Earnings Call Transcript - SLRC Q2 2023

Operator, Operator

Good day, everyone, and welcome to today's SLR Investment Corporation Second Quarter Earnings Call. 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 should you need assistance. It is now my pleasure to turn today's call over to Mr. Michael Gross, Chairman and Co-Chief Executive Officer of SLR Investment Corp. Mr. Gross, you may begin the conference.

Michael Gross, Chairman and Co-CEO

Thank you very much, and good morning. Welcome to SLR Investment Corp.'s earnings call for the second quarter ended June 30, 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.

Shiraz Kajee, CFO

Thanks, 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 founded in the Investors section on our website at www.slrinvestmentcorp.com. Audio replays of this call will be made available later today as disclosed in our August 8 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 on today's conference call and webcast may constitute forward-looking statements which relate to future events or 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 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. SLR Investment Corp does 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 (212) 993-1670. At this time, I would like to turn the call back over to our Chairman and Co-CEO, Michael Gross.

Michael Gross, Chairman and Co-CEO

Thank you, Shiraz. We are pleased to report that for the second quarter of 2023, SLRC generated net investment income of $0.42 per share, over-earning the quarterly distribution and continuing the steady growth in net investment income over the past several quarters as we rebuild the portfolio post our COVID era deleveraging and importantly, during a very attractive investment environment. The improved NII performance resulted from the combination of a larger portfolio and the increase in index rates for a predominantly floating rate portfolio. At June 30, our net asset value per share was $17.98, compared to $18.04 at March 31. Before digging into our performance, I'll touch on the market conditions and investment climate. As the Federal Reserve has continued to fight to curb inflation, labor statistics and consumer spending have remained relatively stable. Based on both the recent economic data and our portfolio company success in navigating higher interest rates as well as input expenses, we view a recession as less inevitable. As the full impact of higher rates reverberates through the economy, we believe our defensively positioned portfolio should weather those conditions. As conservative credit investors, we have always managed our portfolios as if we are heading into a downturn, and we will continue to do so despite signs that the U.S. government's fiscal policy may result in a soft landing for this cycle. The overall health of our portfolio remained solid, and we did not place any assets on nonaccrual during the second quarter. Our weighted average interest coverage on our sponsor finance loans remains at comfortable levels at approximately 2 times. We believe that this is a result of our investment focus in sponsor finance and recession-resilient industries with high recurring free cash flow, such as health care and business services, as well as our emphasis on specialty finance investments with borrowing bases supporting our loans. Additionally, we are monitoring near-term maturities and have not identified any loans with a material risk of nonrepayment. At June 30, approximately 98% of our comprehensive investment portfolio was comprised of first lien senior secured loans. Our long-standing investment focus on first lien loans has resulted in a portfolio better equipped to withstand continued inflationary and interest rate pressures compared to portfolios with second lien loans or equity exposure. Additionally, with 76% of our comprehensive investment portfolio invested in specialty finance assets, which are supported by borrowing bases and full covenant structures, we are defensively positioned should the economy prove unable to withstand the continued higher interest rate environment. Our unique investment approach of coupling cash flow loans with specialty finance loans provides us with greater diversification and additional downside protection. Although direct lending new issue activity picked up in the second quarter, total new issuance volume remained lighter than prior years. Much of the second quarter activity was related to add-on acquisition financings. We're beginning to see more M&A processes as the bid-ask spread for assets narrows. Additionally, access to the broadly syndicated loan market remains extremely limited for all but the largest and highest-rated issuers in our market, and the retrenchment by regional banks continues to benefit our specialty finance strategies. In the second quarter, SLRC originated $394 million of new investments across the platform. With repayments of $265 million during the second quarter, we had net portfolio growth in each of our forward lending strategies totaling $129 million. Looking forward, the current investment environment remains as favorable as we've seen in several years. We currently have a sizable pipeline in which we believe will prove to be a strong vintage for private credit. Our specialty finance businesses are benefiting from the regional banking turmoil as these banks have historically competed with our commercial finance strategies. Additionally, during uncertain economic times, borrowers increasingly turn to asset-based lending strategies for working capital and liquidity management. We believe the structure and collateral supporting our loans provides our investors with greater downside protection across economic cycles. Our ABL businesses have historically outperformed during challenging market conditions when asset-rich companies access to traditional lending sources is constrained, and we have the flexibility to allocate more of our capital to these strategies to take advantage of the attractive risk-reward attributes. Firms with significant available capital, such as the SLR Platform, are able to fill the void left by regional banks retreating and the stalling of the syndicated loan markets. Borrowers value our speed and certainty of execution, flexibility, and ability to invest $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, SLRC has the scale necessary to provide full financial solutions, which benefits SLRC through co-investment. Importantly, we have ample dry powder to capitalize on this favorable investment environment. Our funding profile is in a strong position to weather a rising rate environment with our next fixed-rate maturity not until the end of 2024. Additionally, our senior unsecured fixed rate notes have a weighted average annual interest rate of 3.8%. With $1.2 billion of funded debt at June 30, our leverage was 1.23 times net debt to equity. This point-in-time level of leverage doesn't fully reflect the ramp of the SSLP through loan asset contributions from our balance sheet. Since the end of the second quarter, we continue to make progress on ramping the SSLP. Based on transfers from SLRC's balance sheet during the third quarter to date, as well as new deal activity, we expect a substantially increased investment commitment in SSLP by the end of the third quarter. We believe we are on track to reach $250 million of commitments by the end of this year. As a result of our continued efforts to ramp the SSLP, we expect our leverage ratio to once again be in the middle of our target leverage range of 0.9 times to 1.25 times. At June 30, including available credit facility capacity as the SSLP and our specialty finance portfolio companies subject to borrowing base limits, SLRC had approximately $600 million in 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 second quarter financial highlights.

Shiraz Kajee, CFO

Thank you, Mike. SLR Investment Corp.'s net asset value at June 30, 2023, was $981 million or $17.98 per share compared to $984 million or $18.04 per share at March 31, 2023. At quarter end, SLRC's on-balance sheet investment portfolio had a fair market value of approximately $2.2 billion in 156 portfolio companies across 45 industries compared to a fair market value of $2.1 billion and 145 portfolio companies across 45 industries at March 31. At June 30, the company had approximately $1.2 billion of debt outstanding with leverage of 1.23 times net debt to equity. The increase in leverage is temporarily higher as the company continues to ramp its SSLP. When considering the company's plan to utilize the SSLP's facility as well as the available capacity from the company's credit facilities, together with available capital from the company's specialty finance subsidiaries, SLRC has ample available capital to fund future portfolio growth while remaining within its target leverage range of 0.9 times to 1.25 times net debt to equity. Moving to the P&L. For the 3 months ended June 30, 2023, gross investment income totaled $56.3 million versus $53.5 million for the 3 months ended March 31, 2023. Net expenses totaled $33.7 million for the 3 months ended June 30. This compares to $31.4 million for the 3 months period ending March 31. As a reminder, at the time of the merger of SLR's Senior Investment Corp into the company last year, the investment adviser agreed to waive incentive fees resulting from income earned due to the accretion of purchase discounts allocated to investments acquired as part of the merger. During the quarter ended June 30, the company waived approximately $125,000 of merger-related incentive fees. Accordingly, the company's net investment income for the 3 months ended June 30 totaled $22.7 million or $0.42 per average share compared to $22.1 million or $0.41 per average share for the 3 months ended March 31. Below the line, the company had a net realized and unrealized loss for the second quarter totaling $3.7 million versus a net realized and unrealized loss of $15.3 million for the first quarter of 2023. As a result, the company had a net increase in net assets resulting from operations of $19 million or $0.35 per average share for the 3 months ended June 30, 2023. This compares to a net increase of $6.8 million or $0.13 per average share for the 3 months ended March 31, 2023. Finally, on August 8, the Board of SLRC declared a monthly distribution of $0.137 per share, payable on August 30, 2023, was already as of August 18, 2023. Moving forward, the company intends to make its distributions on a quarterly rather than a monthly basis. We expect this change to begin in Q4 2023. With that, I'll turn the call over to our co-CEO, Bruce Spohler.

Bruce Spohler, Co-CEO

Thank you, Shiraz. Let me begin by providing an overview of our portfolio. As of June 30, on a fair value basis, the comprehensive portfolio consisted of approximately $3.1 billion of senior secured loans to approximately 780 distinct borrowers across over 115 industries, with an average exposure of just under $4 million. Measured at fair value, 99.4% of our portfolio consisted of senior secured loans with approximately 98% invested in first lien loans, including investments in the SSLP attributable to the company, and only 0.2% was invested in second lien cash flow loans, with the remaining 1.2% invested in second lien asset-based loans. Our specialty finance investments account for approximately 76% of the portfolio, with the remaining 24% invested in senior secured cash flow loans to upper mid-market sponsor-backed companies. We believe that this defensive portfolio composition 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 12.1%, up from 11.9% at Q1. The weighted average investment risk rating was under 2 based on our 1 to 4 risk rating scale, with 1 representing the least amount of risk. During the second quarter, we restructured our investment in AmeriMark, which we had placed on nonaccrual last quarter. While it's still early days, we are pleased with the results of our efforts thus far. To date, we foreclosed on the business, contributed transition capital, which has since been fully repaid at par, sold certain assets for cash, entered into a partnership with both operating and financial investors in respect to the company's core operations, and expect to exit bankruptcy later this month. As a result, we increased our second quarter mark by 10% from the prior quarter. We view the successful restructuring of this investment as evidence of our team's long-standing private equity-style approach to investing. It's in our team's DNA to approach a restructuring with an operational mindset, using our expertise and experience to maximize our recovery. Now let me turn to our four investment verticals. In sponsor finance or cash flow business, here, we're originating first-lien senior secured loans to upper mid-market companies in non-cyclical industries, such as health care providers and diversified financials. Our historical focus on these sectors has helped to reduce the impact on the portfolio from rising input costs. As a result of the positive market dynamics Michael highlighted, we are continuing to see new issue yields of 12% to 13% compared to the recent historical range of 8% to 10%. Importantly, these investments are carrying less leverage than we had seen historically. Middle market loans continue to be priced at a premium to leveraged loans, with the added benefit of having better structural protections and lower leverage levels. Our Q3 pipeline has an average yield of just under 13% and a loan-to-value of just under 40%, which supports our thesis that this year should be a great vintage for investing in sponsor finance cash flow upper mid-market loans. Given our current pipeline and reduced level of expected repayments, we expect continued portfolio growth during the remainder of this year. At quarter end, our cash flow portfolio was approximately $740 million, or 24% of the total portfolio invested across 48 borrowers. We have defensively positioned this portfolio with borrowers that have an average EBITDA of over $140 million and low loan-to-values of approximately 40%. Interest coverage ratios have come down from the high of 3 times a few years ago but have leveled off at 2 times. Our portfolio is comprised of businesses that perform essential services with either recurring or reoccurring revenues and have low capital intensity. Overall, the portfolio has exhibited solid credit metrics that have remained steady this year. During the quarter, we originated $115 million of new loans and experienced repayments of $55 million. These investments were made on compelling terms. Our second quarter investments were focused on existing borrowers with over 85% of this capital committed to companies that we have exposure to and that have exhibited strong operating performance. At quarter end, the weighted average cash flow yield was 11.6%. With approximately 98% of this portfolio invested in first lien loans, we believe our investments are well positioned to withstand liquidity pressures that borrowers may face. Now let me turn to our ABL segment. Historically, the ABL segment has performed well during periods of market volatility and economic contraction, such as today's environment. Borrowers, which are asset-rich but have cash flows that are pressured by rising interest rates and slowing demand, are forced to raise capital in the ABL market rather than the cash flow market. The rising rate environment and economic challenges have put pressure on these borrowers, particularly those in more cyclical sectors, which has resulted in an increased opportunity set for our ABL teams. We're seeing increased deal volume that we believe will continue throughout this year. With limited access to capital, as regional banks largely continue to sit on the sidelines, we expect the rate of repayments to slow, translating into additional portfolio growth. Our ABL team has been working to provide full solutions to potential borrowers, including working closely with our life science team. At quarter end, the senior secured ABL portfolio totaled just under $1 billion or 32% of our total portfolio and was invested across 165 issuers. The weighted average asset level yield was 14.6% compared to 13.6% in the first quarter, and our average loan-to-value was approximately 74%. For the second quarter, we originated $113 million of new investments and had repayments of just under $100 million. Now let me move to Equipment Finance. At quarter end, the portfolio totaled just under $1 billion, representing 32% of our total portfolio and was highly diversified, invested across 550 issuers. The credit profile of the portfolio is as strong as it's ever been. The weighted average asset level yield is 9.6%. During the second quarter, we originated $150 million of new assets and had repayments of just under $110 million. Our current investment pipeline in Equipment Finance has increased significantly over the past quarter. Finally, let me turn to our Life Science segment. Activity has moderated in the wake of the SVB failure. Our Life Science team continues to be extremely selective as borrowers seek to increase leverage as an alternative to issuing more equity at this time when valuations have come down in the markets. However, due to our strong presence, we are still seeing attractive investment opportunities and pricing. We anticipate that the opportunity set will continue to improve as we move through the second half of this year. At quarter end, our portfolio totaled $340 million across 15 borrowers. The substantial majority of the portfolio is invested in loans to borrowers that have over 12 months of cash runway. Life Science loans represent 11% of our portfolio and contributed just under 23% of our gross investment income for the quarter. During the second quarter, the team committed to $20 million of new investments and had repayments of $2.7 million. We have just under $120 million of unfunded commitments, which may be drawn by borrowers based upon hitting important milestones, such as FDA approvals, revenue metrics, liquidity, and other milestones. At quarter end, the weighted average yield on this portfolio was 13.2% compared to 12.8% in Q1. These yields exclude any success fees and warrants. In conclusion, all of our lending verticals had a strong quarter on the origination front while maintaining consistent credit quality. Given our available capital and ability to provide a wide spectrum of debt financing solutions, we believe we are well-positioned to take advantage of the attractive investment environment. Now let me turn the call back to Michael.

Michael Gross, Chairman and Co-CEO

Thank you, Bruce. In closing, we are pleased with our progress in ramping our portfolio since our COVID-era lows into investments that have more attractive terms than we’ve seen in many years. Our specialty finance businesses, which were particularly impacted by borrowers having access to government stimulus during the pandemic, have either reached or are nearing pre-COVID portfolio balances. Importantly, the available capital across our platform provides us with the capacity for additional earnings growth. With our investment strategy benefiting from the reduced competition from regional banks in the BSL market, we currently have a sizable investment pipeline. Importantly, we believe it’s one of the most attractive we’ve ever had. In closing, our investment advisers’ alignment of interest with the company’s shareholders continues to be one of our guiding principles. The SLR team owns over 8% of the company’s stock, including having a significant percentage of the annual incentive compensation invested in its stock. The team’s investment alongside fellow SLRC shareholders demonstrates our confidence in the company’s defensive portfolio, stable funding, and favorable position. Thank you for your time today. Operator, will you please open up the line for questions.

Operator, Operator

And we'll take our first question from Sean-Paul Adams with Raymond James. Please go ahead, Sean-Paul. Your line is open, so please check to see if you're muted.

Sean-Paul Adams, Analyst

I was hoping you guys could share some commentary on whether you plan to amend your credit facility to extend their maturities since both mature in 2026, and provide some insight into whether the revolving period for the secured credit facilities is the same as maturity?

Bruce Spohler, Co-CEO

Yes. No, we have some time on our primary corporate revolver. I think that maturity, if I'm not mistaken, is in '25 in terms of the investing period. And then we have the smaller SUNS facility that came with the merger with SUNS, which matures next spring, and we're already in conversations to both upsize it and extend it.

Sean-Paul Adams, Analyst

And as a follow-on, can you provide details on the impact of the banking market tightening?

Bruce Spohler, Co-CEO

Can you just repeat in terms of specifically what you'd like us to address on that front?

Sean-Paul Adams, Analyst

Yes, yes, of course. And so in regards to the banking market tightening and just issuance, can you provide some general targets for the next couple of quarters?

Bruce Spohler, Co-CEO

Sure. I would just say, high level, the cash flow market has been impacted by the tightening on the money center banks, who are the biggest players there. The BSL market is really only open for the largest of issuers. And so on the cash flow side, as you can see in our origination numbers year-to-date, we've seen great opportunity in the upper mid-market there. I think on the specialty finance businesses, they're most impacted and benefit from the tightening in the regional banks, whether it’s equipment finance, all the way through ABL strategies into Life Sciences, where obviously, Silicon Valley and, to some extent, Signature Bank were put on the sidelines. Those teams have resurfaced, but we'll see whether the banks that they landed at will actually provide the capital to support that sector. So, we have seen that dislocation create better opportunities for us, not so much in terms of the fundamentals, but as you know, the regional banks were relatively aggressive when they liked investment opportunities relative to direct lenders such as ourselves. I think that having more rationality in those sectors has led to higher-quality opportunities as well as better pricing. It’s too soon to know how long that will last, but it has definitely given us a better opportunity set.

Operator, Operator

We will take our next question from Paul Johnson with KBW. Please go ahead.

Paul Johnson, Analyst

Regarding the equipment financing sector, particularly the SLR equipment, which was previously known as NEF Equipment Financing, there has been no return on this investment this year. Last year also saw no dividend return on investment. Could you provide an update on what you plan to do with the returns from this investment? The portfolio appears to be performing well, but I would like to know if there are any timing issues or pressures impacting the return at this time. Any insights on that investment would be appreciated.

Bruce Spohler, Co-CEO

Sure. Just as a reminder, we have 2 equipment finance verticals. One is the Kingsbridge vertical that provides equipment finance for investment-grade borrowers, and then there's the equipment finance vertical, formerly NEF, that is more focused on non-investment-grade borrowers. That vertical, in particular, has been repositioning itself, particularly in this stage of the economic cycle, to focus less on the liquidation value of the equipment and more on the fundamental credit of the borrower. So, to put it simply, we've been taking down the risk in that portfolio. Having said that, it has been growing. Just as a reminder, that portfolio is housed on our balance sheet as well as in that subsidiary. The expenses of the team are in the subsidiary, but the majority of the assets are on the balance sheet. So, when we report, we report on a consolidated basis rather than just looking at that legal subsidiary. It has been generating nice income. We expect that to grow. But you need to look at it consolidated between the subsidiary as well as the assets on the balance sheet.

Paul Johnson, Analyst

You experienced significant growth this quarter, and it seems you are optimistic about the pipeline and anticipate further growth this year. Leverage has increased to approximately 1.2 times on a gross basis this quarter. However, the return on equity has noticeably lagged behind the industry thus far. I am curious about what you believe could be the drivers to improve that return on equity, perhaps through enhancing returns from some of your sectors. Are there any repricing opportunities within the portfolio? Your insights on this would be appreciated.

Michael Gross, Chairman and Co-CEO

There are several levers we can pull in our point to accomplish that across our strategies. The first, as we mentioned, our leverage we quoted was at a point in time with the actions we have in place to pull more assets into the SSLP, which will bring our leverage back down to the midpoint of the range. It will also have the effect of increasing our ROE because we're putting assets into that levered 2 times just as a refresh. We've been selling assets into that with our JV partner at par, and these are assets yielding L plus 550. So, we're able to take that capital we get back from those sales and redeploy it into assets that are yielding anywhere from 12% to 15%, depending on the strategy.

Operator, Operator

We'll take our next question from Casey Alexander with Compass Point. Please go ahead.

Casey Alexander, Analyst

Can you quantify the capacity that the JV has in terms of how much can you sell down to the JV that then you can replace on balance sheet?

Bruce Spohler, Co-CEO

Sure. So, Casey, at June 30, we had about $79 million down in the slip and it's been set up to take $300 million of assets. So roughly another $220 million of assets.

Casey Alexander, Analyst

My second question is about the assets that the joint venture was meant to acquire, specifically the lower-yielding assets from Solar Senior. It appears that those assets are now yielding more than the average yield on the equipment finance portfolio. Is there anything stopping you from transferring some of the equipment finance loans to replace them with significantly higher-yielding assets on the balance sheet?

Bruce Spohler, Co-CEO

The JV is set up both from an equity partnership perspective as well as the credit facility to only take cash flow loans. So to your point, it was set up to take the lower-yielding SUNS cash flow loans, which, as Michael just shared, are in the L5 handle spread at par, versus the new cash flow loans, which are coming at SOFR 650 at 97. So there is a nice yield delta there. But no, I think on the Equipment Finance business, as you know, those are fixed-rate assets. They do have a longer life, but they do amortize down monthly. We are looking to continue to cycle out of those assets and bring on higher-yielding equipment finance assets or, if we see better opportunities elsewhere, we’ll deploy the capital into higher-yielding strategies.

Casey Alexander, Analyst

We'll see what happens when you give an analyst a calculator; he'll start trying to get you to do things you're not allowing to.

Bruce Spohler, Co-CEO

We like your idea.

Shiraz Kajee, CFO

We're going to take the calculator away from you.

Operator, Operator

It seems that there are no further questions at this time. I'll now hand the call back to Mr. Gross for his closing remarks.

Michael Gross, Chairman and Co-CEO

Just thank you for your time, and have a great summer. And again, as always, if you have any questions, please feel free to reach out to any of us directly. Take care.

Operator, Operator

Thank you. And this does conclude today's program. Thank you for your participation. You may disconnect at any time.