SLR Investment Corp. Q3 FY2023 Earnings Call

Good day, everyone. And welcome to the Q3, 2023 SLR Investment Corporation Earnings Conference. At this time, all participants are in a listen-only mode. Later, you will have the opportunity to ask questions. Please note this call will be recorded. I will be standing by if you should need assistance. It is my pleasure to turn the conference over to Chairman and Co-Chief Executive Officer Michael Gross.

Thank you very much. And good morning. Welcome to SLR Investment Corp.'s earnings call for the third quarter ended September 30th, 2023. I'm joined today by Bruce Spohler, our Co-Chief Executive Officer; and our Chief Financial Officer, Shiraz Kajee. Shiraz, before we begin, would you please start by covering the webcast and forward-looking statements.

Thank you, Michael. Good morning, everyone. I would like to remind everyone that today's call and webcast are being recorded. Please note that they are the property of SLR Investment Corp. and that any unauthorized broadcast in any form is strictly prohibited. This conference call is also being webcast from the events found in the Investors section on our website. Audio replays of this call will be made available later today as disclosed in our November 7th earnings press release. I would also like to call your attention to the customary disclosures in our press release regarding forward-looking statements. Today's conference call and webcast may include forward-looking statements and projections. These statements are not guarantees of our future performance or financial condition or results and involve a number of risks and uncertainties as 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. We do not undertake 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 this time, I would like to turn the call back over to our Chairman and Co-CEO, Michael Gross.

Thank you, Shiraz. We are pleased to report that for the third quarter of 2023, SLRC generated net investment income of $0.37 per share, representing a 16% increase year-over-year, once again exceeding our distributions for the quarter. The increase in our NII per share over the past year has been driven by portfolio growth and increases in reference rates, which have flowed through to our floating rate portfolio. At September 30th, our net asset value per share was $18.06, up from $17.98 per share at June 30th, reflecting stable credit performance and the improvement in our distribution. Delving into our third-quarter performance, I'd like to touch on the overall investment climate. We're living in a period of heightened market volatility resulting from geopolitical tensions and economic uncertainties, with sadly, no near-term end in sight. Inflationary pressures from elevated energy, labor, and capital costs are proving to be persistent, and interest rates are expected to stay higher for longer. Growth may slow as a result, but the U.S. economy has remained remarkably resilient despite these multiple shocks. The performance of our portfolio companies remains resilient, and in sponsor finance, our portfolio companies largely continue to exhibit both revenue and EBITDA growth. While the rapid increase in rates impacted valuations and diminished M&A volume this year, there are attractive opportunities to finance quality borrowers with resilient cash flows or stable assets supporting borrowing bases. SLRC has been an important provider of capital to the private equity community, and some private credit managers are grappling with hold limitations. Importantly, M&A volume has begun to pick up and is expected to continue expanding next year, given substantial private equity dry powder and projected stable interest rates. Given the uncertainty associated with the economy and geopolitical events, we believe that maintaining a defensive approach vs selection is critical to maintaining our long-term strong performance. Across our platform, we are seeing some of the most attractive investment opportunities in years. We believe that the private credit asset class remains attractive on both an absolute and relative return basis. The current market environment creates opportunities for firms like SLRC with deep experience and expertise in investing throughout market cycles. SLRC will be opportunistic and leverage its diversified platform across sponsor and especially advanced investment strategies to generate attractive returns while protecting our capital. The overall healthcare portfolio remains solid, with a non-accrual rate based on cost at just 0.7% and 0.3% at fair value at quarter end. The weighted average interest coverage on responsive loans is just under two times. We believe these healthy metrics are the result of our focus on sponsor finance and recession-resilient industries, as well as recurring free cash flow in healthcare and business services. As a reminder, our multiple businesses enable us to be highly selective in our sponsor finance strategy. At quarter end, approximately 98% of our portfolio was comprised of first lien secured loans. Our long-term investment in first lien loans has resulted in a portfolio we believe is better equipped to withstand continued inflationary pressures and high interest rates compared to portfolios with second lien and unitranche loans. Additionally, with $36 million in our comprehensive investment portfolio invested in specialty finance assets, which are backed by full covenant structures supporting our investments, we are defensively positioned. Our differentiated investment approach, combining castle loans and specialty finance loans, provides us with enhanced portfolio diversification and additional downside protection in periods of tightening economic conditions. Importantly, our broad set of origination capabilities allows us greater flexibility in allocating capital to our various private credit investment strategies, targeting the best risk-reward opportunities across economic cycles. Through borrowers, significant available capital, such as the SLR platform, is able to fill the void left as regional banks retreat, and the syndicated loan market grapples with structural challenges. Borrowers value our speed and certainty of execution and our flexibility, being able to invest between $150 million to $200 million in a given upper middle market financing, which gives us greater pricing power and influence over terms. With $13 billion of total investable capital across the platform, inclusive of anticipated leverage, SLR offers a scale of financing solutions, which benefits SLRC through co-investment. As SLR increases its capital base, we continue to invest in the firm's infrastructure and origination capabilities. Recent hires in the third quarter include investment professionals, a Chief Operating Officer focused on growth initiatives, a Chief Business Development Officer, and a former BDC equity research analyst. We believe these human capital investments significantly enhance our strategic focus of being a right-side differentiated private credit manager with the scale to access a deep and broad opportunity set, generating alpha through security selection rather than pursuing index returns through a cash flow loan-only approach. Additionally, our special events businesses are benefiting from the regional banking turmoil as borrowers seek alternative financing to replace existing credit lines from banks that have retreated from the market. Our in-place teams of approximately 300 professionals across SLR, including specialty finance affiliates owned by SLRC, provide us with local market knowledge and relationships that lead to competitive sourcing and information advantages. Importantly, we have ample dry powder to capitalize on the favorable investment environment. At September 30th, including available credit facility capacity at the SSLP and specialty finance portfolio companies, SLRC had over $600 million available capital to take advantage of the current attractive investment environment. I'll now turn the call back over to Shiraz, our CFO, to take you through the third quarter financial highlights.

Thank you, Mike. SLR Investment Corp’s net asset value as of September 30th, 2023 was $985 million or $18.06 per share, compared to $981 million or $17.98 per share at June 30th, 2023. The quarter end SLRC’s investment portfolio had a fair market value of approximately $2.2 billion, comprised of 154 portfolio companies across 43 industries, compared to a fair market value of $2.2 billion in 136 portfolio companies across 45 industries at June 30th. As of September 30th, the company had approximately $1.2 billion of debt outstanding, with a leverage of 1.21 times net debt to equity. This point in time level of leverage does not fully reflect client loan asset contributions from our balance sheet to the SSLP as we continue to ramp that vehicle. On September 30th, the SSLP portfolio consisted of $134 million of senior secured floating rate loans. To complete the SSLP ramp, we expect our leverage ratio to once again be in the middle of our target leverage range of 0.9 to 1.25. SLRC’s funding profile is in a strong position to weather a rising rate environment, with existing $470 million of senior unsecured fixed-rate notes having a weighted average annual interest rate of 3.8%. We do not have any maturities until the end of 2024. Moving to the P&L for the three quarters ended September 30th, gross investment income totaled $59.6 million compared to $56.3 million for the three months ended June 30th. Net expenses totaled $36.3 million for the three months ended September 30th, compared to $33.7 million in the prior quarter. As a reminder, at the time of the merger of SLRC Investment Corp. with SUNS last year, the investment advisor agreed to waive incentive fees resulting from income earned due to the accretion of purchase discounts. During the third quarter, the company waived approximately $175,000 of merger-related incentive fees, which now totals approximately $2 million in cumulative waivers related to the merger. For the three months ended September 30th, the company's net investment income totaled $23.4 million, or $0.43 per average share, compared to $22.7 million, or $0.42 per average share for the three months ended June 30th. Globally, the company had net realized and unrealized gains for the third quarter totaling $3.6 million versus a net realized and unrealized loss of $3.7 million for the second quarter of 2023. As a result, the company had a net increase in net assets resulting from operations of $26.9 million for the three months ended September 30th, 2023, compared to a net increase of $90 million for the three months ended June 30th, 2023. As we mentioned in the previous call, the company has returned to making quarterly rather than monthly distributions. On November 7th, the board of SLRC declared a quarterly distribution of $0.41 per share payable on December 28th, 2023 to holders as of December 14th, 2023. We estimate this change will slightly reduce our annual operating expenses and is consistent with our objective to maximize shareholder value. With that, I'll turn the call over to our Co-CEO Bruce Spohler.

Thank you, Shiraz. Before we provide an overview of our portfolio, I'd like to discuss our approach to portfolio construction. Over 17 years of expanding our lending strategies as a diversified commercial finance company has provided us with a financing platform well-suited for the current volatile market environment. We're seeing dispersion in the opportunity set across segments of the private debt markets, and as a result, we believe asset selection will be critical to achieving strong performance during this vintage. Our business model provides us with the flexibility and capabilities to capitalize on the most attractive lending opportunities in today's market. Our fundamental, bottom-up approach to our portfolio construction is based on the relative attractiveness and risk-adjusted returns across our investment verticals. Today, we are more active in sponsor finance; however, we expect to see increased opportunities in both asset-based lending (ABL) and life science lending as we move into next year. At that point, we will readjust our deployment accordingly. We believe having the flexibility to play offense and defense at the right moments across cycles is key to long-term consistent investment performance. Now let me discuss the portfolio. At quarter end, the comprehensive portfolio consisted of approximately $3.1 billion of senior secured loans to approximately 790 borrowers, across 110 industries with a $4 million or 0.1% average position exposure. Measured at fair value, 99.2% of our portfolio consisted of senior secured loans, with approximately 98% invested in first lien bonds, including investments in our SSLP attributable to the company. Only 0.2% was invested in second lien cash flow loans, with the remaining 1.2% invested in second lien asset-based loans, or specialty finance investments accounting for approximately 73% of the comprehensive portfolio. The remaining 26% comprises senior secured cash flow loans to upper mid-market sponsor-owned companies. We believe that this defensive approach to portfolio construction positions us well for potential economic weakness and provides a differentiated risk-return profile for our shareholders. At quarter end, our weighted average asset level yield was 12.3%, up from 12.1% last quarter. Our portfolio credit quality remains strong, with a quarter-end weighted average investment risk rating just under two on our one to four risk rating scale, with one representing the least amount of risk. 99.3% of the portfolio on a cost basis was performing. Now, let me touch on each of our four investment verticals. I'll start with our sponsor finance cash flow business. Here we originate first lien senior secured loans for upper mid-market companies in non-cyclical industries such as healthcare providers and diversified financials, helping to mitigate the impact on our portfolio from cyclical economic factors. At quarter end, our cash flow portfolio was approximately $824 million, including loans in our SSLP attributable to the company, invested across 51 borrowers, with approximately 99% of the cash flow portfolio invested in first lien loans. We believe that this portfolio is well-positioned to withstand any liquidity pressures that individual borrowers may face. Additionally, we believe we have a defensively positioned portfolio. Our borrowers have a weighted average EBITDA of over $130 million, with low loan-to-value ratios of approximately 41% and interest coverage ratios of just under two times. Our portfolio is comprised of businesses that perform essential services with either recurring or reoccurring revenues, and they have low capital intensity, which results in high free cash flow. Overall, our portfolio has exhibited solid credit metrics that have remained relatively steady throughout this year. During the third quarter, we originated $115 million and experienced repayments of $34 million. Our third-quarter investments have an average yield to expected maturity of 12.9%, with leverage of approximately five times and interest coverage of just under two times. Importantly, these investments carry less leverage than the historical average for new cash flow issuance. As Michael mentioned, our sponsor finance deal flow continues to be lower overall, as valuation expectations have resulted in higher base rates. However, we have found pockets of opportunities to make loans with very attractive risk-adjusted yields. At quarter end, the weighted average yield on this cash flow portfolio was 11.8%. Now let me turn to the ABL segment. Historically, this segment has performed well during periods of market volatility, when borrowers are asset-rich but have cash flow pressures to raise capital backed by their liquid assets. The opportunity set for ABL has increased as borrowers seek working capital financing against the backdrop of increased bank regulation, the fallout from the regional banking crisis, and tightening credit. Given these economic headwinds, we are conservative in our approach to underwriting. However, the increase in deal volume is enabling us to remain active while being extremely selective. At quarter end, our senior secured ABL portfolio totaled $976 million, representing 31% of the comprehensive portfolio and invested across 159 borrowers. The weighted average asset level yield of this portfolio was 15.3%, up from 14.6% in the second quarter. The average loan-to-value was approximately 60%. In the third quarter, we had $85 million of new investments and repayments of roughly the same amount. Now let me turn to equipment finance. At quarter end, this portfolio totaled $955 million and was highly diversified across 550 borrowers. The credit profile continues to be strong, with a weighted average asset level yield of 9.6% on the equipment portfolio. During the third quarter, we originated $122 million of new investments and had repayments of $144 million. Our investment pipeline in equipment finance has increased significantly this quarter. We have expanded our vendor financing business for non-OEM distributors, finding attractive risk and adjusted return profiles which we expect to provide portfolio and income growth in this segment in 2024. Now, let me finally turn to Life Sciences. The ripple effect of the Silicon Valley Bank failure has had a profound impact on the life science sector, with a decline in investment valuations evidenced by public market caps. Borrowers are seeking to extend their cash runway via debt financings without corresponding equity cushions provided by incremental equity investment. This dynamic has led borrowers to be reluctant to issue equity at today's lower valuations. As a result, our team is seeing signs of distress in the earlier, riskier stages of the life science issuance market, which is where we do not focus. We are pleased to report that our $325 million portfolio remains fundamentally strong, with over 95% of the portfolio invested in loans to borrowers that have more than 12 months of cash runway. Additionally, all of our portfolio companies have revenues, with at least one product in the commercialization stage, which significantly de-risks our investments. As a result, none of our life science loans are on a watch list or have migrated lower in our risk rating system during 2023. Life science loans represent just over 10% of the portfolio and have contributed just over 20% of our gross investment income in the third quarter. During the quarter, the team committed $39 million to new investments and funded $25 million of those commitments. We also had repayments of $42 million, and we have just under $110 million of unfunded commitments that may be accessed by borrowers based on reaching milestones such as FDA approval or revenue levels. At quarter end, the weighted average yield on this portfolio was 13%. This excludes any success fees and warrants, which would increase our yield. While we expect valuations in the life science market to stabilize over the next quarter or two before we see a pickup in equity issuance, we do continue to see several new issue opportunities that we find extremely attractive. Given SLRC's ability to allocate capital to the best risk-reward segments, we have the luxury of being highly selective in our capital deployment in the life science sector while still generating positive originations for the company overall. As the life science market continues to stabilize, we expect the opportunity to increase, hopefully with less competition from lenders who were risk-on during this current volatile environment. Now I'll turn the call back to Michael.

Thank you, Bruce. SLRC's portfolio reflects stable fundamentals and benefits from the flexibility to allocate capital to investments across our lending verticals that we believe offer the most attractive risk-adjusted returns for our shareholders. We have available capital and the opportunity for continued earnings growth in Q4 and in 2024. While the direction of interest rates remains volatile, it is important to remember that specialty finance spreads and returns are not tied to cash flow sponsor finance investments across cycles. Importantly, we do not expect yield contraction for specialty finance assets to the same extent as sponsor financing markets that return to a more normal state. Looking forward, we expect a broad range of opportunities driven by a combination of increased M&A activity, low maturity, and regulatory/credit contraction forces impacting regional banks to benefit middle market lenders such as SLRC. In addition, as the regional bank allocations continue to unfold, we are seeing increased opportunities to expand our specialty finance capabilities, tuck in acquisitions for existing commercial finance portfolio companies, add required portfolio teams, or acquire portfolios as budget finance assets. SLRC's broad foundation of diversified commercial finance businesses provides the resources and experience to acquire portfolios and service loans opportunistically. We believe that a diversified portfolio approach across sponsor and commercial finance assets is the most effective strategy to generate income and manage risk across economic cycles. In closing, our investment advisor's alignment of interests with the company's shareholders continues to be one of our guiding principles. The SLR team owns over 8% of company stock, including a significant percentage of annual incentive compensation invested into stock. This alignment demonstrates our confidence in the company’s defensive portfolio, stable funding, and solid position. We thank you very much for your time today, and we’ll now open up the line for questions.

We'll take our first question from Eric Zwick of Hovde Group; your line is open.

Thanks. Good morning, everyone. Wanted to start by asking if you could provide a bit of color into the type of investments and the characteristics of those that you are selecting to put into the SSLP at this point?

To refresh for a minute, Eric, you may recall we merged Solar and Solar Senior, which closed in April of ‘22. Solar had a portfolio of low yielding, cash flow-backed sponsor loans, in addition to some ABL assets. The strategy for the SSLP was to migrate the Solar Senior's lower yielding cash flow assets into the SSLP. So, that's primarily what's been moving in there; there have been one or two assets where we've originated direct cash flow loans into the SSLP, but it's been predominantly migrating the SUNS portfolio down there.

Thank you. That's helpful. And I’m curious about your commentary on the life sciences. You’ve mentioned that in some of the areas you deal with, you’re starting to see a little bit of pressure. Could you provide a bit more detail on the issues arising there? Are you confident that those issues would not spread to the areas of life sciences that you are involved in?

Sure. From a high level, the life science segments are largely dictated by capital raising, as they continue to fund the development of drugs and devices through the FDA approval process. We're seeing some stresses in the early stages because valuations have come off on the equity side. We find that issuers are waiting as long as possible for equity value to recover to fund the continued cash burn needed to move through the FDA approval process. We have always focused on late-stage companies. Our team in life sciences has been doing this for over 25 years and has never had a default. We focus on late-stage, and the best evidence is that the burn is lower; we have revenues, as I mentioned, that 100% of our portfolio companies have revenues from at least one product moving through the FDA. This means there is value; you can assign multiple on those revenues. They are moving towards cash flow break-even. Thus, the ability to raise capital still exists on the equity side, but they have been able to tap the equity markets, both private and public. Hence, over 95% of the portfolio has cash runway of over a year to fund that burn as they move towards cash flow break-even.

That's great detail. Thank you. And last one for me. Can you refresh me on your current interest rate sensitivity, as well as your expectation of how long rates might stay where they are or if we might see changes in the near term?

I don’t think we have a unique crystal ball on that; our focus is really on ensuring that our borrowers can cover their liquidity and free cash flow to handle current interest rates. We are stressing them to be 50 to 100 basis points higher when we look at our stress tests across individual portfolio companies. That’s where we have comfort. I don’t think anyone is underwriting an increase much beyond that.

I realize that the second part of that question was more speculative, but I appreciate your thoughts today. Thank you.

Thank you.

We'll take our next question from Sean-Paul Adams of Raymond James; your line is open.

Hey, guys, good morning. Could you provide a bit of color about the status of the joint venture and the facility where their revolving period ends in June 2024 for SSLP?

The joint venture is in the process of ramping. We've combined $57 million of equity between the two of us at $20.5 million each so far, and the assets started tracking in the fourth quarter of last year, with about $18 million of commitments. We've been steadily moving assets each quarter: $46 million of commitments in Q1, $79 million in Q2, and now up to $140 million. As we've stated previously, we continue to expect to get to the $230 million to $250 million range by year-end, with a maximum expected to reach about $300 million by the completion of the ramp in Q1. Note that the credit facility really just opened a year ago, so we have the ability to continue to extend that forward if necessary.

Perfect, thank you for the color.

We'll take our next question from Ryan Lynch of KBW; your line is open.

Hey, good morning. My first question is regarding the chart you have about the asset-based loans with a weighted average yield of 15.3% this quarter. I find this yield on those asset-based loans to be high. However, I look at the entities holding those loans, like SLR Credit Solutions, an entity which only generated about a 6.9% yield for SLRC over the first nine months of 2023, and seems about levered one-to-one. Can you reconcile the high underlying asset yields on those asset-based financings with the lower overall yield generated for SLRC?

Without getting into specific numbers, Ryan, the asset-based loan category that references the 15.3% asset level yield is a combination of credit solutions as well as business credit and healthcare ABL, both of which came into SLR in connection with the merger with SUNS last year. Their asset-level yields are higher than Credit Solutions, which is focused predominantly on receivables financing. Credit Solutions has lower asset yields in that blend to the 15.3%. However, we are ramping up Credit Solutions, and the return on equity is burdened because it is not fully invested, and we expect to see improved returns as we continue rebuilding that portfolio.

Have there been underlying credit issues that have pressured the net returns off of some of these entities? From a high level, your controlled investments represent about 38% of your overall portfolio and the returns they generated for the first nine months show an annualized return of about 7.1%. There's a notable difference from this compared to the overall portfolio yield of 12.3%. Could you provide clarity on that?

Yes, Credit Solutions did have an asset impairment earlier this year, which we've discussed. That impairment is mirrored in the mark, and we're working through it. However, it's not the full story. It's really about revamping that portfolio. Credit Solutions tends to have high churn, dealing with companies that are cash flow-dependent. This makes it challenging to keep that portfolio fully invested. We expect to continue ramping that portfolio and are optimistic about improving returns. Beyond that, we're also exploring opportunities to dramatically increase the portfolio in our other ABL business, which focuses more on factoring and receivables finance. The short story is about expanding those portfolios to a larger scale.

It's notable that we discussed the availability of dry powder; the vast majority of it, or nearly all, is within the finance companies in the assets. We have the opportunity, as we focus that capital, to drive the return on equity of those entities and thereby of SLRC as a whole.

So it sounds like it’s more about capital replacement and further leverage within the entities that drives returns since the underlying yields appear strong?

Yes, we’d look for more capital. In the backdrop of the regional banking crisis earlier this year, it froze the market somewhat. We are beginning to see it reopen, but in this segment, we’re focused on working capital relationship loans, which take time to develop. The good news is these loans are stickier than those in Credit Solutions, which tend to be more transactional. We’re optimistic about building that business further in the context of the recent regional banking crisis.

That's all for me today. I appreciate your time. Thank you.

We'll now turn to Casey Alexander of Compass Point.

Yeah, good morning. Just one question. I apologize; there are a lot of calls going on at the same time, so I’m joining late. If you've already answered this, my apologies, but I'm just curious why you’re returning to a quarterly dividend. You moved to a monthly dividend presumably for a good reason. Could you clarify why you're going back to a quarterly dividend pay?

A couple of reasons. One is that almost all BDCs are correlated with one or two exceptions. This change also saves us money and probably a penny or two per share annually in earnings by reverting back to quarterly. That was a significant factor in our decision to do so.

Right, that sounds like a good reason. Okay. Thank you. That's my only question. Appreciate it.

Thank you, Casey.

We have a follow-up from John-Paul Adams of Raymond James. Your line is open.

Hey, guys, one quick follow-up about Bayside. A couple of other BDCs have put the money on accrual. Is there any commentary on their status within your portfolio?

Bayside is a restructured loan from earlier this year. It has been restructured into a combination of debt and equity. The company itself is in a period of positive transition, with a meaningful strategic joint venture that is underway as we speak. The old security was converted to a new debt and equity security. I can’t speak to how others are treating it, but we think the debt will accrue interest and the company is performing better than expectations.

Got it. Thank you.

Thank you.

And it appears that we have no further questions at this time.

Thank you, everybody. We appreciate your time. If you have any questions, please feel free to reach out to any of us. Thank you.

This concludes today's conference. You may now disconnect your lines. Everyone have a great day.