MidCap Financial Investment Corp (MFIC) 2015 Q1 法說會逐字稿

Presentation

Good morning and welcome to Apollo Investment Corporation's earnings conference call for the period ending June 30, 2014.

(Operator Instructions)

I will now turn the call over to Elizabeth Besen, Investor Relations Manager for Apollo Investment Corporation.

Thank you, Operator, and thank you, everyone, for joining us today. With me today are Jim Zelter, Chief Executive Officer; Ted Goldthorpe, President and Chief Investment Officer; and Greg Hunt, Chief Financial Officer.

I'd like to advise everyone that today's call and webcast are being recorded. Please note that they are the property of Apollo Investment Corporation and that any unauthorized broadcast in any form is strictly prohibited.

Information about the audio replay of this call is available in our earnings press release. I'd also like to call your attention to the customary Safe Harbor disclosure in our press release regarding forward-looking information.

Today's conference call and webcast may include forward-looking statements. Forward-looking statements involve risks and uncertainties including, but not limited to, statements as to our future results, our business prospects, and the prospects of our portfolio companies. You should refer to our registration statement and shareholder reports for risks that apply to our business and may adversely affect any forward-looking statements we make. We do not undertake to update our forward-looking statements or projections unless required by law.

To obtain copies of our SEC filings, please visit our website, at www.apolloic.com.

I'd also like to remind everyone that we've posted a supplemental financial information package on our website which contains information about the portfolio as well as the Company's financial performance.

At this time, I'd like to turn the call over to Jim Zelter.

Thank you, Elizabeth.

This morning, we issued our earnings release and filed our quarterly Form 10-Q. I'll begin my remarks with some highlights for the quarter before turning the call over to Ted, who will discuss the market environment and review our investment activity for the quarter. Greg will then discuss our financial results in greater detail, and then we will open the call to a variety of questions.

For the June quarter, we are pleased to report strong net investment income, an increase in net asset value, a solid level of gross and net asset deployments, an increase in exposure to floating-rate debt, a stable portfolio yield, and an overall improvement in the portfolio's overall credit quality.

For the quarter, we reported net investment income of $0.23 per share, which reflects an improved level of recurring investment income, as well as an increase in income from prepayments.

In addition, net asset value per share rose nearly 1%, to $8.74.

During the quarter, we saw some of the competitive tends in the broadly syndicated market impact the middle market. That being said, we remain selective and disciplined, with a focus on secured debt opportunities with strong risk-adjusted returns. We continue to benefit from the broader Apollo platform which provides us with scale, investment opportunities, and market insights. We continue to deploy our assets in our specialty verticals, which Ted will talk about, which provide attractive risk-adjusted returns.

We also used the strength in the liquid markets to sell lower-yielding investments, as well as to reduce certain larger legacy exposures. As a result, we have been able to maintain our overall portfolio yield by repositioning assets into less liquid investments, maximizing the benefits associated with our sourcing platform and our permanent capital base.

We remain optimistic about the opportunities for providers of capital such as ourselves, as there continues to be a shortage of available homes for illiquid investments. That being said, we recognize that we are likely in the latter part of a robust credit cycle and therefore remain cautious in our overall approach to credit.

Moving to some other recent highlights, the Company held its annual meeting of stockholders and a special meeting this past Tuesday. At these meetings, the Company stockholders approved all three proposals. We [genuinely] and greatly appreciate the support of our shareholders on these important matters.

Lastly, I'd like to mention that we are in the process of establishing an ATM equity offering program. An ATM program typically affords an issuer flexibility in raising incremental equity capital during periods of elevated net investment activity, with lower execution costs and minimal disruption to the market.

Turning our discussion to our dividend, the Board approved a $0.20 dividend for shareholders of record as of September 19, 2014.

With that, I will turn the call over to Ted, to discuss the current market environment and our investment portfolio.

Thank you, Jim. Beginning with the market environment, the non-investment grade credit markets remained firm during the quarter, amid strong equity markets. Record CLO issuance and strong loan warehouse formation offset leverage fund outflows, which had their first significant reduction since the first quarter of 2012.

Given this environment, we continue to focus on secured debt opportunities, particularly in our specialty verticals which have been less impacted by the trends in the broader market. During the quarter, we invested $650 million -- with $355 million in 25 new portfolio companies and $295 million in 24 existing companies.

The weighted average yield on our debt portfolio was 11.1% of costs, unchanged from last quarter. The stability of our yield was due in part to the monetization of certain lower-yielding investments.

Next, I will discuss some specific investment activity for the quarter, beginning with our two specialty verticals, oil and gas and aviation, which on a combined basis accounted for approximately 29% of the assets deployed during the quarter.

During the quarter, we invested $126 million in our oil and gas vertical. Over half this amount was in existing portfolio companies. We also invested $50 million in two new oil and gas companies, Deep Gulf Energy II and Extraction Oil & Gas. At the end of June, oil and gas was 13.1% of the portfolio, up from 11.8% last quarter.

Moving to aviation, we invested $65 million in Merx Aviation, to complete two transactions. Merx purchased its first cargo plane and also completed a direct sale-leaseback with an airline on a new delivery. At the end of June, aviation was 13.5% of the portfolio, up from 12.2% last quarter. Our overall allocation target for this vertical is 15% to 20%.

While these two industries represent 26.6% of the total portfolio on a combined basis, there is significant diversification within each vertical. Our oil and gas portfolio is well diversified by geography and borrower, and our aviation portfolio is well diversified by aircraft type and lessee. Further, we believe that these verticals offer strong risk-adjusted returns with relatively good downside protection.

Moving to investment activity away from our specialty verticals, we've been focused on direct lending to companies. During the quarter, we closed on a $50 million commitment to a subordinated delay-draw term loan credit facility for GenCorp, a leading designer, developer, and manufacturer of mission-critical products and systems to the aerospace and defense industry. At quarter-end, $39.5 million of the facility was drawn.

We also invested $39 million in the secured debt of BancTec to support its acquisition by a financial sponsor. BancTec is a business process services company focused primarily on financial institutions.

We also invested $20 million in secured debt term loan for Xand, a [sponsor-backed] leading northeast regional data center that provides co-location, managed hosting and networking, Cloud, and disaster recovery services. We believe the investment in Xand represents a good risk-reward due to the strong recurring sticky revenue, high switching costs, strong secular trends, strong historical performance, compelling financial profile, and attractive LTV.

Exits, including sales, repayments, and revolver pay-downs, totaled $516 million for the quarter. We used the strength in the market to sell lower-yielding positions and to improve borrower concentration. Sales totaled $397 million for the quarter, including approximately $110 million of lower-yielding investments such as TransFirst, American Energy, and Applied Systems.

We also reduced exposure to some larger legacy positions, including Ceridian, inVentiv Health, First Data, and Altegrity.

Repayments for the quarter totaled $90 million, including investments in Exova, CRC Health, and others.

Credit quality remains strong, as the portfolio's weighted average risk rating at a fair value remained at 2.1. No investments were placed on non-accrual status during the quarter. In addition, the weighted average net leverage of our investments improved to 5.4 times, from 5.5 times, while the weighted average interest coverage ratio remained at 2.3 times.

As of today, our pipeline is strong and consists mostly of proprietary opportunities, although there are no assurances that deals in the pipeline will ultimately close.

With that, I will turn the call over to Greg, who will discuss the financial performance for the quarter.

Thank you, Ted. Total investment income for the quarter was $102.6 million, up 6% from both last quarter and the year-ago quarter. The increase quarter over quarter was due to strong recurring investment income and increased prepayment income.

Interest income for the quarter included $6.1 million of original issue discount and call premium related to prepayments, compared to $4.1 million in the March quarter and $7.8 million for the year-ago quarter.

Expenses for the quarter totaled $49 million, compared to $46.8 million last quarter and $44.3 million for the year-ago quarter. The sequential increase was due to higher interest costs and management fees associated with the increase in the size of the portfolio.

Net investment income was $53.6 million, or $0.23 per share, for the quarter. This compares to $49.6 million, or $0.22 per share, for the March quarter and $52.4 million, or $0.25 per share, for the year-ago quarter.

For the quarter, the net gain on the portfolio totaled $11.1 million, or $0.04 per share, compared to a net gain of $20.3 million, or $0.09 per share, for the March quarter and compared to a net loss of $33 million, or $0.12 (sic - see slide 3, "$0.16") per share, for the year-ago quarter. The net gain in the June quarter was primarily attributable to our equity investments in Merx Aviation and PlayPower.

In total, our quarterly operating results increased net assets by $64.6 million, or $0.27 per share, compared to an increase of $69.9 million, or $0.31 per share, for the March quarter and an increase of $18.8 million, or $0.09 per share, for the year-ago quarter.

On the liabilities side of the balance sheet, we had $1.5 billion of debt outstanding at the end of the quarter, up from $1.3 billion at the end of March. At quarter-end, our debt-to-equity ratio was 0.76 times, up from 0.67 times at the end of March, and our net leverage ratio, which includes the impact of cash and unsettled transactions, was 0.75 times at the end of June, compared to 0.68 times at the end of March.

Heading into the quarter, we were [confident] of the fact that we would have several July repayments, and therefore we managed our debt levels accordingly. In July, we reduced our leverage by over $100 million, as investments in PetroBakken, Ceridian, [Illogics], and First Data were sold. Adjusting these repayments, our net leverage ratio was comfortably within our target range.

With that, Operator, please open the call to questions.

(Operator Instructions) Terry Ma, Barclays.

I apologize if I missed this just now, but can you just remind us what your target leverage range is and how you're thinking about funding new investments, going forward?

Our target debt range has been between 0.55 and 0.75. And I think as I indicated, as we came into the quarter we knew the activity for July. And with the repayments, it brings us down well within that range.

Okay. Got it. And can you maybe just talk a little more about the ATM program and how you're thinking about using that, going forward? And also, I guess, what your philosophy is on issuing below book?

We have no intention to raising any equity below book. We haven't for some time, and we've been very, very clear about that.

But certainly, as we sit back and think about our platform today, we have been able to achieve a lot of the strategic goals we have wanted -- we laid out two years ago. And what we are finding, that really raising equity is not on our radar screen today as a top priority item. But certainly, there are times inter-quarter or we find a robust pipeline, and if the markets are in line and it can be done such that it's accretive to shareholders, we will use that to marginally and be more efficient with our capital structure.

So, it's really looked at as around the edges. If a traditional block equity opportunity came up to us, that, again, is not really on our focus item today. It's not really a radar -- it's not on our radar screen and our focus. So, we're really looking at the ATM as something around the edges for us to really optimize our capital structure as appropriately.

Okay. Got it.

The one thing I would add is, just because we are putting it in place doesn't mean we have to use it. And as Jim said, to do a big equity offering, regular way equity offering, you have to be very, very comfortable in your pipeline. And as Jim said, I don't think that's on our radar screen today. This is just a tool that if our pipeline is very solid, our stock is trading at an accretive level to shareholders, and our leverage is at the high end of our target range, then we may use it.

But again, we've been very consistent about this message. We will not issue stock -- our preference is always to use leverage versus issuing equity, as long as it's within our target range.

Got it, and definitely appreciate the color. Thanks.

Greg Mason, KBW.

Ted, in the two years since you've taken over, you've really shifted the portfolio to much more senior debt, like you wanted to. How much of the portfolio is left to yet be optimized, that you would want to rotate out into new investments?

I think in terms of senior unsecured, secured versus unsecured, I think we've done -- I don't think there's a -- I think we feel pretty good about where we are today. So, I think we kind of reached our targets. If you look at our originations, they still seem to be concentrated in secured debt, but I think we feel pretty good about where our overall business is today.

Now that the shift -- and you've seen it this quarter -- obviously we maintain yields in this environment. We still have one-third of our book that yields less than 10%. And you've seen what we did this quarter, which we monetized some lower-yielding assets as we originated higher-yielding assets. And that's just a way for us to organically grow NII in a prudent way.

So, if you talk about optimization, I think we're more focused now. The shift has been from senior -- secured versus unsecured optimizations and now more what I would call yield optimization.

Got it. And on that, on the new investments on slide 7, your secured new loans had a 10.5% yield, but you had $94 million of unsecured debt -- so, junior debt -- at a 7.7% yield. Can you just talk to us about that, that yield on the unsecured debt? It seems odd.

Yes, it does. I would say it's a little bit misleading to look at it on a consolidated basis. You really have to -- and we'll take you through it in the queue. But you have to look at the individual investment activity.

I think, (a), it's a small number, and it was dragged down by one or two lower-yielding instruments, and I think those are very liquid and instruments that probably we can use as they originate new secured debt.

Most of our first [wing] debt, the recent yield is higher than the more subordinate debt, because a lot of that stuff is less liquid and more specialty verticals. And as you guys all know, all of our specialty verticals yield pretty substantially above our sponsor verticals. And so, that's why the numbers look a little funny on this page on a consolidated basis.

So, is that $94 million of unsecured debt, is that liquid high-yield bonds that were bought in the quarter?

I think a lot of it was related to a bridge that we were in that we've subsequently exited.

Okay. All right. That's great. Thanks. Appreciate it, guys.

Doug Mewhirter, SunTrust.

I guess I had one question regarding, I guess, your portfolio strategy, for lack of a better term. You gave some really good information about how your -- where your yields are going and the opportunity to enhance that yield. And you also talked about liquid versus illiquid. And I know that you do traffic on both sides of the fence. Is there an overall strategic shift towards less liquid investments, away from the more liquid stuff which may be more exposed to competitive pressures? Or, will that always be a significant chunk of your strategy?

Let me start out with that, because I think it's a great question. We were very clear in April of 2012 where we wanted to take this Company and this portfolio and matching the strategic benefit of having long-term permanent capital. And in the past, we collectively, I think, were too reliant and made a lot of statements about the liquidity inherent in our portfolio. And the result of that was we really were not getting the benefit from our permanence of our capital.

So, clearly, what this team did in April of 2014, we reestablished some goals, and certainly it's our view right now that the repositioning that we've done with the specialty verticals, with aircraft and energy and other things that the team has done, and creating [an attachment point] on a secured bass. The tradeoff is, yes, we are trafficking in less liquid opportunities, but that's completely appropriate for this capital base. And we're less reliant on sponsor-driven business, which in itself is more syndicated yield.

So, yes. The idea, we're very comfortable with our liquidity today. As Ted said, we have ample liquidity. But we're willing to trade that liquidity for very, very solid investments when and if they show up to us.

So, I'd say we're finding very little opportunities in the liquid markets and it's really not core to our strategy, in any case.

On the illiquid side, again, the spread between illiquid and liquid risk is still very, very high in our direct business. So, I'll split our illiquid business into sponsor versus direct. Our direct business, or our non-sponsor business, continues to have very elevated spreads vis-a-vis traditional markets.

The middle market sponsor channel has been challenging in terms of yields. You've seen it in some of our peers' results. That has become more competitive over the last 12 to 18 months, and pricing on middle market sponsor deals has come down in line with what's happened with liquid markets.

So, I think you have to bifurcate our business into the three different areas and I think, obviously, we have a huge focus on direct. Sponsor business is really core to our business, but we're really trying to invest a lot of resources here in the non-sponsor business.

Great. Thanks. That's a great answer. I just had one follow-up more, sort of a current events question along that line. Your competitors have all talked about it -- it's in the news -- how the high-yield bond market has backed up a bit, and that's bled over into the liquid market. Have you seen any tone change in the middle market, in any segments of the middle market, because of that? Or, has that sentiment not really migrated down here yet?

It's hard to say. The real sell-off on high yield has really only happened over the last couple of weeks. And the gestation period for one of our illiquid deals is three, four months. And so, if there continues to be choppiness in the liquid markets, both high yield and loans, that's very good for our business.

Our business oftentimes competes against the syndicated markets. We'll offer a private solution; the underwriters will offer a best-efforts deal. And what we offer is we're usually more expensive but we offer certainty of execution. And certainty of execution becomes much more important in periods of time like this. So, hopefully we'll see the benefit in our originations.

But it's very early to say whether what's happened in the last week is going to flow over to the sponsor business.

Great. Thanks for the answer.

(Operator Instructions) Finn O'Shea, Raymond James.

Just going back to the optimization, liquid to illiquid, can you give us a little bit of color on what directionally this is going toward for the size of your portfolio, companies, maybe by EBITDA? And then, any change in characteristics on stuff like leverage, covenants, interest coverage?

So, what we're finding is we're not finding a lot of opportunities in larger companies, nor do we think that's core to the BDC strategy. So, the average EBITDA of our underlying borrowers has come down. We are not trafficking in what I would call the lower middle market. I would say we're in the middle market to upper middle market.

So, the average EBITDA of our portfolio by company has come down pretty dramatically over the last four or five years, but we were trafficking in the upper-upper middle market, or some would say even maybe the larger market, three years ago.

And in terms of covenants, we are still getting covenants in our illiquid deals, especially our direct deals have a lot of -- they're very, very high touch. So, we have a lot of covenants in those. Sponsor deals also all have covenants, by and large. But again, that is always a subject of debate. In the syndicated markets, as you guys know, it's very, very hard to get covenants today.

And I'll add to that. Ted and the team have done a great job in some of these industry verticals. Some of your best covenants right now is on your prepayment protection, and that really has allowed the team to when a company has done well to maintain that name in the portfolio, but have done so with a newly structured piece of paper. So, I think that's a theme you're going to see us try to continue, since we find that that's a great help to the competitive dynamics out there.

And the other thing that's unique about our portfolio is since 2010 our portfolio's -- the average leverage through our debt per company has come down by a turn and a half. So, even though increased leverage has crept into the broader markets, our average portfolio company is one and a half times less levered than what it was in 2010.

Okay. Thanks very much.

Chris York, JMP Securities.

We've seen many BDCs focus on new originations in energy credits this quarter. Did you guys see more competition in your specialty vertical this quarter or any odd activities by lenders to win deals?

I don't think so. There's a complete mismatch right now between demand for capital and supply of capital. So, a lot of the traditional players in the energy space, what I'd call the non-traditional lending space, which is non-RBLs, reserve-based loans. There is just an amazing demand for capital right now, and it's obviously on the front page of the newspaper every day.

I don't think we've really seen that much incremental competition, and I also -- and I think it's more people have crept into the market, but again, the demand for capital is very large. And so, we're actually -- I would say we're relatively bandwidth constrained in our energy business versus opportunity constraints. So, I think there's room for other people to come into the market.

So, if you look at issuance by industry overall, the energy sector really had a big boom in issuance over the last three, four months, if you just track the public numbers. And I think that's just what's going on in the energy patch. The demand for capital right now is very, very high.

Sure. That context is helpful. Thanks.

Jon Bock, Wells Fargo Securities.

I want to dive into Merx really quickly, just as it relates to some of the opportunities, particularly in the structured [spend] on, we'll call it, older metal and whether or not you're starting to see a general trend from the banks to, I'd say, back away from these assets, because we feel a push-pull here? We understand that there are attractive opportunities, but we also understand that lots of people are starting to follow your lead and chase the trade. And we want to know if that perhaps puts some of the competitive dynamics to putting capital to work maybe a little less favorable than they once were?

I'd say similar comments to the energy vertical. Demand for capital is massive. If you think about who is providing capital in the space, the large players are under a lot of pressure to shrink their balance sheets. I think a lot of the non-traditional players have exited the market over the last couple of years due to illiquidity.

And I don't think we've really seen a big pick-up from banks wanting to sell old aircrafts. And I think the strategy of Merx, we're really trying to focus on good counterparties and obviously income-generating assets.

I don't think part-outs, which is taking an old plane and ripping it to pieces and stuff, I don't think that's going to be a huge part of our portfolio. Again, we just think about it, our aircraft business, very similar to the rest of our business. We want to back great counterparties with income-generating leases.

So, again, I'd make the same comment, Jonathan, I made before, which is there's a lot of room for people in this market, just because it's such a large market. And we know a lot of other people have started businesses, but it really hasn't impacted our returns as of yet.

Got it. And as we look at -- and this is a question for Greg -- when we think about the accrual rates on CLO securities today, can you give us a sense of perhaps what you think the base IRR should be on, maybe in aggregate, the CLO portfolio that you're booking into income relative to the cash returns that you're receiving on CLOs today? And then, I'll have a follow-up to that.

As you know, Jonathan, we provide and our accounting for our CLO investments are on a level-yield basis. So, therefore, we're looking at the length of the duration of the investment. And therefore, we're running those yields anywhere from 14% to 17%, 18% today, but the cash yields on those that have been coming in are typically a little bit over 20%. And then, the delta there on the leverage, the way we look at it, goes to the -- it reduces the cost of the investment. And that's how our accounting is for it.

But we feel good about where those yields are. We mark them every

quarter. We stress them.

Great. Appreciate that, because I know there are some in the space that don't do it correctly. And so, maybe if we think about that and the potential for NIM compression as a result of rising LIBOR? Now, one, I understand it could rise in [nebruary], but at some point it should.

Maybe give us a sense of your modeled expectations as it relates to rising rates? And then, maybe touch on a quick risk element there, Ted, on to the extent that rates do rise, are you trying to think about a way to hedge, we'll say, maybe a little bit more of a higher volatile income stream that gets pinched as your CLO liabilities rise, yet your assets don't, as a result of the floors?

I'd say, number one, structured products is a very small part of our business, just to point that out. I think any time we're doing any of the modeling for these, we obviously use the forward LIBOR curve. We're not using flat LIBOR. And we're not [prognosticating on] interest rates. So, we just use what the markets are telling us to use.

And in a rising rate environment -- we could get into a huge debate about the impact to various parts of our business, because it depends on why rates are rising. But higher LIBOR rates above a certain amount benefit us, obviously, and below a certain amount, hurt us a little bit because of the LIBOR floors embedded in a lot of these loans. And obviously those loans are underlying the structured products.

So, I think it depends a little bit on how high rates go, but large move in short-term rates are clearly good for our business.

Great.

Jonathan, we're also revaluing every quarter. So, we're looking out and we're spreading out the risk and the change in rates. So, I think you're getting a fair mark as you look at it. And then, you can adjust the return on those.

Okay. Great. Guys, thank you so much.

This concludes today's question-and-answer session. I will now turn the floor back over to Jim Zelter for any closing remarks.

Well, as usual, thank you all for participating today, and we look forward to having ongoing discussion, and we also hope that the additional disclosure that the team has put together is helpful. And certainly, we are always available to answer questions for all our shareholders.

So, thank you for your support, and talk to you next quarter.

Thank you for participating in today's conference. This does conclude today's call. Please disconnect your lines at this time, and have a wonderful day.