SLR Investment Corp. Q2 FY2020 Earnings Call

Ladies and gentlemen, thank you for standing by and welcome to the Q2 2020 Solar Capital Earnings Conference Call. At this time, all participants are in a listen-only mode. After the speaker presentation, there will be a question and answer session. Please be advised that today's conference is being recorded. I would now like to hand the conference over to your speaker today, Michael Gross, Chairman and CEO. Thank you, and please go ahead.

Thank you very much and good morning. Welcome to Solar Capital Limited earnings call for the quarter ended June 30, 2020. I'm joined today by Bruce Spohler, our Co-CEO; and Richard Peteka, Solar Capital's Chief Financial Officer. Rich, before we begin, would you please start covering the webcast and forward-looking statements.

Thank you. I would like to remind everyone that today's call and webcast are being recorded. Please note that they are the property of Solar Capital Limited and that any unauthorized broadcasts in any form are strictly prohibited. This conference call is being webcast on our website at www.solarcapitalltd.com. An audio replay of the call will be made available later today as disclosed in our earnings press release. I would also like to call your attention to the customary disclosures in our press release regarding forward-looking information. Statements made in today's conference call and webcast may constitute forward-looking statements, which relate to future events or our future performance or financial condition. These statements are not guarantees of our future performance, financial condition or results and involve a number of risks and uncertainties, including the impact of COVID-19 and related changes in base interest rates and significant market volatility on our business, our portfolio companies and the global economy. Additionally, past performance is not indicative of future results. Actual results may differ materially as a result of a number of factors including those described from time-to-time in our filings with the SEC. Solar Capital Limited undertakes no duty to update any forward-looking statements unless required to do so by law. To obtain copies of our latest SEC filings, please visit our website or call us at 212-993-1670. At this time, I'd like to turn the call back to our Chairman and Chief Executive Officer, Michael Gross.

Thank you, Rich. Good morning and thank you for joining us today. We hope this finds you and your family, friends and colleagues healthy and safe. Our thoughts continue to remain with all of our stakeholders including the dedicated employees across Solar Capital and the company’s investment advisor Solar Capital Partners. We would also like to express our gratitude to all the healthcare and other frontline and essential workers and our sincere condolences to those families who have lost loved ones. Before turning to our second quarter results, I’d like to take a moment to reflect back on the initial months of this public healthcare and economic crisis which have tested us as a nation and the global community, including our investment and historic backlog and its management teams and financial sponsors. On a human level, the collaboration and dedication of our employees and counterparties to support our portfolio companies through this crisis has been nothing short of remarkable. The quick and constructive actions of our portfolio companies taken at the beginning of this crisis to preserve liquidity and strengthen their balance sheets are testament to the high quality of the management teams and sponsors. Despite the added stress of working from home and caring for young ones, our colleagues both internal and external are working tirelessly to ensure the financial soundness of our borrowers. Although the year has been dominated by negative news, we believe it’s important to recognize our collective efforts and how that progress has positioned us to successfully weather the remainder of the storm. Solar Capital’s performance in the crisis thus far supports our long-term investment thesis that asset-based lending in niche markets can provide meaningful downturn protection during challenging economic periods. Solar Capital’s primary objective has consistently been maintaining a portfolio where 100% was performing at June 30, 2020. Overall, our portfolio companies are proving to be resilient business models with the access to liquidity that should enable them to successfully navigate this crisis. Solar Capital’s healthy portfolio is a result of our strategic efforts; second in niche asset-based lending verticals, as well as our long-standing investment discipline, continuing the philosophy that we always invest typically late in the credit cycle. Importantly, we’ve remained patient and conservatively under-levered in order to preserve liquidity for market dislocation, where risk-adjusted returns are generally more attractive. As a result of improving credit market conditions on the heels of massive fiscal and monetary support, as well as proactive steps taken by management teams and sponsors, Solar Capital’s June 30 fair value represents a significant recovery of the underlying depreciation. The company reported a net asset value of $20.11 per share at June 30, a 4.5% increase or $0.87 per share in our net asset value quarter-over-quarter. At June 30, 92% of our $1.6 billion comprehensive investment portfolio at fair value is comprised of first lien loans, with over 80% in senior secured investments, and our specialty finance strategies. These businesses have historically exhibited lower default and loss rates throughout business cycles compared to traditional capital lending. Importantly, our ABL and life science teams have each successfully navigated multiple cycles in their careers, spending 20 to 35 plus years in the industry. In the second quarter, Solar Capital originated investments of approximately $103 million and we had $180 million of repayment across our investment strategies. Bruce will provide additional detail on the portfolio activity during the quarter.

Thank you, Michael. First and foremost, we are extremely pleased with how well our portfolio has weathered this crisis so far. This supports our underwriting thesis of minimizing the risk of loss by investing at the top of the capital structure in cash flow loans to non-cyclical industries, and allocating a majority of our exposure to collateralized loans to our specialty finance lending verticals. At quarter end, just under 20% of our comprehensive investment portfolio was invested in senior secured cash flow loans, with the remaining 80% invested in our senior secured asset-based, equipment finance, and life science lending strategies. The weighted average investment risk rating of Solar’s portfolio was 1.9 based on our one to four risk rating scale, with one representing the least amount of risk. 100% of Solar’s portfolio on a cost and fair value basis was performing at quarter end. At June 30, our $1.6 billion investment portfolio was highly diversified, encompassing over 180 borrowers across 80 industries. Our largest industry exposures are healthcare, pharmaceuticals, and diversified financial services, all defensive sectors. The average investment was $8.6 million or 0.5% of the portfolio. As of June 30, 99% of the portfolio comprised of senior secured loans with 92% in first lien and just over 7% in second lien secured loans. We believe that our portfolio of predominantly first lien loans, which carry less risk than second lien and subordinated investments will result in greater capital preservation during this crisis. At quarter end, our weighted average asset monthly yield was 9.9% compared to 10.6% in the first quarter. By focusing on our commercial finance verticals, we've been able to maintain asset level yields of approximately 10% despite a 160 basis points drop in LIBOR since the beginning of the year. Approximately 77% of the company's portfolio is floating rate-based, of which 85% of these loans have a LIBOR floor with a weighted average floor of 1.1%. The 23% of the portfolio invested in fixed-rate loans are predominantly equipment financings. Including activity across our four business lines, originations for the second quarter totaled just over $100 million, and repayments were approximately $120 million, resulting in a modest net portfolio reduction of $15 million. Originations for the quarter were a mix of new deals and upsizing to existing borrowers, and they were focused on the ABL and life science strategies.

Thank you, Michael. Solar Capital Limited’s net asset value at June 30, 2020 was $849.8 million or $20.11 per share, compared to $813.1 million or $19.24 per share at March 31, 2020. At June 30, 2020, Solar Capital's on-balance sheet investment portfolio at fair market value was $1.36 billion in 108 portfolio companies across 27 industries compared to a fair market value of $1.28 billion in 105 portfolio companies across 26 industries as of March 31, 2020. At June 30, the company had nothing drawn on its $545 million and $15 million revolving credit facilities and had $18 million of cash on hand. The company has full access to this undrawn capital. As of June 30, 2020, Solar Capital also had $446 million in unsecured notes. The marginal cost of incremental debt from our revolving credit facilities is currently less than 200 basis points, which should enhance operating leverage as we grow our income producing portfolio and move towards our target leverage. The company has no debt maturities and is investment grade rated, which provides us with continued access to unsecured debt markets.

Solar Capital's liquidity therefore remains strong with over $800 million of available capital including non-recourse credit facilities of Crystal and NEF Holdings, subject to their borrowing base availability. Moving to the P&L, for the three months ended June 30, 2020, gross investment income totaled $28.6 million versus $32.9 million for the three months ended March 31. Expenses totaled $14.4 million for the three months ended June 30, 2020. This compares to $17.1 million for the three months ended March 31, 2020. Accordingly, the company's net investment income for the three months ended June 30, 2020 totaled $14.2 million or $0.34 per average share, compared to $15.9 million or $0.38 per average share for the three months ended March 31, 2020.

Below the line, the company had net realized and unrealized gains for the second quarter totaling $39.8 million versus net realized and unrealized losses of $91.3 million for the first quarter of 2020. Ultimately, the company had a net increase in net assets resulting from operations of $54 million or $1.28 per average share for the three months ended June 30, 2020. This compared to the net increase of $75.5 million or $1.79 per average share for the three months ended March 31, 2020. Now with that, I turn the call over to Bruce Spohler for a portfolio update.

Thank you, Rich. We are focused on ensuring our portfolio continues to perform during this economic uncertainty. We believe our cash flow portfolio is well positioned given the limited direct exposure to cyclical industries. We are maintaining a consistent dialogue with the management teams and sponsors of our portfolio companies regarding their business prospects during COVID, and are encouraged by the actions they have taken to preserve liquidity. Many of these portfolio companies are performing ahead of their post-COVID revised budgets due to rebounds in revenues and cost cuts. Our predominantly first lien portfolio has modest first lien leverage and strong sponsor support positions us well to withstand prolonged economic headwinds. We believe the majority of our cash flow loan portfolio companies provide essential services that will continue during periods of stay-in-place mandates. We are confident in our ability to recoup unrealized depreciation over the coming quarters.

During the second quarter, we originated just over $6 million of first lien cash flow loans and experienced repayments of approximately $7.5 million. Our investments during the second quarter were upsizing to existing cash flow credits. We are thrilled with our available liquidity at SLRC that will allow us to take advantage of the market dislocation, which we expect to persist for some time.

Turning to asset-based lending, our ABL platform specializes in financing companies in transition who have reduced access to traditional financing options. Their ABL loans are underwritten at a discount to net liquidation value. We believe their business is exceptionally well positioned for the current environment, and the opportunity set for this strategy will only grow over the coming months. At quarter end, the senior secured asset-based portfolio totaled approximately $585 million, representing over 37% of our total portfolio.

The weighted average asset level yield of this portfolio was 10.2%. For the second quarter, this segment contributed $9 million to gross income, accounting for over 31% of our total gross income. Unfortunately, the challenging environment meant we had to take a long-term view and patience in working with our borrowers to help them get through this crisis.

Our equipment finance business is led by a seasoned professional team that has navigated multiple economic cycles. A large portion of our equipment finance portfolio is invested in industries deemed essential, such as construction and machinery. While we believe the majority of our equipment finance borrowers have benefited from government assistance, we are cautious and taking a long-term view based on our borrowers' performance.

As of June 30, our Life Science portfolio totaled just under $320 million. The portfolio consisted of 17 borrowers with an average investment of approximately $19 million. Life Science loans represented 20% of our total portfolio and contributed $8 million of our gross investment income, equating to approximately 28% of the total gross investment income.

In closing, we would like to thank Solar Capital shareholders for their support during this difficult time. From inception, we've endeavored to make the right decisions to preserve and enhance long-term shareholder value. Our priority has been to construct and maintain a portfolio that generates steady income for our shareholders and protects their capital. We believe we have taken appropriate steps to navigate through what we anticipate to be a prolonged recovery. Our decisions to prioritize capital preservation over leveraging the portfolio have allowed us to enter this dislocation in a position of relative strength, and we are confident in our ability to make new investments with attractive risk-reward profiles.

Certainly. Your first question comes from the line of Finian O'Shea.

Hi, good morning. Thanks for taking my question. First on Crystal, the income is still down. I know you touched on that last quarter, where the income was down related to lower leverage and lower perhaps prepays. Can you give an updated outlook on that? Should we expect to return to sort of previous levels on Crystal Finance of income that is?

Yeah, I think the outlook for Crystal is, they're seeing a tremendous amount of activity. The income as you may recall is a little bit lumpy and is sometimes driven by repayments given the short duration of the loans together with the fact that we don't recognize upfront fees; we accrue them over time and then accelerate them on repayment. So you will see pops in their income and we try to smooth that out. We feel very good about the prospects but you should assume that this income will be sort of a steady state for the moment until we get a better sense on what repayments look like.

Okay, that's helpful. Thank you. And a question for Michael perhaps on longer-term leverage and portfolio potential. You noted that you expect a very strong pipeline with compelling opportunities. But you've also obviously Solar has disliked the middle market or cash flow market for years. And with capital still on the sidelines, capital still coming into the market or the asset class, that might mean that the investment opportunity will be short-lived. So, do you think Solar might have a really good 2021? And then revert back to being under invested? Or are you more confident in the outlook to grow your company's place in the market?

I think we're pretty comfortable with our longer-term outlook. I think some of our businesses, such as cash flow lending, are a little more sticky. For example, when you put out a lease for an equipment financing, they don't get called out early. We expect that we'll receive better call protection and things of that nature. Lastly, we know we highlighted the lender finance business; those loans tend to be extremely long term, and likely become permanent parts of our platform. So, I think we're confident we can reach our target leverage sometime next year.

Okay, that's helpful. Thank you.

Your next question comes from the line of Paul Johnson.

Yeah. Hey, good morning, guys. Paul on for Ryan here. Thanks for taking my questions. I wanted to ask so, as I look at earnings today, they are about $0.34 for the quarter. And that's with no incentive fee this quarter. And I think you touched on this a few ways with the near expectation for possibly some good deal activity in the second half of this year. I'm just curious, do you see a pathway just with the current environment tightening spreads low interest rates to getting income possibly back above that hurdle rate this year? Or do you think you would need some significant deployment to get there?

Yeah, I think that we expect to approach that $0.41 dividend over the next couple of quarters; it's a little too soon to say whether it's Q4 or Q1, Q2, but definitely over the next couple of quarters. To Michael's point, I think the combination of the diverse asset classes that we have positions us well, as we are not dependent on activity in any one strategy, such as cash flow, along with the very strong pipeline we're seeing in acquisitions of potential specialty finance platforms. It is hard to pin it down to a specific quarter as you can imagine.

Sure, that's a very helpful insight. And then secondly, just on the interest income line, I'm curious, with just a big drop quarter-over-quarter, and I'm guessing, interest rates were driving a big part of that. But do you expect the current kind of $22 million or so to be a good sustainable number sort of all else equal without any kind of minimal growth? Or would you expect that to possibly increase a little bit?

Yeah, just to clarify, the big drop off from Q1 to Q2 was the fact that we had $200 million repayments in Q1 and saw the full impact in Q2. So, I think it's fair to say that, assuming no portfolio growth is shrinking. So, that's a good run rate for now given where interest rates are at pretty much zero today. But clearly, any portfolio growth will drive that number higher.

Okay, thanks for that. And then I'm just curious, I think you mentioned two loans during the call that you provided some cash flows that you provided some amendments or covenant waivers to. Were those the only two loans that you provided any kind of relief for during the quarter?

These are the only ones in cash flow. We did something similar for just a couple of names in Life Sciences, where they had short-term amendments to address short-term revenue shortfalls. In addition, in the equipment finance segment, we do provide relief from time to time that has been greater during COVID than historically, that actually has slowed in Q2 versus what we saw at the onset of the pandemic, and tends to be very short-term in nature, a month or two.

Okay, those are all my questions. Thanks for taking my questions today. And I think you guys deserve a lot of credit for slowly growing the portfolio and designing it the way it is today.

Thank you. Thanks for the support.

Your next question comes from the line of Chris Kotowski.

Hey, good morning. Thank you.

Good morning, Chris.

I guess. I was just wondering, you talked about the cumbersome due diligence process, certainly for cash flow loans; I imagine the same is true when you're looking at other M&A opportunities for specialty finance companies. Is that right or have you been kind of undertaking ongoing due diligence pre-COVID that you can piggyback on so that there are opportunities in the next couple of quarters? And then I guess also related to that. I think you're at 23% or thereabout utilization of your 30% bucket. Should we think of that 30% of current assets as a hard cap, or are there ways to manage the 30% bucket that would enable more significant acquisitions?

Sure, well, we definitely have the ability to make more specialty finance asset acquisitions, as not all assets fall into the 30% bucket. As you know, our equipment finance assets, for example, do not use that 30% bucket. So, we have flexibility there. Additionally, to your first question, it is difficult to conduct due diligence remotely, although specialty finance platforms are effectively asset-based acquisitions. We're underwriting pools of loans for various ABL assets, and that is actually easier to do remotely with teams experienced in doing that type of due diligence on a collateral basis as opposed to pure cash flow loans, which are based on more qualitative factors.

Okay. All right, that's it for me. Thank you.

Thanks, Chris.

Your next question comes from the line of Rick Shane.

Good morning, guys. This is Marisa on for Rick today. A lot of our questions have been asked and answered, but wondering about your comments about portfolio growth and expecting that to ramp. And I think you said in the second half of this year, I'm wondering if that's a function of lower expected repayments, the acquisition of another specialty finance vertical, or some combination of the two? Thanks.

Well, I think in general, we're not expecting much in the way of repayments at all in this environment. We had the bulk of prepayments in Q1 before COVID hit. We had some repayments this past quarter of about $100 million. We don't expect that much in repayments through the balance of the year. So we expect just pure net growth as we think the cash market will become more active. As we shared, our backlog for critical ABL deals is extremely strong right now. The potential for a new acquisition would also significantly enhance our growth.

Great, thank you.

Thank you.

Your next question comes from the line of Matt Jaiden.

Hey, everyone, good morning and thanks for taking my questions. Just to start off, I guess on kind of a simple one, it looks like pick income was up quarter-over-quarter. Could you give any color as to the source of that?

There was not a significant change in impact. We have been fortunate that we have not had to convert cash-paying loans into pick loans. There are some cases I mentioned we had to covenant waivers. In some cases, we will take additional yield, taking that in the form of pick over and above our existing cash coupons. But again, it hasn't been a conversion of cash to pick; it's been more of a yield enhancer.

Okay, and then I guess on the acquisition front, so some great color there. Is there anything, if you're willing, within the specialty finance vertical, is there any niche vertical that looks more favorable or more interesting than others?

No, I think we're both a strategic buyer in terms of evaluating add-on acquisitions to the existing platforms that we have, as well as new platforms that we have been evaluating in the asset class for some time. However, in this environment, management teams and sponsors are looking for partners to add capital either on a lending or equity basis. So, across the specialty finance spectrum, we're finding asset-based lending and broadly leasing, financing, etc., just an increase in opportunity and less competition for those opportunities.

Great. I guess and then kind of just a last one that's a little more broad. On a general competitive environment, since COVID has started, we see spread widening and improved documentation, but with record amounts of capital flowing into the direct lending space. Do you think both of those conditions are likely to persist in the near to mid-term?

We have seen improvement in structure and on the margin pricing but it's been on a very small selection of new deals. The activity just hasn't been there to call it the norm yet. That said, we're hearing from our sponsor community an expectation for increased activity over the next few months heading into the fall and winter, with many looking to make acquisitions at lower purchase prices than they had pre-COVID. But it's too soon to definitively say what sustainable structure and pricing looks like.

That's it for me. Thanks, guys.

Thank you.

Your next question comes from the line of Tom Romero.

Hey guys. Thanks for taking my questions and congratulations on a solid quarter. My question is I’d like to focus on the Life Science sector. Could you give us sort of an overview or a sample of one or two of the credits that you have there? And just in general, I'm assuming that you're secured against patents and intellectual property. How do you look at the warrant component when you're underwriting it? Lastly, could you give us sort of a competitive matrix of who you're competing against in that space?

Thanks for the questions. That's a mouthful. What I would suggest is we'd love to have a follow-up call; we can take you through it in more detail and have the head of the team join as well to discuss our strategy. But high level, our Life Science business focuses on very late-stage companies, which are either pre-commercialization or in commercialization. We're exclusively focused on developmental drugs or devices. The team has an incredible track record, going back to when I founded the business at GE Capital. It's been consistent because of the discipline in underwriting. We emphasize first lien loans and return of principal in all cases, distinct from peers who might take on more credit risk and compensate for that with higher equity-type returns. We would greatly appreciate the opportunity to follow-up with you for a more thorough conversation.

Super. I'll do that and congrats on the solid quarter.

Thank you very much.

There are no further questions at this time.

We appreciate your time this morning. For those of you who participated in the Solar Senior call, we'll speak to you in half an hour. Thank you. Bye-bye.

This does conclude today's conference call. You may now disconnect your lines.