New Mountain Finance Corp (NMFC) 2017 Q3 法說會逐字稿

Good morning, and welcome to the New Mountain Finance Corporation's Third Quarter 2017 Earnings Conference Call. (Operator Instructions) Please note this event is being recorded.

I would now like to turn the conference over to Rob Hamwee, CEO of New Mountain Finance Corporation. Please go ahead.

Thank you. And good morning, everyone, and welcome to New Mountain Finance Corporation's third quarter earnings call for 2017. On the line with me here today are Steve Klinsky, Chairman of NMFC and CEO of New Mountain Capital; John Kline, President and COO of NMFC; and Shiraz Kajee, CFO of NMFC.

Steve Klinsky is going to make some 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 7 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 will 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?

Thank you, Shiraz. The team will go through the details in a moment, but let me start by presenting the highlights of another strong quarter for New Mountain Finance.

New Mountain Finance's net investment income for the quarter ended September 30, 2017, was $0.35 per share, at the high end of our guidance of $0.33 to $0.35 per share and once again covering our quarterly dividend of $0.34 per share.

New Mountain Finance's book value was stable at $13.61 per share as compared to $13.63 per share last quarter. We are also able to announce our regular dividend, which, for the 23rd straight quarter, will again be $0.34 per share, an annualized yield of nearly 10% based on last Friday's close.

The company had another productive quarter of deal generation, investing $202 million in gross originations versus repayments of $203 million, which keeps us fully invested.

Credit quality remains strong. There were no new non-accruals once again this quarter, and we have no portfolio companies on our credit watch list.

I and other members of New Mountain continue to be very large owners of our stock, with aggregate ownership of 9.2 million shares or approximately 12% of total shares outstanding.

Finally, the broader New Mountain platform that supports NMFC continues to grow, with over $20 billion of assets under management and 130 team members.

In summary, we are very 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'd 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 model 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 3, 2017. In the 6.5 years since our IPO, we have generated a compounded annual return to our initial public investors of 11%, meaningfully higher than our peers and the high-yield index and approximately 1,000 basis points per annum above relevant risk-free benchmarks.

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 largely driven by our cash dividend, which in turn has been more than 100% covered by net investment income. As the bar on the far right illustrates, over the 6.5 years we have been public, we have effectively maintained a stable book value, inclusive of special dividends, while generating a 10.4% cash-on-cash return for our shareholders, fully supported by net investment income.

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 always fully utilizing inexpensive, appropriately structured leverage before accessing more expensive equities; and four, our alignment of shareholder and management interests.

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. I am pleased to report that there has been no negative credit migration this quarter.

If you refer to Page 10, we once again lay out the cost basis of our investment, both the current portfolio and our cumulative investments 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 nearly $5.1 billion in 213 portfolio companies, of which only 7, representing just $112 million of costs, have migrated to non-accrual, of which only 4, representing $43 million of costs, have thus far resulted in realized default losses. Further, virtually 100% of our portfolio at fair market value is currently rated 1 or 2 on our internal scale.

Page 11 shows leverage multiples for all of our holdings above $7.5 million when we entered an investment and leverage levels for the same investment as of the end of the most recent reporting period. While not a perfect metric, the asset-by-asset trend in leverage multiple is a good snapshot of credit performance and helps provide some degree of empirical, fundamental support for our internal ratings and marks.

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. Only 2 loans show negative migration of 1.5 turns or more.

One, which has been in our watch list as a 3 for a number of quarters prior to this one, is Paradigm Software, which, while underperforming financially, has a strong strategic position in its end market. The company announced in early October that it was being acquired by Emerson Electric in a transaction expected to close in approximately 60 days that will result in our debt being paid off in full at par.

The second company, Edmentum, which we restructured in 2015, is performing broadly in line with its restructuring plan.

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 gain, portfolio company dividends and trading profits.

Conversely, realized losses, including default losses, highlighted in orange, have generally 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.

As highlighted in blue, we continue to have a net cumulative realized gain of $12 million. Looking further down the page, we can see that cumulative net unrealized depreciation, highlighted in gray, stands at $23 million, and cumulative net realized and unrealized loss, highlighted in yellow, is at $11 million.

The net result of all this is that in our 6.5 years as a public company, we have earned net investment income of $455 million against total cumulative net losses, including unrealized, of only $11 million.

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, the credit markets continue to show broad-based strength. The middle market, which is our primary focus, remains very competitive. The highest-quality deals are fully leveraged, with spreads that are 50 to 100 basis points tighter than 1 year ago.

While most of the deals that we finance continue to have very high levels of cash equity, we have observed an increasing trend towards lower sponsor equity contributions on many other transactions in the market. Additionally, there's currently a high level of repricing activity as sponsors are opportunistically using the strong market to improve pricing on their existing deals.

On the positive side, since our last call, 3-month LIBOR has increased by approximately 8 basis points to 1.39%, which has provided us with a small but valuable offset to the competitive spread environment. Looking forward, we are optimistic that there will be significant new deal activity in the closing months of the year, and we remain confident in our ability to source great deals in our core defensive growth industries.

Turning to Page 14. NMFC continues to be well positioned in the event of future rate increases as 85% of our portfolio is invested in floating-rate debt. Meanwhile, we have locked in 53% of our liabilities at fixed rates to ensure attractive borrowing costs over the medium term. 3-month LIBOR has increased to 139 basis points, which is roughly 40 basis points above the average LIBOR floor on our floating-rate assets.

As the chart on the bottom of the page shows, given our investment portfolio and liability mix, NMFC is very strongly positioned in the event of an increase in short-term rates. Even a moderate increase in the base rate of 100 basis points adds $0.11 or 7.9% to our annual net investment income.

Moving on to portfolio activity. As seen on Pages 15 and 16, NMFC had an active quarter with total originations of $202 million, offset by $203 million of portfolio repayments and $10 million of sale proceeds.

Our 6 largest transactions made up about 80% of our total new originations, including 2 deals purchased by our SBIC subsidiary. The majority of these new deals were club-style executions sourced within our key industry verticals. 5 out of the 6 core deals are new sponsor-backed buyouts, all with equity contributions of 50% or greater. The quality of these new deals in a competitive market shows the continued success of the broad sourcing network that we have built.

Since the end of the quarter, we have continued our consistent investment pace with $122 million of new investments, offset by $115 million of sales and repayments. These repayments are largely the result of opportunistic refinancings, which we have seen accelerate in the second half of this year.

Turning to Page 17, we show the breakout of investments by asset type. On the left side of the page, we show that our new Q3 originations were weighted towards first lien, while on the right side, we show that our repayments were weighted towards second lien. While this mix changes the composition of our investment portfolio slightly in the short term, we don't anticipate a material change in our overall investment mix in the coming quarters. In fact, shown on Page 16, thus far in Q4, our originations are weighted materially towards non-first lien assets.

As shown on Page 18, in Q3, asset yields on new originations of 9.5% were somewhat lower than the average yield of the portfolio. This is due primarily to the first lien-heavy mix on new originations in the quarter and secondarily due to the spread compression that we have experienced in the marketplace.

Looking forward, we seek to maintain our historical credit standards and avoid stretching for more yield on riskier loans. As a result, spread compression will continue to be a risk to the portfolio.

With this in mind, we do see an opportunity to mitigate more potential spread compression through higher income from rising base rates, continued fee generation on new deals and prepayments and increased utilization of our SBA financing program. To this end, we are very pleased to announce that we have been approved for our second SBIC license, which allows us to access another $150 million of SBA debt.

On the top of Page 19, we show a balanced portfolio across our defensive growth-oriented sectors. In the services section of the pie chart, we show a breakout of subsectors to give better insight into the diversity within our largest sector. On the bottom of the page, we continue to maintain our targeted mix between senior and subordinated investments. And on the lower right, we show that we continue to have an exceptionally clean portfolio with virtually no exposure to underperforming loans.

Finally, as illustrated on Page 20, we had a broadly diversified portfolio, with our largest investment at 5.7% of fair value and the top 15 investments accounting for 41% of fair value.

With that, I will now turn it over to our CFO, Shiraz Kajee, to discuss financial statements and key financial metrics. Shiraz?

Thanks, John. 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'd like to turn your attention to Slide 21. The portfolio had approximately $1.87 billion in investments at fair value at September 30, 2017, and total assets of $1.95 billion. We had total liabilities of $919 million, of which total statutory debt outstanding was $696 million, excluding $144 million of drawn SBA-guaranteed debentures.

Net asset value of $1 billion or $13.61 per share was down $0.02 from the prior quarter. As of September 30, our statutory debt-to-equity ratio was 0.67:1. Pro forma for investments that are not closed at quarter end, as reflected in the $79 million of other liabilities, the ratio would have been 0.74:1.

On Slide 22, we show our historical leverage ratios, which are broadly consistent with our current target statutory leverage of between 0.7 and 0.8:1. On the slide, we also show the historical NAV adjusted for the cumulative impact of special dividends, which portrays a more accurate reflection of true economic value creation.

On Slide 23, we show our quarterly income statement results. We believe that our NII is the most appropriate measure of our quarterly performance. This slide highlights that while realized and unrealized gains and losses can be volatile below the line, we continue to generate stable net investment income above the line.

Focusing on the quarter ended September 30, 2017, we earned total investment income of $51.2 million. This represents an increase of $1.2 million from the prior quarter, largely attributable to an increase in prepayment activity. Total net expenses were approximately $24.9 million, a slight increase from the prior quarter.

As in prior quarters, the investment adviser continues to waive certain management fees such that the effective annualized management fee is 1.4%. It is important to note that the investment adviser cannot recoup fees previously waived. This results in third quarter NII of $26.3 million or $0.35 per weighted average share, which is at the high end of guidance and covered our Q3 dividend -- regular dividend of $0.34 per share. In total, for the quarter ended September 30, 2017, we had an increase in net assets resulting from operations of $24.8 million.

Slide 24 demonstrates our total investment income, recurring in nature and predominately paid in cash. As you can see, 88% of total investment income is recurring, and cash income remained strong at 85% this quarter. We believe this consistency shows the stability and predictability of our investment income.

Turning to Slide 25. As briefly discussed earlier, our NII for the third quarter covered our Q3 dividend. Given our belief that our Q4 2017 NII will fall within our guidance of $0.33 to $0.35 per share, our Board of Directors has declared a Q4 2017 dividend of $0.34 per share, which will be paid on December 28, 2017, to holders of record on December 15, 2017.

Finally, on Slide 26, we highlight our various financing sources. Taking into account SBA-guaranteed debentures, we had approximately $1.1 billion of total borrowing capacity at quarter end with no near-term maturities. Post quarter end, we extended the maturity on our Wells Fargo credit facility from 2019 to 2022.

As a reminder, the Wells Fargo credit facility's covenants are generally tied to the operating performance of the underlying businesses that we lend to rather than the marks of our investments at any given time. With that, 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 very 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?

(Operator Instructions) The first question today comes from Jonathan Bock with Wells Fargo.

Joe Mazzoli filling in for Jonathan Bock. The first question, so there's no doubt that you do have several opportunities for NOI support -- several levers, I should say, through additional leverage of the core balance sheet, which it sounds like there's progress there already in the fourth quarter, but also SBA debentures. And of course, congratulations on receiving the second license.

So the question relates to the pipeline for the second SBIC license and then also the types of deals that fall into that. Of course, there are certain requirements, but if you could provide some color around the structure -- or not the structure but the segment of these deals, are these still sponsor backed acyclical deals? Or would you throw in some non-sponsored deals that might not typically be a focus for New Mountain?

Yes, no. I mean, just to be very clear, Joe, we will never change our criteria just to select something that happens to fit for the SBA as much as we'd like to see that get ramped up over time.

So we started always with New Mountain-style acyclical businesses that we know really well from our PE side. And if those businesses happen to have the characteristics that allow them to fit in the SBA, then so much the better. And that's how we ramped up the first facility. And we expect, just based on now almost 10 years both pre-BDC and after BDC, a certain percentage of our deals just naturally have the scale, maybe other elements that allow them to fit in the SBA.

So we would expect that over time, and we have a few things in the -- in various stages of the pipeline that would fit. Whether those make it to the finish line, who knows? But we'd expect to scale up the second license the exact same way we scaled up the first license. But one thing we're never going to do is change our criteria to put something into the SBA facility.

That's helpful. And of course, shareholders appreciate that conservative and patient approach. So the second question relates to the New Mountain Net Lease Corp. And it looks like the portfolio was fairly stable quarter-over-quarter. So is this -- does this continue to be an opportunity for growth? Or are you comfortable with the current portfolio size? Just some thoughts on where we see this going in the coming quarters.

Sure. No, we continue to have an active effort there. It has been quiet for a couple of quarters, but we actually have a few things that are going to close -- likely to close this quarter, and there's a deeper pipeline of things behind that.

Again, we never do any deal whether on the net lease side or in the main BDC to -- for the sake of doing a deal in any category. So it will continue to be episodic, but we do expect net lease activity over time to continue to build. And the one nice thing about the net lease side is it doesn't have the churn, of course, that we see in the regular way, sponsor-financed business -- these are 15-year assets typically that are not prepayable.

So that -- it's sort of a slow and steady build, but it adds upon itself. You don't have to replace old assets at nearly the pace you otherwise would. So yes, we do expect to continue to see growth on the net lease side, but it will be lumpy in nature.

That's helpful. And then for a final question, this relates to the substantial fair value increase in your second lien investment in Pinnacle. I think the loan was marked in the high -- the second lien loan was marked in the high 70s, now it's marked into the mid-90s. If you could provide some color around the company and the underlying performance, I'm sure there must be some performance improvement here?

Yes. And that actually -- Pinnacle is Paradigm, which I touched on in the prepared remarks. It was underperforming financially but was announced that it was being acquired by Emerson in early October. So we're going to be taking out at par within 30 to 60 days. So that mark reflects that announcement.

And we'd expect a further modest write-up to par when the takeout occurs either by the end of this quarter or very early next quarter. We've seen the purchase and sale contract. It's a very tight contract. So we have very, very high expectations that that deal will close as expected and announced.

Okay. That makes sense. And apologies, that's right, that you already touched on that. But...

Yes, but no, it remains a little tricky because yes, I know, it shows up as Pinnacle. That's the actual technical holdco that we talked on the SOI. But you're right, it's -- Pinnacle and Paradigm are the same entity. So I should have made that clearer on the call.

(Operator Instructions) The next question comes from Paul Johnson with KBW.

Just a follow-up on Joe's question about the SBIC and your outlook for growth there. I'm just wondering, are you guys comfortable, I guess, sort of over the long-term running leverage, effectively higher -- total leverage higher by utilizing that SBC perhaps into the 90s, mid-90s percent of total leverage?

Yes, we are. I mean, we manage the business really against the statutory leverage. And obviously, we always want to have that cushion given the 1:1 statutory cap, so we, as you know, run that in the 0.7 typically. But we are comfortable having economic leverage that creeps up modestly higher than that given the attractive nature of the SBA financing.

Great. And then I guess my next question is just a little bit more technical. Hopefully, it's the easy one, but I'm just kind of trying to get a quick number on the income from the net lease corp. I'm sort of backing into, like, $642,000 for the quarter. Does that sound about right?

Yes, that's about right. So we've been running for this year about $700,000 a quarter roughly. So I think on the SOI, you see about $2.1 million in aggregate. That's about right, which is roughly at 10.3% return roughly -- net of expenses on the portfolio.

Okay, okay, that's great information. And then my last 2 questions real quick, I guess, would just be -- first, would you describe the fourth quarter of this year so far as more or less competitive in any way than what we've seen for year-to-date?

I would describe it as consistent with the last couple of quarters. I mean, John, you have a different view there?

Yes. We tried to get that -- to that in our prepared remarks, but I agree with that 100%. I think we've been at a competitive level in the market for, honestly, the last 6 months, and we don't see it getting worse or better. It's just consistent.

Okay. And then finally, I was just wondering if you could possibly provide any sort of outlook on your investment in Edmentum education. I saw that it was marked down 80% this quarter, and it's a sub debt investment. I was just wondering if there's any sort of commentary you could make on that company.

Yes, sure. I mean, I would say that -- as you may recall, we restructured Edmentum a couple of years ago. We've been using -- we've been working with -- us and the 3 other owners that control the company now have been working with the management team to really kind of fix some of the issues that have caused the company to have the downdraft in earnings to begin with. The earnings have been relatively stable.

The key news at Edmentum is we've brought in a new CEO as of the summer, who we're really, really excited about and who has already in 3 or 4 months injected a lot of positive energy into the company and really developing a multiyear road map to return the company to growth in what is a growthful market.

So really, it's all about execution. And we think we were maybe lacking a little bit in execution with the legacy leadership, and now we've got somebody who's got a proven track record in the space. And so we're -- it's going to take time because education, the selling cycles are long, and the lag between selling and recognizing revenue is there.

But we're excited about the prospects. But we have to mark the book more based on trailing numbers as well as projections. And as we get a new strategic plan from the new management team in the coming months, that may be reflected in the BCS that drives the valuation. So we're in a little bit of an in-between stage right now. But we are long term quite optimistic about the prospects for Edmentum.

(Operator Instructions) Since there seems to be no questions, this concludes our question-and-answer session. I would like to turn the conference back over to Rob Hamwee for any closing remarks.

Thank you. Well, thanks, everyone. We appreciate as always the interest and the support and look forward to speaking again next quarter. Bye-bye now.

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