MidCap Financial Investment Corp (MFIC) 2023 Q2 法說會逐字稿

Good afternoon, and welcome to the earnings conference call for the period ended June 30, 2023, for MidCap Financial Investment Corporation. (Operator Instructions)

I will now turn the call over to Elizabeth Besen, Investor Relations Manager for MidCap Financial Investment Corporation. Please go ahead, ma'am.

Thank you, operator, and thank you, everyone, for joining us today. Speaking on today's call are Tanner Powell, Chief Executive Officer; Ted McNulty, President; and Greg Hunt, Chief Financial Officer. Howard Widra, Executive Chairman, as well as additional members of the management team are on the call and available for the Q&A portion of today's call.

I'd like to advise everyone that today's call and webcast are being recorded. Please note that they are the property of MidCap Financial 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 press release. I'd like to also 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. You should refer to our most recent filings with the SEC 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 from what's required by law. To obtain copies of our SEC filings, please visit our website at www.midcapfinancialic.com.

I'd also like to remind everyone that we posted a supplemental financial information package on our website, which contains information about the portfolio as well as the company's financial performance. Throughout today's call, we will refer to MidCap Financial Investment Corporation as either MFIC or the BDC, and we will use MidCap Financial to refer to the lender headquartered in Maryland.

At this time, I'd like to turn the call over to our Chief Executive Officer, Tanner Powell.

Thank you, Elizabeth. Good afternoon, everyone, and thank you for joining us today. I will begin today's call by highlighting our results for the June quarter, and we'll then provide our thoughts on the current environment. Following my remarks, Ted will cover our investment activity and portfolio, and we'll also provide an update on credit quality. Lastly, Greg will review our financial results in detail. We'll then open the call to questions.

Beginning with our results, we're very pleased with our performance for the June quarter given our strong net investment income, a slight increase in net asset value per share and stable credit quality. Net investment income per share for the June quarter was $0.44, well above the current $0.38 dividend, as we continue to see the benefit of higher base rates on our floating rate assets.

We are particularly pleased with these results when considering the relatively muted transaction environment, which resulted in below-normal prepayment income. At the end of June, NAV per share was $15.20, an increase of $0.02 from the end of March, which reflects earnings in excess of the dividend, stable credit quality and includes approximately $0.01 per share accretion from the stock -- from stock buybacks.

We are pleased to report that we continue to observe relatively stable credit quality in our portfolio. We're seeing that most of our portfolio companies are able to handle higher interest costs. We constructed our portfolio to withstand challenging periods.

As a reminder, our Corporate Lending and Other portfolio, which makes up 92% of our portfolio, primarily consists of first-lien, top-of-the-capital structure loans, is well diversified by borrower and the industry, is largely sponsor-backed and has what we consider to be robust documentation and financial covenant. At the end of June, 96% of our corporate lending debt portfolio on a cost basis or 97% on a fair value basis had one or more financial covenants.

Let me -- sorry, next, let me give a brief update on Merx. As discussed previously, we are focused on reducing our investment in Merx. While we don't expect the paydown to occur evenly, we believe aircraft sales and servicing income should allow for the paydown of third-party trade level debt and MFIC's equity and debt investment in Merx. Although Merx did not sell any aircraft in its portfolio during the June quarter, Merx repaid $3.5 million to MFIC, which applied to the revolver -- which was applied to the revolver. At the end of June, our investment in Merx totaled $193 million, representing approximately 8% of our total portfolio at fair value.

Turning now to the market environment. The heightened volatility that we saw in the first quarter stemming from the regional banking crisis subsided as the quarter progressed despite ongoing concerns about inflation, higher interest rates and fears about recession. Against this backdrop, new issue volumes were slow, driven primarily by slower M&A activity, partially offset by add-on activity as sponsors pursue bolt-on acquisitions. We still see financial sponsors, particularly those focused on the middle market, seeking financing solutions in the private credit market. We continue to observe more lender-friendly pricing and terms on new commitments compared to prior vintages, although we are seeing the pace of increases plateau.

Moving to the dividend. Our Board of Directors declared a dividend of $0.38 per share to shareholders of record as of September 12, 2023, payable on September 28, 2023. A $0.38 dividend represents an annualized dividend yield of 10% at NAV -- on NAV. At current base rates, we are well positioned to generate net investment income in excess of this dividend level. We believe our portfolio will continue to earn above the current dividend in a normalized rate environment. Our Board and management team continue to evaluate potential dividend increases versus retaining earnings.

With that, I will turn the call over to Ted.

Thank you, Tanner, and good afternoon, everyone.

Beginning with investment activity, as a reminder, MFIC is focused on investing in loans sourced by MidCap Financial, an affiliate of Apollo Global, which provides MFIC with a large pipeline of investment opportunities. MidCap Financial is a leading middle-market lender with one of the largest direct lending teams in the U.S. with close to 200 investment professionals.

MidCap Financial was active during the June quarter, closing approximately $4.4 billion in new commitments. Specific to MFIC, new corporate lending investment commitments during the quarter totaled $79 million, all first lien, across 15 different borrowers for an average new commitment of $5.2 million as we continue to emphasize diversification by borrower. 17% of new commitments were made to existing portfolio companies.

We continue to observe favorable pricing at lower leverage levels for newly originated loans. The weighted average spread on new commitments was 681 basis points with an average OID of approximately 266 basis points. This translates into a very attractive weighted average yield of approximately 12.5% based on current base rates. The weighted average net leverage of new commitments was 3.7x.

In terms of funded investment activity, gross fundings, excluding revolvers for the corporate lending portfolio, totaled $73 million. Higher interest rates and a lack of new deal activity led to a slowdown in repayment activity. Sales and repayments totaled $58 million. Net revolver fundings totaled $11 million. And we also received a $3.5 million paydown for Merx, as Tanner mentioned. In aggregate, net fundings for the quarter totaled $22 million.

Turning to our investment portfolio. At the end of June, our investment portfolio had a fair value of $2.41 billion and was invested in 150 companies across 25 different industries. Corporate Lending and Other represented 92% of the total portfolio, and Merx accounted for 8% of the total portfolio on a fair value basis. 95% of our corporate lending portfolio was first lien.

We continue to have conservative weighted average attachment and net leverage on our corporate loans of 0.1x and 5.45x, respectively. Both of these metrics were flat compared to the prior quarter, which we consider to be another indication of our portfolio's stable credit quality. At the end of June, the average funded corporate lending position was $15.4 million or approximately 0.7% of the total corporate and other lending portfolio.

MFIC is focused on lending to the core middle market where MidCap Financial has strong long-standing relationships with sponsors and borrowers and a proven track record across cycles. As of the end of June, the median EBITDA of the MFIC's corporate lending portfolio companies was approximately $55 million. We believe the core middle market offers attractive investment opportunities across cycles and does not compete directly with either the broadly syndicated loan market or the high-yield market.

The weighted average yield at cost of our corporate lending portfolio was 11.7% on average for the June quarter compared to 11.3% last quarter, driven by an increase in base rates. These yield figures are an average of the beginning and the end of the quarter. At the end of June, the yield of the corporate lending portfolio at cost was 11.9%, up from 11.5% at the end of March. The weighted average spread across the corporate lending portfolio was 614 basis points, up 1 basis point compared to last quarter.

Turning to credit quality. Our portfolio companies continue to have solid fundamental performance with positive revenue and EBITDA growth. We're not seeing any signs of overall credit weakness, although we have observed a deceleration in top line growth and some margin pressure. We've not seen a meaningful increase in covenant breaches or a pickup in amendment activity.

We believe our credit quality has benefited from MidCap Financial's strong sourcing and underwriting capabilities. Based on data since mid-2016, which is the approximate date upon which we began utilizing our co-investment order, MFIC's annualized net realized and unrealized loss rate on loans sourced by MidCap Financial is extremely low at approximately 1 basis point. The weighted average net leverage of the companies in our corporate lending portfolio was 5.45x, unchanged compared to the prior quarter. As mentioned, the net leverage on new commitments was 3.7x, well below the portfolio average.

Moving to interest coverage. The weighted average interest coverage ratio was 2.1, down from 2.3x last quarter with 4 companies below 1x. If we utilize June 30 base rates, the interest coverage would be 1.6x compared to 1.7x last quarter in that stress test scenario.

In the coming quarters, we are closely monitoring these situations, which we believe are manageable as these companies either have strong current liquidity or the underlying businesses are performing well. We want to underscore that we have not increased PIK income to create interest coverage. Importantly, MFIC benefits from MidCap Financial's large dedicated portfolio management team of nearly 60 investment professionals, which helps identify and address issues early.

It is also important to note that MidCap Financial leads and serves as administrative agent on the majority of our deals, which provides meaningful downside protection. As agent, we are in active dialogue with the borrowers and have enhanced information flow, which allows us to be proactive in resolving problems in credit -- problem credits as issues arise. We are also monitoring near-term maturities to identify any potential risk of repayment so that we can address any issues early and proactively work with borrowers to help them meet their liquidity needs.

As part of our investment process, we are mindful of the specific fund making an acquisition as we believe sponsors are more likely to support businesses and funds with greater remaining duration. We continue to have very low levels of nonaccruals. No investments were placed on nonaccrual status during the quarter. At the end of June, investments on nonaccrual status totaled $7.5 million or 0.3% of the total portfolio at fair value.

With that, I will now turn the call over to Greg to discuss our financial results in detail.

Thank you, Ted, and good afternoon, everyone.

Beginning with our financial results, net investment income per share for the June quarter was $0.44 as we continue to benefit from higher base rates on our floating rate assets and improved net interest margin. Prepayment income declined quarter-over-quarter due to lower prepayment activity. Prepayment income was approximately $600,000 compared to $2.6 million last quarter.

Fee income also declined compared to the prior quarter. Fee income was approximately $1 million in the June quarter compared to $2.2 million last quarter. PIK income remained very low, representing approximately 1.2% of total investment income for the quarter. GAAP net income per share for the quarter was $0.39.

NAV per share at the end of June was $15.20, an increase of $0.02 since the end of June. The $0.02 increase reflects net investment income of $0.44, which is $0.06 above the $0.38 dividend; $0.05 per share net loss on the portfolio; and approximately $0.01 accretion from stock buybacks. Additional details on unrealized net gain and losses are shown on Page 16 in the earnings supplement.

Total expenses for the quarter were $39.8 million, up $1.5 million compared to last quarter, primarily due to higher interest expense. Gross management fees totaled $4.3 million, essentially flat quarter-over-quarter. As a reminder, MFIC's base management fee was reduced to 1.75 on equity beginning January of 2023. Among listed BDCs, MFIC's management fee is the lowest, and we are the only BDC to charge management fees on equities -- on equity, which we believe provides a greater alignment and focus on net asset value.

Gross incentive fees totaled $6.1 million for the quarter. As a reminder, our incentive fee on income is 17.5% and includes a total return hurdle with a rolling 12-quarter look-back. We believe our fee structure is best-in-class amongst listed BDCs and provides a strong alignment of interest with our shareholders. For the quarter, we generated an annual ROE based on net investment income of 11.6% and an annualized ROE based on net income of 10.2%.

Moving on, from a balance sheet perspective, our net leverage stood at 1.4x at the end of June. As highlighted last quarter, in April, we were pleased to extend the maturity of our senior secured revolving credit facility by over 2 years to April 2028. We also are pleased that Kroll affirmed our investment-grade rating in June. During the quarter, we repurchased approximately $2.3 million of stock, which had a $0.01 accretive impact on NAV per share.

This concludes our prepared remarks, operator, and please open up the call for questions.

(Operator Instructions) Our first question comes from Arren Cyganovich from Citi.

Maybe you could just talk a little bit about how your conversations with equity sponsors are right now. Are you seeing any kind of loosening up in terms of increasing activity? I know it's August now, so I imagine a seasonal slowdown happening. But just in general relative -- since we have some better lender-friendly type of terms today.

Sure. Thanks for the question, Arren. So in terms of -- I'll try to handle it in 2 aspects. As it relates to, I think, which is primarily what your question is getting at, in terms of overall activity, notwithstanding the kind of the summer doldrums, which we inevitably encounter in August, we are seeing a modest tick-up from earlier in the year off of a relatively low base. I think that there's a Bain report -- Bain Capital report that came out that said LBO volume was down 50% in the second quarter. We're seeing a modest uptick in a more -- and a greater willingness to engage from LBO sponsors.

The second aspect of our conversation of sponsors relates to those companies where either they're trying to do something strategic and/or things are moving sideways. And we continue to see a very healthy level of support from the sponsors. And in particular, in this type of environment, one of the ways that sponsors are electing to try and counter the bid-ask spread, if you will, in terms of expectations on multiples is by completing add-on acquisitions. And that dialogue has been very, very healthy and shows continued equity support for the underlying borrowers.

Our next question comes from Kyle Joseph with Jefferies.

Just on the portfolio yield side, obviously, that's been expanding. How much of that is base rates? And how much of it is spread movement? I know you mentioned it's kind of -- still kind of a more lender-friendly environment out there.

Yes. Thanks, Kyle. In terms of the spread, let's just talk spread to help you disaggregate it there, in the quarter, we deployed at 681 and an OID of just over 2.5 points, which reflects what we've seen for a number of quarters, which is a very attractive environment for private credit lenders. Notwithstanding the downdraft in M&A, private credit is able to service a disproportionate share of M&A that's getting done. And more broadly against that backdrop, it continues to be lender-friendly.

To my response to Arren's question, we're seeing -- if I were to look at the deals that are being screened today, there might be a slight tightening in terms of spread as M&A picks up and people are feeling better about prospects and/or there is some level of stabilization, which is enabling sponsors to make better decisions and/or risk appetite has improved as we get further from some of the stress that we saw earlier this year, not to say that all has been mitigated. But generally speaking, thanks that markets are feeling a little bit better relative to what was a relatively low base for much of the first half of the year.

Very helpful. And then one follow-up for me. You mentioned some of the banking volatility negatively impacted deal flow. But stepping back from a longer-term perspective, with potentially higher capital requirements at banks, do you see that in the longer-term opportunity for MidCap but also the BDC sector as a whole?

Yes, absolutely. I'm sorry, I should have drawn the distinction there. I think, Kyle, when we see periods of volatility, which in this case earlier this year happened to be related to banking stress, there was more broadly a greater reticence to transact. And it wasn't necessarily a function of whether banks were able to provide that financing or not. But you just saw reduced volumes, which were more connected to volatility and has less to do on whether or not the banks were providing it.

As we and our peers have stressed and we are huge believers in, we continue to benefit very much from a secular trend that has private credit taking share from the banking system as we roll forward, and we expect that to continue.

Our next question comes from Sean-Paul Adams, Raymond James.

I think you guys had shared some light on the amount of companies you guys have been at below a 1x interest coverage ratio. Do you guys have the exact numbers about the portion of the total portfolio that those companies represent and your -- and maybe share some thoughts on your total outlook for your general portfolio as interest coverage might continue to decline later in the year?

Yes, sure. And thanks for your question. The -- I'll start with the outlook, which is if base rates -- to state the obvious, if base rates continue to increase, our borrowers as well as everyone else's borrowers are going to face increased pressures. We run a number of different stress tests and scenarios around what those numbers could look like in different types of situations.

As to the existing portfolio, the ones that we have that are below 1x now, in some cases, sponsors are putting in equity to cover that. In other cases, there's still sufficient liquidity, and we're in active dialogue with those.

Our next question comes from Melissa Wedel, JPMorgan.

First, I wanted to start with some of the capital return activities and comments you made on the call. I know last quarter, you talked about a potential special dividend at some point. Based on the comments you made today about the Board continuing to evaluate sort of over-earning and whether to pay that out versus retain it, I guess the question would be, is the Board still thinking about a potential payout in the form of a special? Or has that conversation evolved a bit to something else?

This is Howard. I think effectively, everything is on the table, meaning we have -- it is a cornerstone of our -- of the goal for us is to have stable NAV. We are helped by that by over-earning the dividend. We also have both requirements, obviously, to pay out a certain amount of income as well as sort of a desire, obviously, to return to the shareholders the -- some excess return.

And so the answer is, if you did this over a longer period of time and we were out-earning what is our core dividend, $0.06, $0.07 a share each quarter as were in the last 2 quarters, there's sort of room for both. But so -- but it's a year -- it's effectively a decision. I would say as much as we -- the thing that sort of has been decided, the decision that we will sort of make at the end of the year so that like we'll retain it for now and then make it through the year about the size of what we may or may not do.

So I know that's not that definitive, but we're just sort of trying to like balance all things. And obviously, if base rates continue to go up or even they went up in July, obviously, just now, and there's some -- and our fee income builds off a very low base, we could even out-earn the dividend by even more, and so then there's even more room for both options.

Okay, understood. I appreciate the delving into the framework. That way is helpful. In terms of the share repurchase activity that you did, I noticed that, obviously, it ticked up. I think the last repurchase activity was about a year ago. As we think about moving forward and the capital allocation choices that you have in front of you, you've got a really attractive investment environment, you've got net leverage kind of where it is, I think, towards the midpoint of your target range, if I'm looking at this right, and how should we think about you guys evaluating those opportunities for appetite for additional share repurchase versus deploying capital into an attractive environment?

Yes, I mean it's -- the buying back of shares is a -- it's definitely a function of the things you said, obviously, how levered we are and how much capital we have, but more importantly is compare it against alternative investments. And we bought back those shares much earlier in the quarter at markedly lower prices than we're at today. And so -- which changes sort of the return on that buyback multiple hundreds of basis points. So it does change that metric. So we're always looking at it.

And so obviously, if yields on assets or opportunities went down, that could change the appetite at this price because we still think that it's a good value. But when there are these lending opportunities at this level based on where we've traded to now, that balance is different. So I think the answer is, we will buy back shares when it is clearly accretive to the shareholders versus all other options, right? Paying dividends, making a different loan, delevering, and we felt that was the case at the level we were able to buy shares very early in this quarter.

(Operator Instructions) Our next question comes from Paul Johnson, KBW.

So I guess just with everything that's occurred, I guess, in the first half of this year and based on kind of what you're seeing from sponsors' behavior and appetite for deals today, do you think that we've reached or maybe we're approaching an inflection point in terms of just kind of risk appetite from sponsors? And if that is the case, I guess, what do you guys kind of expect for the remainder of the year? And maybe more so like 2024, are you expecting a big year or just kind of a slower recovery to normalization?

Yes, sure. Thanks, Paul. And let me make a quick comment before opining on your question. I think one of the parts of our story that we try to stress quite a bit is that we're at $2.4 billion of a $30 billion business. And that affords us a nice strategic advantage in that in any given quarter, there is plenty of volume. And as we called out in our prepared remarks, MidCap -- the broader MidCap, the Bethesda MidCap did $4.4 billion of originations in the given quarter. And that gives us a dynamic where we're less sensitive to the ebbs and flows in deal volume.

In terms of the inflection point, what we hear from sponsors in our discussions, and not to give you half the answer by any stretch of imagination, but what we have seen while there is some volatility, the dispersion from the -- has been reduced, and there's some modicum of stabilization while things were -- and that's not to say that no one is discounting the potential for higher rates. And at least being able to say that I've got something that's unlikely to go up materially from here has enabled sponsors when they digest the implications to the next buyer's ability to pay, particularly if it's a sponsor-to-sponsor buyout that enables models to be able to be run with a greater degree of confidence and precision.

And so I think that's the impetus currently as well as also some distance from the stresses that we saw earlier in the year as well as some upside to economic trends. But it would be very premature to call the inflection point as data on the front lines is changing. But certainly, some modicum of reprieve there, and that's what we've sort of seen in the kind of post quarter-end period with some modestly higher M&A volume and activity levels.

Got it. I understand. It's always difficult to predict. My other question is just a little more specific to Merx. I'm just -- I'm trying to kind of understand, as I do understand, these are obviously fixed rate, fixed payment leases on the underlying aircraft. This is obviously a portfolio company that's in runoff with you guys.

But in terms of aircraft leasing, comparable lease rates, I guess, is how I would term it, for any sort of borrower in the market, what are the current, I guess, set of comparable rates that are available to lessees? And what I'm sort of getting at is, are any of these borrowers, when they go to renew leases or I don't know if it's possible to refinance leases, are these being done at higher fixed payments? Is that driving a longer average life of the assets, pushing out that sort of termination data? I'm just curious how that works.

Yes, absolutely. And what could be a very long answer, I'll try to be specific here. And first and foremost is with respect to the assets that we have on the books today, yes, they are fixed leases, but we have fixed debt costs against those. And then -- so then as you play it forward and we look at kind of the next buyer analysis, so we look at transitioning those leases, ultimately, a plane is an economic instrument utilized by airlines to make money, in the same way you see plane tickets going up to kind of recover the broader increase in interest rates. And ultimately, because of the long duration of a lot of leases, there's a lag there, maybe even more significant than what you'd otherwise see in maybe the leveraged loan market. But notwithstanding, that does adjust. And you do -- you will see that become reflected in how there's -- the lease rates.

One quick comment also, one of the aspects that gives us some cautious optimism in terms of reducing our exposure in Merx right now is that it is, generally speaking, a good yield environment for leasing companies. The increase in demand is well documented. And at this juncture, actually, domestic revenue passenger miles are actually above COVID levels. International is lagging slightly. And overall, we're at 96%. But importantly, with Asia having recently come back online, we would expect increases in demand there.

And that's -- on the other side of the equation, in terms of supply, we continue to see issues with Airbus and Boeing to deliver significant amounts of lift. And as a result, put aside the question you asked about lease rates and interest rates, notwithstanding we're seeing a healthy environment for lease rates and leasing on account of those supply-demand dynamics, which we hope will support our disposition efforts at Merx and to reduce that exposure.

Appreciate that. So interesting dynamic, and obviously, this conversation could go on a lot longer, but appreciate the abbreviated answer, and that's all for me.

Our final question comes from Kenneth Lee, RBC Capital Markets.

Wasn't sure whether this was discussed already, but wondering if you could just talk about any amendment activity you've been seeing in the portfolio, whether they're just a routine or whether they're out of the ordinary.

Yes, sure. So the activity level on the amendment side of things has not ticked up materially. We do have -- most of our borrowers and most of our transactions have a set of covenants in them. And so when borrowers come back and want to grow, as we mentioned before, they're looking to do accretive acquisitions, or if there are things where covenants are getting tight and sponsors want to be proactive, that brings us to the table to have those discussions.

And our stance when we've been doing that is looking to derisk and/or get enhanced economics around it. And so if a sponsor is looking for additional cushion on a leverage covenant, for example, we're going to put -- we may grant that cushion, but they were going to have step downs. And then it also provides the opportunities for fees, and we can also look at the spreads as well.

So the bigger picture is we have covenants, so we are in dialogue. The tone and the pace of amendments has not increased materially as kind of at the same pace as it has been over the last several quarters. But when it does occur, we view that as an opportunity as well to either derisk or enhance the economics.

Got you. Very helpful there. And then just one follow-up, if I may, and this is just a follow-up question from an earlier one about originations. Given that you see a lot of the potential deal flow from the broader MidCap origination platform, and perhaps you're a little bit less dependent upon deal flow there or M&A activity, would it be fair to say that the key constraints to originations over the near term would be more on the underwriting, finding the appropriate deals, the appropriate returns, leverage constraints more so than broader industry trends?

Yes. Yes, I mean as we've mentioned, MidCap closed on over $4 billion of new commitments in the last quarter. We get to look at those, look to see what fits into our portfolio from a diversification standpoint and, obviously, from a yield and structure standpoint. So in terms of constraints to new activity, it's certainly not the top of the funnel because we get that via MidCap.

What we've continually expressed in terms of leverage is a range of 1.4 to 1.6 and a desire to stay at the lower end of that range. And so you've kind of seen us in between 1.4 and 1.45 over the last several quarters. And so as we think about deploying into new capital, we're balancing our desire to be in that leverage range with the attractive opportunities that are out there.

We have no further questions in the queue at this time. I would now like to turn the call back over to today's speakers.

Thank you, operator. Thank you, everyone, for listening to today's call. On behalf of the entire team, we thank you for your time today. Please feel free to reach out to us if you have any other questions, and please have a good evening.

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