MidCap Financial Investment Corp (MFIC) 2018 Q2 法說會逐字稿

Good morning, and welcome to Apollo Investment Corporation's earnings conference call for the period ended September 30, 2017.

(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. Speaking on today's call are Howard Widra, President; Tanner Powell; 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 that 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 supplemented 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 Howard Widra.

Thanks, Elizabeth. Good morning, everyone, and thank you for joining us for our quarterly conference call.

I'll begin today's call by briefly discussing the market environment, followed by an update on the progress we have made executing on our strategy, including a brief overview of our results for the quarter. Tanner will then cover our investment activity for the period and provide an update on credit quality. Finally, Greg will review our financial results in detail. We will then open the call to questions.

Beginning with the environment, middle market private credit remains highly competitive for lenders, as robust middle market loan fundraising has contributed to spread compression and competitive terms and supplies are dominated by dividend and refinance activity. We believe that our size relative to our funnel of investment opportunities allows us to remain selective and find attractive opportunities even in today's market. That said, we've passed on many deals that do not provide adequate risk-adjusted returns and have allowed our leverage ratio to decline.

Moving to an update on the execution of our strategy, we believe that we are now more than halfway through our repositioning plan. I will now discuss the progress in detail.

First, we continue to deploy capital into our core strategies, which include middle market corporate loans to sponsor-backed companies as well as opportunities in life sciences lending, asset-based lending and lender finance. We believe these 3 specialty areas can generate good deal flow with pricing that is less impacted than sponsor-backed corporate lending.

We are also benefiting from our ability to coinvest with other Apollo funds or entities managed by Apollo. Since commencing our repositioning strategy last year, we have funded over $1 billion into our core strategies, including $417 million, or 38% of our total deployment, into co-investment transactions. Core strategies now account for 73% of the portfolio, including 16% in co-investments, at fair value.

Second, we continue to reduce our exposure to non-core and legacy assets which now account for 27% of the portfolio at fair value. In aggregate, non-core and legacy assets have decreased by $432 million since commencing our repositioning strategy and now total $633 million at fair value.

Oil and gas exposures declined to 6.9% of the portfolio at fair value; structured credit exposure has declined to 3.3%; renewables exposure has declined to 8.2%; and legacy and other exposure has declined to 3.6% of the portfolio. These are all down significantly from when we commenced our repositioning strategy. Recall, these non-core assets are higher on the risk spectrum and have more volatile returns.

Third, we continue to make steady progress to improve the overall risk profile of our portfolio by increasing our exposure to first lien and floating rate loans and decreasing our average borrower exposure. As of the end of September, first lien debt have increased to 48% of the total portfolio; the floating rate portion of our corporate debt portfolio has increased to 91%; and our average borrower exposure decreased to $27.1 million, all at fair value.

Next, moving to an overview of our results. During the quarter, we invested $265 million, of which nearly half were investments made pursuant to the co-investment order. Repayment activity was elevated, and net investment activity was negative $74 million.

Net leverage as of the end of the quarter was 0.59x. In today's market, we believe it is prudent to have dry powder.

Net investment income for the quarter was $0.16 per share. Net asset value declined $0.01, to $6.72 per share, as gains on investments were offset by losses and there was a $0.01-per-share unrealized loss from our oil hedge, which Tanner and Greg will discuss later.

Regarding the distribution, the board approved a $0.15 distribution to shareholders as of record of December 21, 2017.

In summary, we're pleased with our progress to date, and we will continue to focus on executing our strategy. We'll remain disciplined and not reach for yield. That said, there are several levers we can pull, including increasing our leverage to our target range, redeploying sub-yielding assets and refinancing some of our more expensive debt.

With that, I'll turn the call over to Tanner.

Thanks, Howard. During the quarter we invested in $265 million in 12 new portfolio companies and 11 existing companies, with a focus on senior floating rate debt in our core strategies. Nearly half of our investments were made pursuant to our co-investment exemptive relief order.

In this competitive environment, we are focused on opportunities that capitalize on Apollo's scale and areas of expertise and can also take advantage of our ability to coinvest with other funds and entities managed by Apollo.

Given the continued strength in credit markets, repayment activity was elevated. Exits totaled $340 million, which consisted of $328 million of repayments and $12 million of sales. Net investment activity before repayments was $254 million, and net investment activity after repayments was negative $74 million for the quarter.

The weighted average yield on investments made during the quarter was 10%, and the weighted average yield on sales and repayments was 10.3%.

I will now discuss our activity in greater detail. During the quarter, we deployed $124 million, or approximately 47% of total deployment, in investments made pursuant to the co-investment order. Co-investments during the period included RA Outdoors, Electro Rent, Wright Dose, Wright Medical, Purchasing Power and Simplify, among others.

Turning to aircraft leasing, which continues to be one of our larger industry concentrations, we continue to be pleased with our investment in Merx Aviation, as the underlying portfolio continues to perform well. As of the end of September, our investment in Merx was $429 million, representing 18.2% of the total portfolio at fair value. Merx continued to see attractive opportunities to add to its portfolio with high-quality aircraft and lessees as well as opportunities to monetize select aircraft in the portfolio.

During the period, we deployed approximately $10 million into Merx and were repaid $41.5 million of capital, resulting in net repayment of $31.5 million. Merx also paid a $2.25 million dividend to us during the quarter.

The balance of our investment activity was spread across several secured debt floating rate corporate loans within our core strategies.

In addition to the repayment from Merx, repayments included the partial repayment of our investment in U.S. Security Associates. We received $55 million repayment on our unsecured debt investment, reducing our position from $135 million to $80 million. This repayment reduced an outsize position and improved the portfolio's concentration risk, which was one of our stated objectives. Repayments also included the full repayment of our investments in My Alarm Center, SCM insurance and MW Industries, among others.

Regarding our energy portfolio, at the end of September, oil and gas represented 6.9% of our portfolio at fair value, or $163 million across 3 companies. During the quarter, we funded $2.5 million into Glacier Oil & Gas. We continue to work closely with the respective management teams and may deploy some additional capital into these names during the coming quarters to support accretive development projects.

During the quarter, we hedged our oil exposure by entering a costless collar. More specifically, AINV purchased put options and sold call options on WTI. The options were structured so that the premium paid for the put options offset the premium received from selling call options, producing a costless collar. If oil prices decline, the gain on our hedge should mitigate the losses on our underlying investments. If oil prices rise, the loss on our hedge should be offset by an improvement in our underlying investments.

Now let me spend a few minutes discussing credit quality in the overall portfolio. No investments were placed on or removed from non-accrual status during the period. At the end of September, investments on non-accrual status represented 1.3% of the portfolio at fair value and 1.9% at cost.

The risk of our portfolio as measured by weighted average leverage and interest coverage for our portfolio companies was unchanged compared to the prior quarter. The current weighted average net leverage of our investments remained at 5.5x, and the current weighted average interest coverage remained at 2.7x.

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

Thank you, Tanner. Total investment income for the quarter was $66.5 million, essentially unchanged quarter-over-quarter. A decline in recurring interest income and dividend income was offset by higher fee and prepayment income.

Recurring interest income declined due to the lower average portfolio balance. Dividend income, which is primarily derived from our aviation and shipping investments as well as our remaining CLO investments, was $4.3 million for the quarter, down from $5.9 million last quarter. The decrease was primarily due to a lower dividend from Merx. We received a $2.25 million dividend from Merx, (inaudible) $6 million last quarter.

Prepayment income was $4 million in the quarter, compared to $3 million in the June quarter. Fee income was $2.6 million in the quarter, compared to $800,000 in the June quarter.

Expenses for the September quarter totaled $32.3 million, compared to $33.4 million in the June quarter. Expenses were down slightly quarter-over-quarter due to lower interest expense and lower G&A expenses.

The incentive fee [raise] for the quarter was 15%.

Net investment income was $34.2 million, or $0.16 per share, for the quarter. This compares to $33.3 million, or $0.15 per share, for the June quarter.

For the quarter, the net loss on the portfolio totaled $2.4 million, compared to a net loss of $4.5 million for the June quarter. Included within the $2.4 million net loss is an unrealized mark-to-market loss of $1.9 million, or $0.01 per share, on our oil and gas option contracts. However, assuming we hold these contracts until maturity and oil remains within the strike price range, we will not ultimately recognize any gain or loss on these contracts.

Excluding the unrealized loss on the oil hedge, the net change in NAV on the portfolio was essentially flat.

In total, our quarterly operating results increased net assets by $31.8 million, or $0.14 per share, compared to an increase of $28.8 million, or $0.13 per share, for the June quarter. Consequently, net asset value per share declined $0.01, to $6.72 per share, during the quarter, primarily as a result of the mark-to-market on our option contracts.

Turning to portfolio composition, at the end of September, our portfolio had a fair value of $2.4 million (sic) [$2.4 billion] and consisted of 87 companies across 24 industries. First lien debt represented 48% of the portfolio; second lien debt represented 32%; unsecured debt represented 5%; structured products, 5%; and preferred and common equity, 10%.

We were able to avoid yield compression as the weighted average yield on the debt portfolio at cost was 10.3%, unchanged quarter-over-quarter.

On the liability side of the balance sheet, we had $865 million of debt outstanding at the end of the quarter. Our net leverage, which includes the impact of cash and unsettled transactions, stood at 0.59x at the end of September, compared to 0.6x at the end of June.

We have also made some modifications to our liability. During the quarter, we increased the commitments under our revolving credit facilities by $50 million, bringing total commitments to $1.190 billion and the addition of 1 new lender.

Subsequent to quarter-end, in October, we redeemed all of our $150 million of our 6 5/8% unsecured notes that were due in 2042. We will recognize a realized loss of approximately $5.8 million on the extinguishment of these notes in the December quarter due to the acceleration of the associated unamortized debt issuance cost. There is an approximate 1-year payback period for this loss, given that the redemption of these notes will result in interest expense savings, going forward.

It is our current intention to redeem our 2043 notes when they become callable in July of 2018.

Regarding stock buybacks, during the period we repurchased approximately 660,000 shares at an average price of $5.99, inclusive of commissions, for a total cost of $4 million. We have continued to repurchase our shares subsequent to quarter-end under our 10b5 plan. Since the inception of the program a year ago and through yesterday, we have repurchased approximately 18.3 million shares, or 7.7% of initial shares outstanding, for a total cost of $108 million, leaving approximately $42 million available for future purchases under the current board's authorization.

This concludes our prepared remarks. Operator, please open the call to questions.

(Operator Instructions) Our first question comes from the line of Rick Shane, of J.P. Morgan.

Just want to talk about a couple of different things. When we look at the yield, it was flat quarter-over-quarter, at 10.3%. 3-month LIBOR was up, on average, probably about 15 basis points. You're at a point now where you should be off of the floors on most of the assets. You're now 91% floating rate. Is the offset here just spread compression and reinvestment risk on the new investments?

Correct. That is exactly right. And as we alluded to in the prepared remarks, we've allowed leverage to come down a little bit as we've encountered some of that spread compression. And your comments about off the LIBOR floor are correct, given where current 3-month sits today.

Got it. And then the next thing related to that on the liability side, obviously, you're redeeming some of the high-cost notes and high-cost fixed rate notes and essentially moving to more floating rate debt, so partially offsetting some of the asset sensitivity that you've created by the portfolio shift. Is the idea that you just think that LIBOR rates are going to stay low enough that even though you're going to give up a little bit of that asset sensitivity you're going to pick it up on margin?

Rick, I think that's a logical conclusion as we look at it at this point. I think it is our long-term goal as we manage our balance sheet to have a mix between fixed and floating. But in this current environment, I think moving to floating and using our credit facility is the prudent measure.

Got it. And then last question, is it going to turn out to be that it is more efficient to lock in some of that financing to increase your asset sensitivity in the swaps market? Is that a possibility, going forward?

Yes, it is an option as we look at it. You could swap to a floating. You could swap -- we could do that. Or to a fixed in that. So we are always obviously kind of looking at that based upon our different options.

Because I'm just thinking in the current environment where volatility is low, reducing swap costs or maybe even swaptions costs that that might be what you're thinking about in terms of some of reducing of those long-term notes.

Rick, I think these are very good ideas, and we will continue to look at them. I think it's a good idea.

Our next question comes from the line of Leslie Vandegrift, of Raymond James.

The first one, I know you mentioned it in the prepared remarks on how much was coinvested with Midcap. Was it $133 million? What was that number? I apologize.

The overall co-investments were about $125 million, roughly. That includes not just with Midcap but also co-investments with other (inaudible), not just Midcap.

Okay. And then for this coming quarter, is the outlook about the same, about half and half? Or are you guys seeing more opportunities with them right now as the risk kind of calms a bit after the prepayment activity last quarter?

Without predicting what's going to happen in the quarter, our intent is for, like, as large a portion as possible of our activity to be coinvested and as much as possible to be with Midcap, just because it is more protected from sort of the volatility -- from the pressure in the overall sponsored market. So it's our intent to have that number be as high as we possibly can.

Okay. And then on the rotation out of the non-core assets, obviously you had a lot of movement this quarter out of those. I think you said 73% core now of the whole portfolio. Now for the remaining of that, what's kind of the -- how long do you think you're looking at, for the next few quarters, another year or so, before you feel like most of that rotation is done?

So, again -- this is the key question. We don't expect it to get to zero when we sort of say we sort of settled in, because there's certainly assets that either are too compelling to get rid of or the prices don't match what we sort of understand is the underlying value. So let's start with that. So we're not done when it gets to zero.

I think there's some significant exposures that we're focused on. So one is Solarplicity, which we've talked about before on the renewables side. And then the other is sort of, generally, our oil and gas exposure. So those are the ones we're focused on. So if you looked at Glacier and Spotted Hawk and Solarplicity combined, you're talking about roughly $300 million of our book, and those are the ones we're focused on, on ultimately being able to move out of or at least being able to be comfortable with sort of complete stability there.

On the oil and gas side, for Glacier and Spotted Hawk, given where oil prices are, things have been on the operating side very good this quarter. And so things are going the right way. And so we put our hedge on in order to sort of try to lock some of that in, as they're also doing at the company level. On Solarplicity, we're in an active auction process.

So what I would say is moving out of one of those oil and gas names and moving out of Solarplicity, we would then sort of probably focus everybody on how we want them to think about it, going forward. Like, let's put that behind us and just assume it's going to dribble out, but stop thinking about that as a separate strategic challenge. And so when will that happen? Not sure, but hopefully sooner rather than later.

Okay. And then just last question, you mentioned wanting to stay at the lower leverage right now, below target. Because of the spread compression you're seeing, kind of wait it out a bit. Do you see yourself for the next couple of quarters probably staying at that lower level? Or is that something you're just going to wait maybe one more quarter for?

I think it's tough to say definitively when it will change. I think this current environment, as I think other of our peers have also recognized, it makes a lot of sense to be prudent, and it will be market dependent on when and how we approach our leverage over the coming quarters.

Our next question comes from the line of Kyle Joseph, of Jefferies.

Just first, in terms of yield trends, I know you mentioned on the call you're about halfway through sort of going through into the new strategy, but we saw yields sort of -- we did see yields actually increase Q-on-Q. Just given your evolution and the fact that we're seeing yields stabilize, is this a good run rate from here? Or would you still anticipate a little bit of contraction, given the strategy shift?

I think we would assume some contraction, assuming flat LIBOR. So obviously we should benefit from LIBOR increases versus that contraction. But we'd still -- again, hard to know exactly, but I think we sort of said around 10%, and I think that's still sort of prudent to use.

Got it. And then in terms of the industry, it's been kind of a challenging few quarters. Are you guys seeing any consolidation opportunities out there?

I think all the BDCs out there, public or private, that are exploring strategic alternatives, we're focused on, and you could presume we're kicking the tires sort of fullsomely as anybody else is. And I think, for us, given what we perceive as our long-term size of our pipeline versus our current balance sheet, it would benefit us to have more capital, because we think we could sort of put that to use just by sort of expanding our hold sizes [into] larger equity base.

And so we do think there's opportunities, but it's not like a secular thing. It's an anecdotal thing. But there's a few that this quarter have clearly said that they're looking at things. And so we will be as involved as anybody else is, for sure.

Got it. And then one last question from me. In terms of the deals you're passing on, is it a pricing, covenant or leverage issue? A combination of all 3? And then as a follow-up to that, are you seeing these deals sort of get done at those levels that they're asking you for?

The answer is, yes. In any one unique situation, it might be more so one or the other, but broadly speaking, this type of environment, which has not only been marked by quite a bit of demand, but less supply, and I think that's been well published, particularly in the middle market, you have any number of those that you enumerated have affected. And frankly, to the last part of your question, in these sorts of environments not only are we competing with other private credit managers, and the new fund formation there has introduced new entrants to that space, but so, too, do we compete with the syndicated market. And then when we -- so to answer the last part of your question, in those deals that are getting syndicated, you've seen a lot of those deals get [flexed] tighter and far inside of where we would have been evaluating that opportunity on a private basis.

(Operator Instructions) Our next question comes from the line of Jonathan Bock, of Wells Fargo.

Guys, can you walk me through just when we look at some of your long-term dated debt options why we haven't seen the prospect for a potential refinancing, just given that costs for same long-dated issues have really come in and given your size and strength it's entirely possible you could borrow cheaper than where have been the issues that you have outstanding on the balance sheet?

I think, Jonathan, it's a good question. I think if you think about the size of doing different and getting the best rates, I think what we'd like to do is get closer to the 2043 bond, taking that out. And then we've always been pretty clear that we'd like to have about 40% floating, 60% fixed and unsecured. And so we'll look to do that.

And I think there will be a better opportunity. I think if you just look at what's been done in the marketplace, size has been attracting considerably different rates when you look at the current deals that were done and the different spreads on the different companies. I think it's prudent to wait and use our revolver, and that's kind of why we have the facility. It's a 5-year facility. So we're very comfortable with using it at this time.

Our last question comes from the line of Ryan Lynch, of KBW.

First one kind of is a broader question. Can you -- how would you describe the competitive environment right now that we're seeing in the middle market? Obviously, that's competitive, but how would you kind of compare that with the competitive environment in the deals that you're seeing in the life sciences asset-based lending and lender finance versus the middle market kind of cash flow-based loans?

It is significantly different. I think the first thing is that new entrants into the leveraged loan market are significant and constant, and there's not nearly as many barriers to entry. And so you're finding almost every asset manager being able to sort of form some capital around that and focus on it and sort of believe they know how to do it, for a bunch of reasons. One, because generally those asset managers are borrowers in that space. So they think they know how to do it. And two, it's easier to originate, frankly, than the other more proprietary stuff. So people (inaudible) cheaper to do.

In the other areas, the competition happens less linearly. It's more -- it's somebody significant in size to enter that market. And so if you looked at those few markets over the past 3 or 4 years, there's more competition today than there was 3 or 4 years ago, certainly in the life sciences space, but you'd see 2 or 3 people who have entered over the last few years that have sort of compressed that.

But on the flip side, on the asset-based, for healthcare asset-based, the people we've competed with the most over the last few years have generally exited the market, GE Capital, for example, and that has (inaudible) better opportunity. And in general, asset-based lending, there have been a few entrants over the past year.

And so it really is much more anecdotal, which makes it much more appealing, because obviously anecdotal things go bad. Two, there could be a lot of them. But right now there's so much capital formation in the leveraged loan sponsor coverage, think that by definition it has to be better. And by and large, the platforms that are looking to sort of get a piece of the private credit world, because that's where LPs want to put their money, will only do it in leveraged loans, because it's cheaper and easier. And so that's what you're seeing.

At this time, I would like to turn the floor back over to management for any additional or closing remarks.

Thanks. On behalf of our team, we thank all of you today for your continued support. Please feel free to reach out to any of us if you have any questions. Have a great day.

Thank you, ladies and gentlemen. This does conclude today's conference call. You may now disconnect.