Earnings Call Transcript - NMFC Q3 2020

Operator, Operator

Good day, and welcome to the New Mountain Finance Corporation Third Quarter 2020 Earnings Conference Call. Please note, this event is being recorded. I would now like to turn the conference over to CEO, Rob Hamwee. Please go ahead.

Rob Hamwee, CEO

Thank you, and good morning, everyone, and welcome to New Mountain Finance Corporation's third quarter earnings call for 2020. On the line with me here today are Steve Klinsky, Chairman of NMFC and CEO of New Mountain Capital; John Kline, President and COO of NMFC; and Shiraz Kajee, CFO of NMFC. Before diving into the business update, we do want to recognize that we continue to live through a public health crisis that is taking a significant human toll on our community across our country and around the globe. We hope that everyone is staying safe and that you and your families remain in good health. Turning to business, 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 November 4 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 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 4 of the slide presentation. Steve?

Steven Klinsky, Chairman

Thanks, Shiraz. It's great to be able to speak to all of you today as both the Chairman of NMFC and as a fellow shareholder. New Mountain as an organization has always sought to explicitly emphasize downside safety and risk controls as well as upside returns, and therefore has emphasized defensive growth industries that can best survive unexpected market downturns. New Mountain started with private equity 20 years ago and now manages over $28 billion of assets, including both private equity and credit. Risk control was part of our founding mission. Happily, we have never had a private equity portfolio company bankruptcy or missed an interest payment in the history of our private equity efforts. Similarly, as of today, we have had only $74 million of realized default losses for just a 0.3% loss rate on the over $12 billion of total debt we have bought since beginning our credit arm in 2008. Meanwhile, we have had significant gains both in private equity and credit. NMFC has paid $810 million in total cash dividends since NMFC went public in 2011 or about $13.27 of dividends per share in total. As investment managers, our general belief is that the greatest mistakes in private equity or credit come when the industry melts beneath you. We have sought to avoid such mistakes by being focused on our sector deep dive process where we proactively identify and study sectors years in advance of making investments so that we understand the dynamics of the industry well. I believe NMFC was built with defensive growth industries and risk control in mind long before COVID hit. The vast majority of NMFC's loans are in areas that might best be described as repetitive, tech-enabled business services, such as enterprise software. Our companies often have large installed client bases of repeat users who depend on their service day in and day out. These are the types of defensive growth industries that we think are the right ones at all times and particularly attractive in difficult times. With that background, let me turn to the specifics of this earnings report on Page 4. Net investment income for the quarter ended September 30 was $0.30 per share, fully covering our dividend of $0.30 per share and in line with our prior guidance. The regular Q3 2020 dividend of $0.30 per share was paid in cash on September 30. Every borrower paid their interest in Q3, and no assets were placed on non-accrual this quarter. We currently do not anticipate any additional portfolio companies going on non-accrual in Q4. Our September 30 net asset value was $12.24 per share, an increase of $0.61 per share or 5.2% from the June 30th NAV of $11.63 per share. The regular dividend for Q4 2020 was again set at $0.30 per share and will be payable on December 30, 2020, to holders of record as of December 16. New Mountain, as the manager, has been highly supportive of NMFC and if it was to become necessary, has significant resources, including a strong balance sheet, to further support NMFC. I and other members of New Mountain continue to be the largest shareholders of the company with ownership of approximately 13%. Insiders have added over 1 million shares to our holdings since the onset of the COVID crisis. In conclusion, we, in no way, want to minimize the COVID crisis. With that said, we remain proud of the work that our team did in carefully building a portfolio to withstand the crisis, and I remain confident in NMFC's own competitive advantages and future prospects.

Rob Hamwee, CEO

Thank you, Steve. While key quarterly highlights and our standard review of NMFC are detailed on Pages 5 and 6, respectively, once again, this quarter I would like to focus my time on getting into more detail on the crisis' impact on asset quality, net asset value, leverage migration, and net investment income. As detailed on Page 7, in order to assess how the crisis is impacting our borrowers, throughout the quarter, we have had extensive conversations with both company management and sponsors. Based on those discussions, we have updated each portfolio company's scores on the 2 metrics we use to generate our overall risk rating. As a reminder, the first metric, COVID exposure, ranks from 1 to 4, indicating the degree to which a company is currently being directly impacted by COVID. The second metric, overall company strength, is a combination of 3 sub-metrics: pre-COVID business performance, liquidity, balance sheet strength, and sponsor support, which we rank on a scale of A to C. Based on our rankings for the 2 metrics and the resulting risk rating for each company, we once again plotted the overall portfolio accordingly to create the risk rating heat maps. The updated heat maps show that risk migration has been stable, as summarized on Pages 8 and 9. The vast majority of negative migration is from 3 of our weaker green credits moving to yellow as COVID impacts rippled through their trailing numbers. Looking forward, we see stability in these names and would not expect further negative migration. Conversely, the largest driver of positive migration is a dramatic move from red to green as one of our specialty dental businesses fully reopened and has already achieved monthly operating results consistent with pre-COVID levels as well as receiving increased sponsor support. On balance, we are pleased with the asset quality and credit trends across the portfolio. The updated heat map is shown on Page 10. As you can further see from the heat map, given our portfolio's strong bias towards defensive sectors like software, business and federal services, and tech-enabled healthcare, we believe our assets are very well positioned to continue to perform no matter how the public health and economic landscape develops. Our remaining red assets continue to be significantly impacted by COVID but are not getting worse. Our largest orange asset, Benevis, continues to make significant progress towards value recovery as we have now completed the balance sheet restructuring and brought in a new Executive Chairman and a new CEO. The operating metrics of the business continue to improve, and our fully engaged private equity operating team, together with new management, is developing a strategic plan that we believe has a high likelihood of achieving full principal recovery and even significant gains in the coming years. While the very recent resurgence of global COVID cases is a troubling trend that we are monitoring closely, it is our belief that absent the lockdown even more lengthy and draconian like what we experienced in the spring, our borrowers have the business models, liquidity, and balance sheet strength to support their capital structures. Page 11 outlines the quarter's net asset value increase and attempts to describe what we believe is, to a significant degree, a temporary decline in net asset value since 12/31, largely driven by market spread movement and comparable company valuation, not underlying credit problems. In Q3, we recovered an additional $0.61 of the dramatic decline we witnessed in Q1. The largest driver of this ongoing recovery, representing $0.37, was the overall market impact in our green names as spreads for well-performing credits in our core verticals continue to decline. The other significant driver, accounting for $0.29, was a significant increase in the valuation of Edmentum, which is a leading provider of distance learning and credit recovery software and services, and has seen a large benefit in the current environment where earnings have grown dramatically. Looking forward, we would expect further positive price movement in our green- and yellow-rated loans, which, if our risk assessment is correct, should continue to recover in the coming quarters as the world normalizes. In our orange and red current pay securities, representing another $18 million of potential NAV recovery, while risks are clearly elevated, we would expect the significant majority of those to continue to pay full interest and principal and ultimately move back towards par. Finally, of the remaining roughly $51 million value change in restructured securities, the majority of the value change is in UniTek. While COVID-induced risks remain elevated for UniTek, there is also a path toward value recovery. Page 12 shows that we continue to manage our statutory leverage ratio at a very comfortable level. While gross debt was up modestly, this was fully offset by an increase in net asset value. Further, we have a number of portfolio companies currently in active sale processes, the anticipated culmination of which will give us additional financial flexibility to either reinvest or further delever. DDTL activity was moderate at $30 million as our well-positioned portfolio companies continued acquisition activity. At this point, we only have $17 million of undrawn DDTL exposure. We ended the quarter with a significant cash balance. On a net balance, if this cash was applied to further pay down debt, our pro forma statutory leverage ratio would be 1.24x. Our current intention as we continue to manage through the COVID crisis and receive repayments from our borrowers is to manage the business at a statutory leverage ratio, net of cash, of 1.0 to 1.25x. While our first priorities in this crisis continue to be asset quality and balance sheet strength, we also want to continue to maximize net investment income while preserving enterprise safety. To that end, quarterly net investment income is stable at $0.30 in Q3. We continue to remain confident, absent a dramatic change in market conditions, in our ability to generate approximately $0.30 of NII per quarter going forward to support the dividend. With that, I will turn it over to John Kline to discuss market conditions and other elements of the business.

John Kline, President and COO

Thanks, Rob. Since our last call, direct lending market conditions have continued to improve. Deal flow was sluggish throughout the summer, but has shown signs of improvement supported by add-on M&A activity for existing portfolio companies along with select new sponsor-backed buyouts. Our forward pipeline continues to build week-over-week, leading us to believe that we could see a flurry of post-election deal activity. Secondary trading levels in the broader sub-investment-grade credit markets, which we view as a gauge of market health, have nearly returned to pre-COVID levels. Most loans made to companies in our core defensive growth sectors, such as software, healthcare technology, and technology-enabled business services, are performing particularly well. Going forward, these sectors should continue to attract capital as investors seek to maximize exposure to COVID-resistant companies that can do well even in uncertain times. Overall, we believe that spreads in the private credit market continue to be attractive on a relative basis compared to virtually all other yield-oriented options, many of which offer less yield today than in pre-COVID times. Turning to Page 14, we show how potential changes in the base rate could impact NMFC's future earnings. As you can see, the vast majority of our assets are floating-rate loans with our liabilities evenly split between fixed and floating-rate instruments. As of our last call in July, 3-month LIBOR was 25 basis points. Since then, it has been flat at approximately 22 basis points today. While this low LIBOR level has pressured our earnings, NMFC has benefited from 1% LIBOR floors on 76% of its assets. Given where rates are today, there is extremely limited downside from further negative base rate movements. Conversely, if base rates exceed 1%, NMFC's earnings will be positively leveraged to any increase above that level. Page 15 addresses historical credit performance. On the left side of the page, we show the current state of the portfolio where we have about $2.9 billion investments at fair value, $64 million of which are currently on non-accrual. This quarter, as mentioned earlier, we did not place any new investments on non-accrual. On the right side of the page, we present NMFC's cumulative credit performance since inception, which shows that across nearly $8 billion of total investments, we have $600 million that have been placed on our watch list, with $220 million of that amount migrating to non-accrual. Of the non-accruals, only $74 million have become realized losses. The non-accruals that have not become credit losses represent about $146 million of cost. While some of these troubled names have risk of becoming permanently impaired, we do have optimism that over time, with the ongoing support of our private equity team members, we will be able to take actions to achieve material credit recoveries and in some cases, gains on these assets. Page 16 is a view of our credit performance based on underlying portfolio company leverage relative to LTM EBITDA. As you can see, despite COVID, the majority of our positions have shown performance that is very consistent with our underwriting projections, exhibiting either very minor leverage increases or in many cases, leverage decreases. There are 6 names that have more than 2.5 turns of negative leverage drift. Three of these names, including UniTek, Edmentum, and Benevis, were covered in Rob's comments. I will discuss the other 3 now. The first name is Company BZ, which is a marketing services business that we noted on our previous call. The company has underperformed over the past 12 months due to various internal operational challenges. Company BZ continues to receive sponsor support and has benefited from recent management upgrades and strategic acquisitions. Company BY is a financial services compliance company which benefits from strong long-term business trends but has been challenged by past management missteps and business impacts from COVID. In response, the sponsor has made material changes to management and injected significant equity capital into the business to support liquidity and growth. Finally, Company CA sells products and services for high school and college graduations which have materially been impacted by COVID. While performance has been challenged in 2020, the company continues to take actions to position itself for success in 2021 and beyond through both liquidity enhancing actions and business improvement. In summary, while we have seen a slightly higher number of companies that experienced material multiple drift, we note that this is a backward-looking metric and believe the aggregate performance of this group of companies will improve over time. The chart on Page 17 tracks the company's overall economic performance since its IPO. At the top of the page, we show that our net investment income has always covered our regular quarterly dividend. On the lower half of the page, we focus on below the line items. First, we look at realized gains and realized credit and other losses. As you can see looking at the row highlighted in green, we have had success generating real economic gains every year through a combination of equity gains, portfolio company dividends, and trading profits. Moving down the page, the orange section of the chart shows year-to-date realized losses of $36.5 million, $32.3 million of which were crystallized in Q1. In Q2 and Q3, we have experienced just $4.2 million of additional realized losses relating primarily to our balance sheet deleveraging program, which is now complete. As a result of this activity, we now have cumulative net realized losses since inception, highlighted in blue, of approximately $17 million. While we do everything in our power to avoid them, over the long term, we do expect to incur realized credit losses on our investment portfolio, which we hope to largely offset with realized gains just as we have historically accomplished throughout our nearly 10 years as a public company. Looking further down the page, we show the material impact from unrealized portfolio markdowns of $128 million since inception and cumulative net realized and unrealized losses of $144 million highlighted in yellow. The bottom line number represents a $59 million improvement compared to last quarter driven by the positive change in our portfolio marks that we discussed in detail earlier in the presentation. Cumulatively, we've recovered $112 million of unrealized losses since the Q1 low point of the company's fair market value. We continue to believe that most of the remaining cumulative net unrealized loss is reflective of temporary business conditions and will recover in time. Page 18 shows a stock chart detailing NMFC's performance since IPO. While the performance of our stock inclusive of our quarterly dividend has historically been very strong compared to relevant benchmarks, over the past 8 months, NMFC's stock price has had soft performance versus certain benchmarks. However, our overall track record exceeds that of the high-yield index and materially exceeds the return of an index of BDCs that we have followed since our IPO. Page 19 provides a final look at the stock performance compared to the individual stocks of our peers that have been public at least as long as we have. While we seek to improve our performance going forward, this chart shows that we remain a top performer among this cohort of competitors. Finally, we break down NMFC's total return attribution since inception on Page 20, where on the far right side of the slide we show that the core of our value creation has been cash distributions of $13.27 per share supported by consistent income from our defensive growth lending portfolio. Offsetting this dividend performance has been a $1.84 per share decline in book value, most of which has occurred in 2020, and the $2.35 per share decline related to the contraction of our book value multiple since our IPO. As we have mentioned, we believe that NMFC has good prospects to improve in both areas of underperformance while maintaining a compelling and consistent dividend. As of yesterday's closing share price, assuming our announced $0.30 per quarter dividend payout, NMFC's annualized dividend yield is approximately 12.6%. Turning to our investment activity tracker on Page 21. This quarter, our originations were almost exactly equal to our repayments, yielding de minimis net originations. New originations primarily consisted of various delayed draw fundings supporting M&A for our existing portfolio companies highlighted by a financing for Insightsoftware as well as an investment into our SLP III first-lien loan program, which continues to operate very well in this environment. While we acknowledge COVID as a material risk, based on conversations with our clients and our building investment pipeline, we do expect overall activity to pick up after the election. On Page 22, we have several detailed breakouts of NMFC's industry exposure. The center pie chart shows overall industry exposure, while the charts on the right and left give more insight into the diversity within our services and healthcare verticals. As you can see, we have successfully avoided nearly all of the most troubled sectors while maintaining high exposure to the most defensive, COVID-resistant sectors within the U.S. economy. On the lower half of the page, we show that the portfolio continues to have a high degree of first-lien exposure with nearly 70% of our portfolio invested in senior-oriented assets. Additionally, we present a breakout of risk ratings that match the heat maps shown in the beginning of our presentation. Finally, as illustrated on Page 23, we have a diversified portfolio with our largest single name investment at 3.7% of fair value and the top 15 investments accounting for 36% of fair value.

Shiraz Kajee, CFO

Thank you, John. For more details on our financial results and today's commentary, please refer to the Form 10-Q that was filed last evening with the SEC. Now I'd like to turn your attention to Slide 24. The portfolio had over $2.9 billion in investments at fair value at September 30, 2020, and total assets of $3 billion. We have total liabilities of $1.8 billion, of which total statutory debt outstanding was $1.5 billion, excluding $300 million of drawn SBA-guaranteed debentures. Net asset value of $1.2 billion or $12.24 per share was up $0.61 from the prior quarter. As of September 30, our statutory debt-to-equity ratio was 1.27:1. And as mentioned, net of available cash on the balance sheet, the pro forma leverage would be 1.24:1. On Slide 25, we show our historical leverage ratios and our historical NAV adjusted for the cumulative impact of special dividends. On Slide 26, we show our quarterly income statement results. We believe that our NII 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 September 30, 2020, we earned total investment income of $65.3 million, a $2.4 million decrease from the prior quarter due to the full quarter impact of our deleveraging program last quarter, lower base rates, and a lower fee income quarter. Total net expenses were approximately $36.5 million, a $2.3 million decrease due primarily to lower debt service costs from the client base rates and less average debt outstanding. To cover our shortfall in pre-incentive fee operating income, the investment adviser waived a portion of its incentive fee this quarter. Also, as in prior quarters, the investment adviser continues to waive certain management fees. The effective annualized management fee this quarter was 1.34% to 1. It is important to note that the investment adviser cannot recoup fees previously waived. This results in third-quarter NII of $28.8 million or $0.30 per weighted average share, which covered our Q3 dividend of $0.30 per share. As a result of the net unrealized depreciation in the quarter, for the quarter ended September 30, 2020, we had an increase in net assets resulting from operations of $88.2 million. Slide 27 demonstrates our total investment income is recurring in nature and predominantly paid in cash. As you can see, 95% of total investment income is recurring, and cash income is stable at 82% this quarter. We believe this consistency shows the stability and predictability of our investment income. Turning to Slide 28. As discussed earlier, our NII for the third quarter covered our Q3 dividend. Based on preliminary estimates, we expect our Q4 2020 NII will be approximately $0.30 per share. Given that, our Board of Directors has declared a Q4 dividend of $0.30 per share, which will be paid on December 30, 2020, to holders of record on December 16, 2020. On Slide 29, we highlight our various financing sources. We had over $2.2 billion of total borrowing capacity at quarter end, but over $400 million available on our revolving lines, subject to borrowing base limitations. On September 30, we amended and extended our Wells Fargo credit facility, adding 1 year to the maturity at an attractive rate. 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 30, 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. We have one near-term maturity in May 2021 and are evaluating multiple avenues to address that maturity in a most efficient manner. With that, I would like to turn the call back over to Rob.

Rob Hamwee, CEO

Thanks, Shiraz. In closing, we are increasingly 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 serve us well as the uncertain environment likely to characterize upcoming quarters. While risks are more elevated than in the past and we cannot unequivocally discount more challenging scenarios, we believe our model is well suited for the current environment. We once again thank you for your continuing support and interest in these difficult times, 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 Bryce Rowe with National Securities.

Bryce Rowe, Analyst

Just a few questions here. You all mentioned the, I guess, the upcoming maturities possibly tied to those credits in that orange or red risk rating area. Maybe if you could just kind of provide a little bit of color around that comment, kind of size and maturity, when those maturities occur? And are there challenges around it? Or do you see it as an opportunity?

Rob Hamwee, CEO

Yes. Sorry, Bryce. I'm not exactly sure what you're referring to. The maturities in orange and red credits?

Bryce Rowe, Analyst

Yes, please go ahead, Rob.

Rob Hamwee, CEO

No, I was just going to say that I apologize if we misspoke on the call. There are no material maturities on those items, and some of them are already restructured. The ones that are current pay do not have any near-term or medium-term maturities. I’m sorry if there was any misunderstanding about that.

Bryce Rowe, Analyst

It's okay. Yes, I might have just misheard the comment about the opportunity to recoup the $0.19 of NAV within the orange and red buckets.

Rob Hamwee, CEO

Yes, that's really more a question of as they reach maturity. We do not believe that most of those are currently making payments, and we think that none of them are likely to default. Therefore, as conditions improve, which could be over the next three to four years, we expect their values to approach par. That was the point.

Bryce Rowe, Analyst

Okay. Fair enough. Fair enough. Sorry for that. Then Rob, I wanted to, I guess, ask about the comments you made about possibly seeing some activity around sale activity within the portfolio and what that might mean in terms of your flexibility, your balance sheet flexibility, and how you're thinking about possibly using those proceeds if, in fact, sales do occur.

Rob Hamwee, CEO

Yes, we are closely monitoring the situation. Generally, it revolves around two main factors: first, the overall recovery of the M&A market, which we are observing significantly in our own private equity activities, our sponsor clients, and our portfolio. Second, we are focusing on the types of businesses most likely to be sold, such as those that have thrived during COVID, like enterprise software, healthcare, and IT. We anticipate some significant repayments in the coming months. Depending on how circumstances evolve, we'll decide whether to use these funds for further debt reduction or reinvestment. Our decisions will depend on our assessment of risk and the opportunities available in relation to current market and operational conditions.

Bryce Rowe, Analyst

Got it. Okay. And then one more follow-up on the comment you made about the dental practice moving from red to green. And obviously, you've had some migration within the retail healthcare names that are in the portfolio over the course of second quarter to third quarter. So curious, what was the factor that moved that particular one from red to green? And then what are you seeing within the other retail healthcare names that are either keeping them stuck in a particular yellow or orange category versus moving into a higher rating?

Rob Hamwee, CEO

The one that changed significantly was a DPM in the northeastern region that focuses on specialty treatments. This area, particularly around New York City and Boston, was completely shut down through May and into early June, which is why it was rated red during that time in June for Q2. There was uncertainty about the sponsor's support and how the balance sheet would handle the lack of incoming cash and revenue, justifying the red rating in June. However, by September, the situation improved as it started to reopen in late June and saw a strong uptick in activity in July and August. By August, it was not only fully operational but also fully utilized, with efficiencies implemented that increased margins. The data showed usage numbers in August and September that exceeded pre-COVID figures. Therefore, the overall impact of COVID shifted it from Tier 1 to Tier 3, indicating a modest effect remaining, but the numbers implied it was no longer significantly impacted by the pandemic. This change moved it from a C rating to a B rating. This is detailed as seen on Page 9 of the earnings presentation. Other retail healthcare entities have improved as well, but not to the same extent. Some remain at 80% or 90% utilization and couldn't implement operational efficiencies yet, while others' balance sheets are stable without showing the same progress. These case-by-case variations contribute to the different risk ratings observed.

Bryce Rowe, Analyst

Got it. Okay. That's helpful, Rob, and good to see the NAV recovery and keep up the good work.

Operator, Operator

Our next question comes from Finian O'Shea with Wells Fargo.

Finian O'Shea, Analyst

I have a question about the incentive fee waiver. I believe this is the first one we've encountered in some time. Can you provide some details on what led to this? Was it related to dividends or some other type of portfolio income?

Rob Hamwee, CEO

Yes. I mean it's really in keeping with our goal to make sure the NII is aligned with the current dividend rate. And that number was about $0.5 million, but we want to make sure we're earning our dividend every quarter. And that's kind of all that boils down.

Finian O'Shea, Analyst

Yes, that makes sense. Edmentum has been a business you've worked on for a long time, and it's performing well, which is great for everyone. What is your updated perspective on holding that asset, considering it may be more flexible at this point based on the current valuations? Do you see that as equity you'd like to move, or do you prefer to keep it as an investment?

Rob Hamwee, CEO

I think it's a good question, and the answer is likely somewhere in between. We might look to take some chips off the table, recapitalize the balance sheet, or potentially bring in a partner. However, we also see significant upside from this point forward, which may not fully materialize until we establish the sustainability of the earnings trend, in which we have strong confidence. Therefore, we might choose to maintain some exposure for a while longer to capture that additional value gain. So, somewhere in the middle there, Fin, if that makes sense.

Finian O'Shea, Analyst

It does. And final question on the, I believe, post-quarter CLO business you all launched. Is that part of your group, Rob, the private credit? Will that be in your co-investment for private transactions? Or will that be completely distinct focused on BSL and so forth efforts for New Mountain?

Rob Hamwee, CEO

Yes. I mean it's within the broader credit platform, but it's totally distinct from anything we're doing in public capital markets or in private credit, generally. It's a very, initially at least, a BSL-focused strategy. And we brought in a senior executive to have day-to-day management of that. Obviously, John and I and the rest of the team are very involved, and the industrial logic is still the same. We're still recognizing that we have to have a little bit more industry diversity there, but we are still skewing as much as possible given CLO constraints towards the business areas that we know and love. And we're still utilizing the intellectual capital of the broader firm to underwrite the credit there. So we think we can, again, have a differentiated credit track record there. But to be very clear, totally separate. We're not funding the equity out of the BDC, and none of that is either happening or intended to or will happen.

Finian O'Shea, Analyst

Can the co-investment process be clarified? The market is increasingly uncertain regarding lightly syndicated transactions in a club format. There are numerous transactions you participate in that might be considered syndicated, such as in the second lien context. Your involvement in the club and contribution to structuring has been significant, but are these transactions eligible for co-investment? Since they are syndicated by an arranger and New Mountain only invests based on price, could there be a gray area in some of the strategies used by New Mountain BDC that might be friendly for co-investment with the CLOs?

Rob Hamwee, CEO

Yes. I do think that's possible over time. I think it will be a very small minority. But I do think it's definitely possible that the CLO could have $2 million of a $30 million or $80 million, whatever it may be, overall hold just like we share things between NMFC and our guardian funds. Again, I think it will be a few and far between, but sure. I mean we're not adverse subject to all the co-investment restrictions, if it makes sense to share an asset across NMFC regarding funds and maybe CLO.

John Kline, President and COO

And Fin, this is John. I just want to add one thing. As our businesses stand today, we view the market as incredibly different. When we're pitching our CLO, the average tranche size is approximately 1.2 billion to 1.4 billion, with average spreads in the L 200 to L 300 range. We see it as a complementary product to our core direct lending strategy. However, as Rob mentioned, there isn't much overlap right now, which is good, between our efforts in building our CLO business and our activities in our core private credit business.

Operator, Operator

Our next question comes from Paul Johnson with KBW.

Paul Johnson, Analyst

It seems that the deleveraging process is largely behind us at this point. The portfolio has been improving, and you've paid down some debt recently. I'm curious about your approach to evaluating new companies. Is that something you are currently pursuing, or is the priority more focused on existing borrowers and maintaining liquidity?

Rob Hamwee, CEO

Yes, I believe we have ample liquidity. The focus is less on liquidity and more on managing our leverage ratio within the range of 1.0 to 1.25x, and we are currently at the upper end of that range. We see potentially interesting transactions ahead, and we're in the market because we have other capital available. The decision will depend on how repayments come in and how the situation unfolds. We will need to consider whether to apply the next amount of capital towards reducing leverage further or investing in new assets. We are certainly in the market and will be careful in redeploying our return capital, likely balancing between some incremental debt reduction and pursuing select new deals.

Paul Johnson, Analyst

Okay. Sure. That makes sense. And the next question was on your net lease business model. I'm just kind of curious like how that has performed in this environment. I mean it appears to be holding up relatively well. How are you evaluating new opportunities in that business? Is that something you're still looking to grow? Any sort of commentary there would also be helpful.

Rob Hamwee, CEO

Yes, absolutely. The net lease portfolio has performed very well, especially since it offers long-term fixed-rate cash flows. The decline in interest rates has lowered cap rates, which has increased valuations, so we're pleased with that aspect. We will continue to make small commitments alongside this portfolio. We have a dedicated net lease fund, as previously mentioned, and we plan to selectively expand that portfolio in a diversified manner with smaller investments. We remain optimistic about that business and see good opportunities ahead. Most importantly, the existing portfolio is performing quite well.

Paul Johnson, Analyst

Okay. And my last question, I'm just wondering, so for your Tier 1 and 2 companies that you guys break out, is any part of that classification or optimism for recovering, is any of that contingent upon additional stimulus programs or any kind of additional support for those companies coming from the government?

Rob Hamwee, CEO

No, there is no connection there.

Operator, Operator

Our next question comes from Art Winston with Pilot Advisors.

Arthur Winston, Analyst

Thank you on behalf of all shareholders besides myself for your performance. It's really terrific. And thank you for the great disclosure. I just had 2 questions. The first one is I assume that there's very little opportunity to reduce interest expense other than by paying down debt, if that's the case.

Rob Hamwee, CEO

Yes, thank you for the nice comments. I appreciate that. And yes, I mean, we have benefited to some degree from the decline in base rates across our variable rate credit facilities. But I think you're right. At this point, there's not much opportunity there given how far base rates have come down. And so yes, beyond deleveraging, I wouldn't expect interest expenses to decline materially from here. I think that's a fair observation.

Arthur Winston, Analyst

And from what you said, the probability of increasing the asset portfolio over the next 4 or 5 months is not great. It's like 50-50 as to whether you could make enough investments to increase the size of the portfolio?

Rob Hamwee, CEO

Yes, I agree. I believe the portfolio will likely remain at a similar size, and any new investments will probably be funded by the repayment of older investments, which means the overall portfolio will stay the same size. So I think that’s a reasonable conclusion, yes.

Operator, Operator

This concludes the question-and-answer session. I would like to turn the conference back over to Rob Hamwee for any closing remarks.

Rob Hamwee, CEO

Thanks, operator. Well, thank you, everyone. Again, challenging times for sure, but it does feel like things are improving. We remain very optimistic about our prospects going forward and look forward to staying in touch and talking on our next call. Take care. Buh-bye now.

Operator, Operator

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