 7 basis points a year since we began our credit operation in 2008. Our portfolio company risk ratings have remained generally unchanged since our last earnings call and we had no new nonaccruals this quarter. The fourth quarter represented a record origination quarter for our credit business overall given the active market and increasing market share of direct lending more broadly, combined with the strength of our sourcing capabilities. Lastly, I would like to provide a quick update on the several initiatives discussed last quarter. Given our strong earnings profile, we have not needed our dividend protection program, but we want to remind shareholders of its existence and our support of the $0.30 per share dividend. Additionally, our at-the-market or ATM stock program is off to a nice start with approximately $18 million of net proceeds since it launched in November. Together, New Mountain professionals have invested over $600 million personally into NMFC and New Mountain's credit activities. I and management remain as NMFC's largest shareholders. We have continued to add to our personal positions in the last 12 months, and Rob, John and I have never sold a share.

Rob Hamwee, CEO

Thank you, Steve. As we have throughout the COVID crisis, we continue to update each portfolio company scores on our heat map using the same criteria discussed in the past and as outlined on Page 8. We believe our portfolio continues to be very well positioned overall. The updated heat maps show the slightly net negative risk migration this quarter as summarized on Pages 9 and 10 with $49 million of negative migration from one issuer in the insurance services space. Certain segments of this business have faced some COVID headwinds and the company has had some foreign exchange challenges more broadly. Given these performance challenges, combined with an upcoming revolver maturity, we migrated the risk to orange from yellow on our heat map. We are in active discussions with the sponsor and hope to have an update regarding a potential solution in the near term. The updated heat map is shown on Page 11. As you can see, given our portfolio's strong bias towards defensive sectors like software, business services and health care, we believe the vast majority of our assets are very well positioned to continue to perform no matter how the public health and economic landscape develops. We continue to spend significant time and energy on our remaining red and orange names, which represent just 8% of our portfolio at fair value. We have seen some positive momentum in several of these names and are optimistic that as the impact of the pandemic hopefully continues to recede in the months ahead, these credits will benefit and migrate positively on our heat map. Page 12 is a view of our credit performance based on underlying portfolio company leverage relative to last twelve months EBITDA and shaded to the corresponding color of the heat map. As you can see, the vast majority of our green-rated positions have shown results that are very consistent with our underwriting projections, exhibiting either very minor leverage increases or, in many cases, leverage decreases.

John Kline, President

Thanks, Rob. So far this year, we have seen volatility in many parts of the equity and fixed income markets, driven by interest rate concerns, supply chain disruptions and geopolitical instability. However, direct lending remains healthy, given floating interest rates and secured debt structures that are inherent to the asset class. While the direct lending market has experienced a normal seasonal lull in the first part of Q1, in recent weeks, we have seen increased activity as sponsors seek to deploy a significant amount of dry powder in 2022. Over the course of the last few years, we believe that direct lending has increased its share of the overall financing market, and we expect this trend to continue in 2022 as sponsors seek ease of execution, single debt tranches and committed capital for future acquisitions. Operating performance trends across our core defensive growth industries remain strong, which has created a backdrop for healthy sponsor purchase prices resulting in very attractive loan-to-value ratios for lenders. As we reported last quarter, there is a tight pricing range for direct lending solutions as most deals that we evaluate have very similar spreads regardless of credit quality. Given this dynamic, there is little incentive to stretch on credit quality which plays very well to our strategy of financing best-in-class companies in defensive industries. Page 14 presents an interest rate analysis where we show how potential changes in the base rate could impact NMFC’s future earnings. Given the expectation for base rate increases, this analysis has become more relevant than any time in recent memory. As shown, the vast majority of our assets are floating rate loans while our liabilities are 53% fixed rate and 47% floating rate. Given this balance sheet mix, NMFC offers its shareholders consistent and stable earnings in all scenarios where LIBOR or SOFR remain under 1%. If base rates rise above 1%, which is expected to happen in the near future, there is meaningful upside to NMFC’s net investment income. All things being equal, if base rates rise to 2%, which could occur within the next 12 months, annual earnings per share will increase by $0.10 or 9%. This positive interest rate optionality offers material potential return enhancement to our shareholders and provides an attractive hedge against higher rates across the U.S. economy. Turning to Page 15, we present our book value performance since the COVID pandemic began, where we show that the portfolio recovered nicely over the course of the last 2 years. In fact, today, our book value is nearly 2% higher than it was in the quarter preceding the health crisis. This recovery has been driven by an increase in the fair value of our core debt portfolio and appreciation of certain equity positions, the largest of which are shown on the right side of the page.

Laura Holson, COO

Thanks, John. As Steve previewed, Q4 was a record origination quarter for our direct lending platform with aggregate deployment of $1.5 billion. Pages 19 and 20 outline the strong and diverse originations within NMFC, which were well balanced with portfolio exits, keeping us fully invested and within our target leverage range. Our originations included lead and co-lead mandates, club deal flow and add-on investments into existing portfolio companies. We continue to have great success targeting and sourcing high-quality deals within niches of the economy where we have the highest conviction. Since quarter-end, as shown on Page 21, we continued our sourcing momentum with 5 new financings during the month of January and February. Net of repayments, we expanded our book by $105 million, and we remain within our target leverage range. Turning to Page 22, we show that in Q4 our portfolio continued to migrate up the capital structure as our originations were heavily weighted towards first-lien loans due to increasing sponsor interest in the unitranche product, while our sales and repayments were evenly split between first-lien and non-first-lien assets. We plan to maintain an asset mix that is consistent with our quarter-end portfolio, where approximately 2/3 of our investments inclusive of first-lien, SLPs and net lease are senior in nature. Page 23 shows that the average yield of NMFC's portfolio increased slightly from 8.8% in Q3 to 9.1% for Q4. While the environment is competitive, the market spreads for high-quality deals remain supportive of our net investment income target.

Shiraz Kajee, CFO

Thank you, Laura. For more details on our financial results in today's commentary, please refer to the Form 10-K that was filed last evening with the SEC. Now I'd like to turn your attention to Slide 26. The portfolio had approximately $3.2 billion in investments at fair value at December 31, 2021, and total assets of $3.3 billion with total liabilities of $2 billion of which total statutory debt outstanding was $1.6 billion, excluding $300 million of drawn SBA-guaranteed debentures. Net asset value of $1.3 billion was $13.49 per share was up $0.23 from the prior quarter. At December 31, our statutory debt-to-equity ratio was 1.23:1 and net of available cash on the balance sheet, the pro forma leverage ratio would be 1.20:1. On Slide 27, we show our historical leverage ratios and our historical NAV adjusted for the cumulative impact of special dividends. Consistent with our goal of minimizing credit losses and maintaining a stable book value over the long term, you will see that current NAV adjusted for special dividends has recovered from the depths of COVID and has surpassed NAV from our IPO almost 11 years ago. On Slide 28, we show our quarterly income statement results. We believe that our net investment income is the most appropriate measure of our quarterly performance. This slide highlights that while realized and unrealized gains and losses can be volatile below the line, we continue to generate stable net investment income above the line. Focusing on the quarter ended December 31, 2021, total investment income of $67.8 million, a slight decrease from the prior quarter. Total net expenses were approximately $38.2 million, a slight increase quarter-over-quarter. And as discussed, the investment adviser has committed to a management fee of 1.25% for the 2021, 2022 and 2023 calendar years. We have also placed to reduce our incentive fee if and as needed during this period to fully support the $0.30 per share quarterly dividend. It is important to note that the investment adviser cannot recoup fees previously waived. This results in fourth quarter net investment income of $29.6 million or $0.31 per weighted average share, which exceeded our Q4 regular dividend of $0.30 per share. As a result of the net unrealized appreciation in the quarter, for the quarter ended December 31, 2021, with an increase in net assets resulting from operations of $52.2 million. On Slide 29, I'd like to give a brief summary of our annual performance for 2021. For the year ended December 31, 2021, with total investment income of approximately $270 million and total net expenses of $151 million. This results in 2021 total adjusted net investment income of $118 million or $1.22 per weighted average share which more than covered our $1.20 regular dividend paid in 2021. In total, for the year ended December 31, 2021, we had a total net increase in net assets resulting from operations of approximately $202 million. Slide 30 demonstrates our total investment income is recurring in nature and predominantly paid in cash. As you can see, 91% of total investment income is recurring, and cash income remained strong at 81% this quarter. We believe this consistency shows the stability and predictability of our investment income. Turning to Slide 31. As briefly discussed earlier, our net investment income for the fourth quarter exceeded our Q4 dividend. Based on preliminary estimates, we expect our Q1 2022 net investment income will be approximately $0.30 per share. Given that, our Board of Directors has declared a Q1 2022 dividend of $0.30 per share, which will be paid on March 31, 2022, to shareholders of record on March 17, 2022. On Slide 32, we highlight our various financing sources. Taking into account SBA guaranteed debentures, we had over $2.3 billion of total borrowing capacity at quarter end with over $360 million available on our revolving lines subject to borrowing base limitations. During the fourth quarter, we closed on a $10 million upsize in our NMFC credit facility and amended and extended our management company revolver, pushing out the maturity to 2024, while decreasing our applicable spread materially by 300 basis points. As a reminder, both our Wells Fargo and Deutsche Bank credit facilities covenants are generally tied to the operating performance of the underlying businesses that we lend to rather than the marks of our investments at any given time. Finally, on Slide 33, we show our leverage maturity schedule. As we've diversified our debt issuance, we've been successful at laddering our maturities to better manage liquidity and over 75% of our debt matures after 2025.

Rob Hamwee, CEO

Thanks, Shiraz. In closing, we are optimistic about the prospects for NMFC in the months and years ahead. Our long-standing focus on lending to defensive growth businesses supported by strong sponsors should continue to serve us well. We once again thank you for your continuing support and interest, wish you all good health and look forward to maintaining an open and transparent dialogue with all of our stakeholders in the days ahead. I will now turn things back to the operator to begin Q&A.

Operator, Operator

Our first question comes from Paul Johnson with KBW.

Paul Johnson, Analyst

So on the last couple of quarters, I know you discussed slightly or just about on the private equity co-investments you would be making with the New Mountain Adviser. Is there any developments there? Have you guys made any investments alongside New Mountain in the last quarter or year-to-date?

Rob Hamwee, CEO

Yes. So far in the last quarter and year-to-date, there have been no developments. We did make one early on. We plan to be very selective, and our available capital will influence our decisions. Our traditional debt origination has been strong, leaving us with limited available capital. However, I do expect to see several investments throughout 2022, but I can't make any promises.

Paul Johnson, Analyst

Sure. And then I'm just wondering if you could talk a little bit about the net lease program and just kind of the return profile from that asset class? I'm sort of curious how rising rates affect the asset class and with rates going higher, does that benefit the yield from the investment? And then also just what are your, I guess, growth intentions there? Any color on that would be helpful.

Rob Hamwee, CEO

Yes, that's a great question. The net lease program has proven to be a highly attractive source of returns for us, providing both double-digit current income and significant capital appreciation as cap rates in this area decline. The movement in cap rates is influenced by two main factors: base rates, which have been very low until recently, and risk premiums. As rates begin to shift, there is a potential risk of rising cap rates, which could decrease asset value. However, we continue to observe a decline in risk premiums due to the value of real estate as an inflation hedge. We are looking into the possibility of monetizing a significant portion of the portfolio to mitigate exposure in this new rate cycle. I expect to share more details about this throughout 2022. Overall, total returns have exceeded 20% across the portfolio when considering both current income and equity appreciation, making it a strong performer for us.

Paul Johnson, Analyst

Appreciate that. And then your portfolio, I know it's more defensive and service-oriented in nature. So I'm just curious for companies like that, how does inflation generally flow through those types of companies and kind of what do we expect to see or I guess maybe more what you're seeing today?

John Kline, President

Sure, Paul. This is John. I mean I think you hit on it. We financed a lot of technology-enabled business services, software, life sciences especially material. So these are all businesses that I think have really good pricing power. They're growth-oriented businesses, and so I'd really think they will last to suffer when we think about inflation. I'm not saying there's no impact, but in general, yes, we really like our businesses in an inflationary environment. And I think if you look across our competitors, I just think our portfolio stacks up very well with regard to protection against inflation given the characteristics that I mentioned.

Paul Johnson, Analyst

I appreciate that. And last one for me. I'm just curious, I don't know if this is something that you've talked about in the past. But for your portfolio, did you guys have an average EBITDA of the portfolio that you have today? And is that changed over time over the course of the last several years or so?

Rob Hamwee, CEO

So I would say – I mean, we have some data as I’m just flipping to – let’s see, I just want to make sure. We can dig that up. But on balance, I would say the businesses have gotten modestly larger. I think all else equal, we take comfort in larger businesses. And I think as we talked about on the call a little bit today, we’ve seen the private unitranche penetrate deeper into the upper middle market. And a lot of those deals are in our sweet spots. And so we’ve been participating there. And so that will modestly increase the average EBITDA of our borrower, but we still cover the waterfront from, call it, $20-or-so million of EBITDA, $100-plus million of revenue on the low end, all the way up to multi-hundred million dollar EBITDA borrowers on the higher end.

Bryce Rowe, Analyst

I wanted to ask about the comment Shiraz made regarding the small $55 million tranche of unsecured notes that is due in 2022. There are a few more in 2023, and it seems like you've been monitoring the unsecured notes market. I’d like to understand your perspective on possibly transitioning from the unsecured position to more secured facilities, considering the current rates and that spreads for these instruments may have increased a bit. What are your thoughts on these upcoming maturities and your comfort level with a higher reliance on secured versus unsecured?

Rob Hamwee, CEO

I'll take a crack at it. I don't think we would expect to materially change the mix. We really do like the flexibility provided by the unsecured capital. So that roughly 50-50 mix that we have, it may move by plus or minus 5%, but we're not going to wake up and be 70% secured one day and 30% unsecured. So we're constantly evaluating the trade-offs between flexibility and cost. And we think both markets are very open to us right now, and it's just marginal cost versus marginal flexibility, but unless the cost got incredibly prohibitive, I think we will maintain roughly the ratios we're running with today.

Bryce Rowe, Analyst

Okay. That's great, Rob. And then maybe just a question about the competitive environment you all have stayed active and you typically do in terms of new activity and really being offset by some of the repayments in the sales. Have you seen any shift in pricing, whether tighter or wider didn't necessarily sound like it, but just curious what you've kind of seen here in the early part of '22, if there's been any shift in spreads or pricing?

Laura Holson, COO

No, we haven't seen any material changes. I would say it's kind of largely in equilibrium at the moment. John talked about just the general market environment where we're seeing really high-quality deals in the sectors that we know and like. And those deals definitely do remain competitive, but we've seen largely pretty consistent spreads in the last couple of quarters, I think, largely due to the equilibrium kind of more broadly in the market.

Rob Hamwee, CEO

Yes. The only thing I'd add to that, I think the interesting question will be, over the course of the year, if and as LIBOR, SOFR gets materially above 1, 1.5, it starts getting to 2, maybe even low 2s early next year, are people ultimately absolutely turn? Or are they spread and it's a mix, I think, like my guess is you'll see some of that total return given back in spread compression, but not nearly all of it. But again, that, I think, is an interesting dynamic and one we haven't really lived through in a long time, so we'll have to see.

Bryce Rowe, Analyst

Yes, for sure. It will be interesting to see how rates and especially the shorter end plays out this year. I appreciate the comment.

Rob Hamwee, CEO

Great. Thank you.

Operator, Operator

There are no further questions. This concludes our question-and-answer session. I would like to turn the conference back over to Rob Hamwee for any closing remarks.

Rob Hamwee, CEO

Great. Thank you. And thanks, everyone. As always, appreciate the time and attention and the support. As you know, we’re always here to answer questions directly and look forward to speaking to everyone again if not over the course of the quarter, next quarter. Thank you. Have a great day.

Operator, Operator

The conference has now concluded. Thank you for attending today's presentation. You may now disconnect.