New Mountain Finance Corp (NMFC) 2016 Q3 法說會逐字稿

Good day, and welcome to the New Mountain Finance Corporation third quarter 2016 earnings conference call.

(Operator Instructions)

Please note this event is being recorded. I would now like to turn the conference over to Mr. Rob Hamwee, Chief Executive Officer. Please go ahead, sir.

Thank you, and good morning, everyone, and welcome to New Mountain Finance Corporation's third quarter earnings call for 2016. On the line with me here today are Steve Klinsky, Chairman of the NMFC and CEO of New Mountain Capital; John Kline, President and COO of NMFC; Teddy Kaplan, Head of our Net Lease Effort; and Shiraz Kajee, CFO of NMFC. Steve Klinsky is going to make an introductory remarks, but before he does, I'd like to ask Shiraz to make some important statements regarding today's call.

Thanks, Rob. Good morning, everyone. Before we get into the presentation, I would like to advise everyone that today's call and webcast are being recorded. Please note that they are the property of New Mountain Finance Corporation, and that any unauthorized broadcast in any form is strictly prohibited. Information about the audio replay of this call is available in our November 8, 2016 earnings press release.

I would also like to call your attention to the customary Safe Harbor disclosure in our press release, and on page 2 of the slide presentation regarding forward-looking statements. Today's conference call and webcast may include forward-looking statements and projections, and we ask that you refer to our most recent filings with the SEC for important factors that could cause actual results to differ materially from those statements and projections. We do not undertake to update our forward-looking statements or projections, unless required to by law. To obtain copies of our latest SEC filings, and to access the slide presentation that we'll be referencing throughout this call, please visit our website at www.newmountainfinance.com.

At this time, I'd like to turn the call over to Steve Klinsky, NMFC's Chairman who will give some highlights, beginning on pages 4 and 5 of the slide presentation. Steve?

The team will go through the details in a moment, but let me start by presenting the highlights of another solid quarter for New Mountain Finance. New Mountain Finance's adjusted net investment income for the quarter ended September 30, 2016, was $0.34 per share, in the middle of our guidance of $0.33 to $0.35 per share, and once again, covering our Q3 dividend of $0.34 per share. New Mountain Finance's book value was $13.28 per share, as compared to $13.23 per share last quarter, a $0.05 increase per share. We're also able to announce our regular dividend for the current quarter, which will again be $0.34 per share, an annualized yield in excess of 10% based on Monday's close.

The Company invested $172 million in gross originations in Q3, and had $141 million of repayments in the quarter, maintaining a fully invested balance sheet. During this quarter, we further diversified our sources of credit, issuing two attractively priced tranches of unsecured debt. Additionally, in light of a very strong pipeline of investment opportunities in Q4, in October we raised $79 million of new equity. NMFC's external manager provided significant financial support for this offering, allowing the Company to raise this capital at an effective price of $13.75 per share, significantly above our book value.

Finally, we made our first two investments in our new net lease vehicle, an area we believe strengthens and diversifies NMFC's core franchise, and which Teddy Kaplan will discuss in greater depth shortly. In summary, we are pleased with NMFC's continued performance and progress overall. With that, let me turn the call back over to Rob Hamwee, NMFC's CEO.

Thank you, Steve. Before diving into the details of the quarter, as always I like to give everyone a brief review of NMFC and our strategy. As outlined on page 6 of our presentation, NMFC is externally managed by New Mountain Capital, a leading private equity firm.

Since the inception of our debt investment program in 2008, we have taken New Mountain's approach to private equity, and applied it to corporate credit, with a consistent focus on defensive growth business models and extensive fundamental research within industries that are already well-known to New Mountain. Or more simply put, we invest in recession-resistant businesses that we really know and that we really like. We believe this approach results in a differentiated and sustainable model that allows us to generate attractive risk-adjusted rates of return across changing cycles and market conditions. To achieve our mandate, we utilize the existing New Mountain investment team, as our primary underwriting resource.

Turning to page 7, you can see our total return performance from our IPO in May 2011 through November 4, 2016. In the 5 1/2 years since our IPO, we have generated a compounded annual return to our initial public investors of 10.1%, meaningfully higher than our peers in the high yield index. Page 8 goes into a little more detail around relative performance against our peer set, benchmarking against the 10 largest externally managed BDCs that have been public at least as long as we have.

Page 9 shows return attribution. Total cumulative return continues to be driven almost entirely by our cash dividend, which in turn has been more than 100% covered by NII. As the bar on the far right illustrates, over the 5 1/2 years, we have been public we have effectively maintained a stable book value, inclusive of special dividends, while generating a 10.5% cash on cash return for our shareholders fully supported by net investment income. We are very happy to be able to deliver this performance over a period of time, where risk-free rates have been effectively zero, and we'll strive to continue this performance.

We attribute our success to, one, our differentiated underwriting platform; two, our ability to consistently generate the vast majority of our NII from stable, cash interest income in an amount that covers our dividend; three, our focus on running the business with an efficient balance sheet, and to always utilizing, and always fully utilizing inexpensive appropriately structured leverage before accessing more expensive equity; and four, our alignment of our shareholder and management interest. Our highest priority continues to be our focus on risk control and credit performance, which we believe over time is the single biggest differentiator of total return in the BDC space.

If you refer to page 10, we once again, lay out the cost basis of our investments, both the current portfolio, and our cumulative investment since the inception of our credit business in 2008, and then show what has migrated down the performance ladder. Since inception, we have made investments of over $4 billion in 186 portfolio companies, of which only 6 representing just $84 million of cost have migrated to non-accrual, and only three representing $32 million of cost have thus far resulted in realized default losses. This $32 million figure reflects 80% of the Transtar position classified as a realized loss. No new names have been put on non-accrual this quarter, and approximately 98% of our portfolio at fair-market value is currently rated 1 or 2 on our internal scale.

Page 11 shows leverage multiples for all our holdings above $7.5 million when we entered an investment, and leverage levels for the same investment, as of the end of the current quarter. While not a perfect metric, the asset by asset trend and leverage multiple is a good snapshot of credit performance, and helps to provide some degree of empirical fundamental support for our internal ratings and marks. Because as you can see by looking at the table, leverage multiples are roughly flat, or trending in the right direction with only a few exceptions.

The three loans that show negative migration of 2.5 turns or more, are the same names we have been discussing for a number of quarters, including our two prior period non-accruals, Transtar and Permian. The final loan is a first lien loan to an energy services business, that while cyclically challenged, continues to have substantial liquidity, and which we expect to be current for the foreseeable future. Permian has completed its restructuring early in Q4, and we believe long-term prospects for a meaningful recovery on our initial investments are good. The Transtar restructuring is still ongoing, but given its current status we do expect a significant loss, as reflected in our 9/30 mark of $0.10 on the dollar.

The chart on page 12 helps track the Company's overall economic performance since its IPO. At the top of the page, we show how the regular quarterly dividend is being covered out of net investment income. As you can see, we continue to more than cover 100% of our cumulative regular dividend out of NII.

On the bottom of the page, we focus on below the line items. First, we look at realized gains and realized credit, and other losses. As you can see looking at the row highlighted in green, we have had success generating real economic gains every year, through a combination of equity gains, portfolio Company dividends, and trading profits. Conversely, realized losses, including default losses highlighted in orange, have been smaller and less frequent, and show that we are typically not avoiding non-accruals by selling poor credits at a material loss prior to actual default.

We have suffered our first significant realized loss since our IPO with Transtar, but despite that, continue to have a net cumulative realized gain of $21 million highlighted in blue. Looking further down the page, we can see that cumulative net unrealized depreciation highlighted in gray stands at $50 million, and cumulative net realized and unrealized loss highlighted in yellow is at $29 million, an improvement of $3 million from last quarter. I will now turn the call over to John Kline, NMFC's President to discuss market conditions and portfolio activity. John?

Thanks, Rob, as outlined on page 13, throughout 2016, we have seen strong performance in the credit markets, driven by good economic conditions, generally positive flows into leveraged credit, and an increased desire for yield in the current low rate environment. As expected, post summer deal activity has been strong.

Generally, there's been a healthy balance between new deal flow and investor demand. Recently, however, the broader markets, particularly the high yield market, has been slightly weaker due to concern about the prospects for higher rates in the future. This continues a reoccurring theme that we have seen that shows healthy tension between positive and negative market forces, that have maintained asset yields in an acceptable range for our investing strategy. Looking forward, we expect a good environment for deal activity for the remainder of the fourth quarter.

Turning to page 14, NMFC is well-positioned in the event of future rate increases, as 86% of our portfolio is invested in floating rate debt. Meanwhile, we have locked in about half of our liabilities at fixed rates to assure attractive borrowing costs over the medium-term. The bottom line, as the chart of the bottom page shows is given our investment portfolio and liability mix, NMFC is positively exposed to continued rising short-term rates.

Moving onto portfolio activity, as seen on pages 15 and 16, Q3 investment activity increased from Q2. Total originations were $172 million, offset by $141 million of repayments, and $12 million of sale proceeds yielding a use of cash of $20 million. Our new originations consisted of new platform investments, continued investment in the SLP2, an investment in our newly formed net lease real estate entity. Since the end of the quarter, we've continued our strong investment pace with $88 million of new investments, offset by $127 million of sales and repayments, yielding a net source of cash of $40 million. Based on our pipeline of both committed and expected deals, we expect to utilize the proceeds from our equity offering, and continue to operate the business within our target leverage range.

Page 17 shows that during the quarter, our originations and repayments were skewed towards first lien by asset type, which is a reflection of good opportunities that we've found in the first lien and unit tranche loan markets. Meanwhile our sales and repayments were 58% first lien, and 42% second lien and other. Asset yields as shown on page 18, ticked up slightly from last quarter to 10.4%. Despite the continued strong market, we've had success finding portfolio investments with attractive yields in our core defensive growth industries like software, distribution logistics, and business services, that we believe will perform well in a variety of economic environments.

On page 19, we show a balanced portfolio across our defensive growth-oriented sectors, and a healthy mix between first and second lien investments. On the lower right, it is important to note that the vast majority of our portfolio continues to perform at or above our expectations. Finally, as illustrated on page 20, we have a broadly diversified portfolio with our largest investment at 3.6% of fair value, and the top 15 investments accounting for 39% of fair value. With that, I will now turn it over to Teddy Kaplan to discuss our net leasing investment strategy. Teddy?

Thank you, John. I want to give everyone a brief overview of our strategy within the single tenant net lease real estate space, the area of focus of NMFC's newly formed REIT entity. We seek to buy operationally critical real estate assets with long-term leases. Just as with NMFC's credit investments, these real estate investments reflect the benefit of the existing New Mountain investment team, from an origination and underwriting perspective.

We are first and foremost focused on the credit quality of our [assets]. We are further focused on identifying mission-critical real estate assets that are operationally complex to vacate, thus providing long-term high rates of occupancy within the portfolio with limited downside. Underwriting these operational complexities is something we feel New Mountain is well-positioned to do, given its extensive experience owning and operating businesses as a private equity investor.

Overall, we target non-cancellable leases of 12 to 20 years with low double-digit yields, using modest asset level mortgage financing. In the third quarter, we closed two transactions with an average cash on cash yield of in excess of 12%, and a targeted IRR inclusive of annual rent escalators in excess of 15%. With that, I will now turn it over to our CFO, Shiraz Kajee to discuss the financial statements and key financial metrics. Shiraz?

Thank you, Teddy. For more details on our financial results and today's commentary, please refer to the Form 10-Q that was filed last evening with the SEC. Now I would like to turn your attention to slide 22. The portfolio had approximately $1.55 billion in investments at fair value at September 30, 2016, and total assets of just over $1.6 billion. We had totally liabilities of $769 million, of which total statutory debt outstanding was $597 million, excluding $121.7 million of [grown] SBA-guaranteed debentures. Net asset value of $848.2 million or $13.28 per share was up $0.05 from the prior quarter. As of September 30, our statutory debt to equity ratio was 0.71.

On slide 23, we show the historical NAV per share and leverage ratios, which are broadly consistent with our current target statutory leverage of between 0.7 and 0.8 to 1. We also show the NAV adjusted for the cumulative impact of special dividends which portrays a more accurate [profession] of true economic value creation. On slide 24, we show our quarterly income statement results. We believe that our adjusted NII is the most appropriate measure of our [operating] performance.

This slide highlights that while realizations in unrealized appreciation/depreciation can be volatile below the line, we continue to generate stable net investment income above the line. Focusing on the quarter ended September 30, 2016, we earned total investment income of approximately $41.8 million, slightly up from the prior quarter. Total net expenses of $20.1 million, are also up slightly from the prior quarter.

As mentioned in the prior calls, due to the merger of our Wells Fargo credit facilities, and consistent with the methodology since our IPO, the investment advisor will continue to waive management fees on the leverage association, associated with those assets that share the same underlying yield characteristics, with investments leveraged under the legacy SOF credit facility. This results in an effective annualized management fee of 1.4% for the quarter, which is in line with prior quarters.

It is expected based on our current portfolio construct that the 2016 effective management fee will be broadly consistent with prior years, and it is important to note that the investment advisor cannot [preclude] management fees previously waived. This results in third quarter adjusted NII of $21.7 million or $0.34 per weighted average share, which is in line with guidance, and covers our Q3 regular dividend of $0.34 per share. In total, for the quarter ended September 30, 2016, we had an increase in net assets resulting from operations of $25.1 million.

As slide 25 demonstrates, our total investment income is recurring in nature, and predominantly paid in cash. As you can see, 93% of total investment income is recurring, and cash income remains strong at 94% this quarter. We believe this consistency shows the stability and predictability of our investment income.

Turning to slide 26, as briefly discussed earlier, our adjusted NII for the third quarter covers our Q3 dividend. Given our belief that our Q4 adjusted NII will fall within our guidance of $0.33 to $0.35 per share, our Board of Directors has declared a Q4 dividend of $0.34 per share, in line with the past 18 quarters. The Q4 quarterly dividend of $0.34 per share will be paid on December 29, 2016, to holders of record on December 15, 2016.

Finally on slide 27, we highlight our various financing sources. During the quarter, we upsized our convertible notes and unsecured notes by approximately $40 million each. We believe that both these deals enhance our liquidity, and provide stable capital at attractive rates, with no borrowing base requirements. Taken into account SBA guaranteed debentures, we had a little over $1 billion of total borrowing capacity at September 30, 2016. As a reminder, our Wells Fargo credit facility's covenants are generally tied to the operating performance of underlying businesses that we lend to, rather than the marks of our investments at any given time. At this time, I would like to turn the call back over to Rob.

Thanks, Shiraz. It continues to remain our intention to consistently pay the $0.34 per share on a quarterly basis for future quarters, so long as the adjusted NII covers the dividend in line with our current expectations. In closing, I would just like to say that we continue to be pleased with our performance to date. Most importantly, from a credit perspective, our portfolio overall continues to be healthy. Once again, we'd like to thank you for your support and interest. And at this point, turn things back to the operator to begin Q&A. Operator?

Thank you.

(Operator Instructions)

And our first question will come from Jonathan Bach of Wells Fargo Securities. Please go ahead.

Good morning. Joe Mazzoli filling in for Jonathan Bach this morning.

Hey, Joe.

Good morning. You have no doubt generated substantial returns for shareholders since the IPO, but today's environment is becoming more competitive, right? We've got a lot of capital formation in the middle market, strong technicals in the syndicated market, and with an estimated cost of capital of over 10% on the recent equity offering, can you provide some color as to how your deal pipeline is kind of coming together, because with average new investments yields in the quarter of around 9.5%, it seems that new investments could be falling below that threshold?

Sure, Joe. So I'm not sure where your 9.5% is coming from. If you look at the slide on page 18, we're sort of mid-10%s. Now that obviously is consistent with sort of where we've been, and sort of where we expect to continue to be. So we do feel like we are earning this hypothetical cost of capital.

I'm not overly sympathetic to this whole quote/unquote cost of capital argument, frankly. I think if we can earn, whether it's a 10.5% or a 9.5% in this rate environment with de minimis default losses, that's a great outcome for our investors. So, but in any event, we're currently running kind of in the 10%s, and our expectation is, even in what is unarguably a competitive market, we can continue to do that.

Okay. That totally makes sense. And I think I may have been missing actually the yield on the new REIT, that may have been the difference there.

Now, the largest new investment in the quarter was the first lien investment in Redbox. And so this was an L plus 750, which is attractive for a 3B facility rating first lien position. But when kind of approaching an investment like this, do you think of it as again, this is a great risk-adjusted return here on this asset, and so we're going to kind of put capital to work? Or do you kind of consider that within the overall investment mix in the quarter?

Yes. I mean, we've always done a blend of things with the yields, ranging from as low as the 7%s to the high as the mid-teens. And that's always been a key part of our strategy, and to blend that into sort of 10% plus or minus that we've been consistently able to deliver for the shareholders.

What's critical for us, is less whether it's an 8% or a 12% or a 10%, than is it do we have great insights into the business, and based on those insights, do we fully expect to get paid under virtually all circumstances that we can imagine? So that's our litmus test, not so much any one-off absolute yield, or exactly where it is in the capital structure.

Okay. Thank you for that. And now the final question. So you invested $17 million this quarter into the REIT strategy. And while we know that there's certainly could be the potential, and I'm sure there will be the potential for outsized returns here, we've also seen other BDCs dive into a REIT strategy, albeit a different type of REIT strategy from what we've seen.

Do you believe that it's appropriate to move beyond traditional real estate assets within your newly formed REIT? And then we also saw that you made a strategic hire. So if you could provide a little bit more color as to your real estate capabilities, I think that would be helpful?

Yes, absolutely. So just to be clear, right, the REIT is a wrapper. What's important are the underlying assets, and those underlying assets are effectively loans to operating businesses, that once again, we know and like through our New Mountain work.

So to us, this is just another way to have frankly, a differentiated product offering to our sponsor clientele, that allows us to get the incremental security, not just of the corporate credit, but actually have the backstop of the real estate as well. So we're really excited about this niche business, we think we can really earn some excess return, given the niche nature of it.

You're not going to see us buying office buildings and hotels and other things in the REIT. The REIT again, is a wrapper of convenience. But what's key, are these assets going in there. And again, we're not doing this -- we believe we've sort of over-resourced this effort by bringing in someone of Teddy's status in the industry, really one the leaders in this nichey field, and Teddy's going to further build out his team over time.

But yes, to us, this is just another way, in an enhanced and secured way to do what we've done sort of all along with the business.

Yes, and this is Steve Klinsky. Let me add one comment because I worked to recruit Teddy, and this was an effort that we started preparing for, I think a year and three quarters ago. Teddy was one of the leaders of Angelo Gordan's practice in the space, which is one of the major practices, has an outstanding personal track record.

And again, if you can get the yield that we're talking about getting, without pre-payment risks because these are long duration assets, where you don't -- if the company's doing great, you don't get pre-paid. You can own it for a long duration, have the rents rise over time, so they become a more valuable assets, and are collateralized by both the credit of the company, and the value of the real estate. And these are assets that are indispensable to the company.

Even if they did go bankrupt, they would keep the assets, if they were going to just stay in existence. We think it's just another great way to strength and diversify the core franchise. So that's the philosophy behind it.

That totally makes sense, and thank you very much for taking my questions this morning.

Yes. Thanks, Joe.

Our next question will come from Ryan Lynch of KBW. Please go ahead.

Hey, Ryan.

Hey, good morning. Thanks for taking my questions. Just to follow up a little bit more on the conversation about the leasing. So you brought in Teddy to kind of run this operation. So obviously, he has some expertise in this area, but are there any sort of benefits, or can you, I'm assuming there are, can you describe the benefits that you guys are going to tap in from the New Mountain platform that allows you, and gives you have guys confidence to be making these leases going forward?

Yes. Sure, I think Teddy is frankly best fit to answer that, so I'll turn it over to Teddy.

So just to take a step back. If you think about what we're buying, these are primarily operationally critical real estate assets that are leased to the portfolio of companies of financial sponsors. So at the name level, the credits if you will, look very similar to the credits that we've bought through NMFC over a very long period of time, and that we're capable of underwriting from a private equity perspective.

So two of the things that we do is, first and foremost, we underwrite credit in very much the way that we've underwritten credit at NMFC and PE deals at the NMC level. Furthermore, we underwrite the way that the real estate connects to the credit, from an operational criticality standpoint. And I would argue that we're very well-positioned to do that, because of our history of owning and operating businesses as a firm, and as a adviser to NMFC.

And that was what was very attractive to me, in terms of thinking about joining the firm, was that is the critical capability of underwriting these investments successfully is, one, to get the credit underwriting correct. And two, to understand how the real estate connects to such credits through operational criticality, and I'd argue that New Mountain is uniquely positioned to do that.

Okay. Is there any sort of size limitation or how big do you guys foresee this asset class being, as either a potential portfolio, or just an absolute dollar amount call it, two to three years from now?

Yes. I think the best way to think about it is percentages. We've always talked about sort of 10% to 15% as sort of the upper bound. And that's still sort of where I would be guiding people towards.

Okay. And then just one technical, last technical one on the lease one. Because it's structured as a REIT, is this considered a non-qualified asset or not?

Yes.

For you?

Yes. It would be a non-qualified asset for the BDC.

Okay.

Yes, and so (multiple speakers)

And -- (multiple speakers)

It's, yes, it's a qualifying -- sorry.

It's a qualifying -- (technical difficulty)

Sorry. Yes. No, we are still preserving our capabilities, within our 30% bucket. We really haven't used that very aggressively, so we still have that in our meaningful [light].

Sorry, you broke up there for a second there. So this is one of the 70% qualifying assets (inaudible) -- ?

Yes.

Okay. Perfect. And then, one about your fee structure. You guys have done a really good job, and have made a point of waiving fees for loans that would originally fit in your original [SOF] facility, and that's definitely benefited shareholders nicely. And it's basically effectively reduced your guys management fee to around 1.4% from 1.75%. So it's been a really beneficial concession you guys are giving to shareholders.

I'm not sure that the market gives you have guys full credit for it. So I mean, pending that there isn't any meaningful plans to meaningfully shift your guys portfolio or investment strategy around it, why not change the fee structure to the more simplified version, which I think would give you guys more credit in the markets?

I guess, there's really two elements to that. And thank you, we appreciate that, that at least some folks do recognize, and I think we get maybe a little more credit than hopefully none.

But there's -- we do like the flexibility that if the mix over time does change, that does preserve flexibility. And also there's a technical element to this, that change would require shareholder approval, which is that there's obviously expense and degrees of pain associated with that. So I think we do think about the issue. I'll say never say never, but right now, it's just not on our near-term radar screen.

Okay. Great. Those are all the questions for me. Thanks for taking them.

Great, thanks, Ryan.

Our next question will come from Jim Young of West Family Investments, please go ahead.

Hi, Jim.

Yes, hi. I just wanted to clarify the offering of 5.75 million shares, where you mentioned that you had net proceeds of $79.1 million or $13.75 per share, but that excludes offering expenses. So net of offering expenses, how much did you raise per share?

So the shares were offered to the public at $13.50 per share. However, and then the manager paid all expenses associated with that deal, so the true net proceeds to the Company were $13.50 per share. But then on top of that, the manager also made a payment, effectively the covering the re-offered discount to get the actual proceeds, the cash proceeds received by the Company back to $13.75 per share.

Okay. Great. Thank you for the clarification. I appreciate it.

You're very welcome.

And our next question will come from Chris Kotowski of Oppenheimer & Co. Please go ahead with your question.

Hi, Chris.

Hi. Just back on the lease vehicle, because it's new and it's interesting, how much do you intend to lever the vehicle? And it describes it as non-recourse asset leverage. I assume that means non-recourse to NMFC, but it's recourse to the -- to the lease, to the REIT?

No, no. Actually that's one the great things about the business is, is there's no leverage at the REIT level. Each asset has leverage against it. That leverage is both a non-recourse back to NMFC obviously, but more importantly, is non-recourse to the REIT and to all the other assets within the REIT.

So if there is any, ever a problem with any of the asset, individual assets within the REIT and the associated leverage, there's no way for that problem to impact any other elements of the REIT. So you're truly only exposed to your individual equity investments at each asset level. And that's, we really like that element of the strategy.

Right. Okay. And it's generally, how long a term is the funding on these? Or is each deal the spoke?

Yes, they're generally the spoke, but 10 years. I mean, we're pretty well matched from a life of lease and the term of the asset level funding.

10 years and fixed rate for 10 years.

Okay. Interesting. And but, so what we will see, when we see disclosures on this is, we'll just see NMFC's equity contribution, we won't see the individual assets or the leverage on the assets? It will look like just an equity contribution to the LeaseCo?

That is correct. And what we'll recognize from an income perspective will be the dividend that the REIT pays up to NMFC.

Okay. All right. Thank you. That's it for me.

Great. Thanks, Chris.

(Operator Instructions)

Our next question will come from Bryce Rowe of Baird. Please go ahead.

Thanks, good morning.

Hey, how are you doing?

Doing well. Doing well. Was curious, all the questions I had on the net lease business were asked and answered, but did want to get a feeling for the upcoming pipeline? And if there are any SBA eligible investments that you might use the capacity on the SBIC on?

Yes. So we have one SBA eligible investment that's approved through our committee, that they're not done until they're done, but we're in documentation on, and we would expect to close in the next few weeks. And then there are two of the visible pipeline, that is in advanced diligence and advanced terms, there are two candidates within the pipeline, neither of those to get to the finish line, both of them could, one of them could. But yes, we do have some candidates, reasonably advanced candidates there.

Right. That's helpful, Rob. And then just curious, what you're seeing from a mix standpoint within the capital structure? This past quarter was heavier first lien, than would be in the overall portfolio now. Is that kind of the focus, or is that just more flavor of what you're seeing right now, and what's available to you? Thanks.

Yes. I mean, I hate to kind of beat the dead horse, but we focus first and foremost on the business, and the security leads us to where the opportunity is, or the opportunity leads us to the security. We're not, we don't go out saying, okay, we're trying to source extra first lien this quarter, or extra mezz this quarter or whatever it may be. So I'd say the current pipeline is reflective of kind of our traditional and durability consisting roughly 50/50 mix.

But if any quarter, such a small sample, every quarter, idiosyncratically, we could be like where we were this quarter, two-thirds first, and one-third other. In other quarters, you've seen we've been one-third first and two-thirds other. So it's just it's so dependent on which of the remaining deals in the pipeline get to the finish line, whether we're at 50/50, 60/40 or 40/60.

Yes. All right. Thank you, guys. Appreciate it.

Yes. Thank you.

Our next question will come from Mitchell Penn of Janney. Please go ahead.

Hey, Mitchell.

Hey, a quick question. On the REIT, are you guys exposed to either rising cap rates or rising interest rates?

Sure. Yes, the short answer is yes, but let me let Teddy speak a little bit to that.

So we think about that a lot, and one thing I just want to mention is that real estate cap rates are less correlated to broader interest rates, than I think might be intuitive, and there's plenty of data to support that. Where there is a greater correlation is between cap rates and risk spreads. And we're still seeing very wide risk spreads on our underlying cost of debt, that we would expect could absorb raises in the underlying base rate or risk-free rate, and historically that has been the case.

Most importantly, the debt that we put on these deals is assumable by future buyers. So to the extent that our cap rates wind up looking to be below market cap rates, typically what that means is that the assumable debt in place is also below market level debt, and therefore the equity yield that we can pass onto a future buyer remains whole. And that is something in my personal history has proven to be the case, where I've been able to execute on the sale of assets at below-market cap rates, because the debt that was being passed on on an assumed basis to the buyer was also a below-market level or rate of debt, I should say.

Will a rising cap rates impact the dividend? So quarter to quarter, are we subject to, let's say cap rates rise 1%, would that impact the mark on the property, and then the dividend would be impacted?

So the dividend will, the dividend will certainly not be impacted. Like all assets we own, we will use varying techniques to determine fair-market value. So yes, all else equal, material changes in cap rates could have an impact from a book value perspective. But you could say the same thing about any other interest rate rise on our fixed-rate assets within the portfolio.

I would also say, if you look at page 14, we've pretty materially in recent quarters increased the fixed component of our funding sources, we're all the way up to 50/50 now fixed floating. So we've been very conscious about that, using the current low interest rate environment to add to our fixed sources of funding, which we think gives us some flexibility to add a little bit of duration to the portfolio.

And as we've said, the flip side of adding the duration, is we do get very strong call protection, i.e. these are not callable, and they do have escalators built in. So we think we're very consciously thinking about our match between our funding sources and our assets. And under all circumstances, we'll maintain a positive exposure to rising rates.

Got it. One last question. Are you guys responsible for tenant improvements?

No. Under traditional structure, we're not responsible for any tenant improvements. In rare circumstances, we might be willing to fund tenant improvements for the tenant. But we would do so, only if we earned a specific return, equal or greater to the deal level return on that capital.

And most importantly, we would push the construction risk, to the extent that any existed onto the tenant. And to be very specific, the way that we would do that, is the tenant would perform the work, and all liens would be waived on the construction work, before we would advance any capital against such work.

Got it. Okay. Thank you.

Yes. Thank you, Chris.

Ladies and gentlemen, this will conclude our question-and-answer session. I would like to turn the conference back over to Mr. Hamwee for any closing remarks.

Great. Well, thanks, everyone. As always, we appreciate the support and the interest, and look forward to getting back on the phone next quarter. Have a great day. Bye-bye.

The conference has now concluded. Thank you for attending today's presentation. You may now disconnect your line.