New Mountain Finance Corp (NMFC) 2018 Q3 法說會逐字稿

Good morning, and welcome to the New Mountain Finance Third Quarter 2018 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. Mr. Hamwee, please go ahead.

Thank you, and good morning, everyone, and welcome to New Mountain Finance Corporation's third quarter earnings call for 2018. 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?

The team will go through the detailed performance, 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, 2018, was $0.36 per share, above our guidance of $0.33 to $0.35 per share, and more than covering our quarterly dividend of $0.34 per share. New Mountain Finance's book value was stable at $13.58 per share as compared to $13.57 per share last quarter. We were also able to announce our regular dividend, which for the 27th straight quarter will again be $0.34 per share, an annualized yield of over 10% based on last Friday's close.

The company had a very productive quarter of deal generation, investing $489 million in gross originations versus repayments of $280 million, as we continue to deploy the incremental leverage approved by shareholders last quarter. Once again, we were able to access the debt capital markets at attractive rates, issuing 2 new notes. Credit quality remains strong, with no new nonaccruals.

I and other members of New Mountain continue to be very large owners of our stock, with aggregate ownership of 9.7 million shares, approximately 13% 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 over 145 team members. 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'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 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 2, 2018. In the 7.5 years since our IPO, we have generated a compounded annual return to our initial public investors of over 10%, meaningfully higher than our peers and the high yield index and approximately 900 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 NII, as the bar on the far right illustrated. Over the 7-plus 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. 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 equity; and four, our alignment of 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. Credit performance continues to be strong, with no new nonaccruals during the quarter and no material quarter-over-quarter credit deterioration in any single name. If you refer to Page 10, we once again lay out the cost basis of our investments, 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 over $6.3 billion in 248 portfolio companies, of which only 8 representing just $125 million of cost have migrated to nonaccrual, of which only 4 representing $43 million of cost 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 over $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 and 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.

The only loans with negative migration of 2.5 turns or more are the same 3 loans discussed last quarter, none of which have experienced material changes in current leverage ratios or medium-term prospects;. These 3 loans include the previously restructured Edmentum, where prospects remain bright; National HME, where we expect an imminent closing on the balance sheet restructuring discussed last quarter; and a third issuer, where we continue to believe the likelihood of payment default is low.

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 generally been smaller and less frequent and show that we are typically not avoiding nonaccruals by selling poor credits at a material loss prior to actual default. As highlighted in blue, we continue to have a net cumulative realized gains, which currently stands at $9 million

Looking further down the page, we can see that cumulative net unrealized depreciation, highlighted in gray, stands at $25 million, and cumulative net realized and unrealized loss highlighted in yellow is at $16 million. The net result of all of this is that in our 7.5 years as a public company, we have earned net investment income of $563 (sic) [$563 million] against total cumulative net losses, including unrealized, of only $16 million.

Turning to Page 13. We have seen significant growth in the portfolio over the last 2 quarters, as we have increased our statutory leverage of 0.81 to 1.17. Consistent with the strategy we articulated when we received shareholder authorization to increase leverage, the preponderance of our asset increase has been in the form of senior loans. In fact, over the 6-month period, more than 100% of the growth in assets has come from senior securities, as through repayments and sales, nonfirst liens have actually shrunk on an absolute basis by $75 million, while first lien assets have grown by $380 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 14, the market environment across leverage credit has been relatively stable. Spread levels and leverage structures on middle market loans, where we see the majority of our deal flow, have been consistent through the first 3 quarters of the year. However, in recent weeks, we have observed pockets of volatility in the syndicated new issue market, where certain aggressive debt structures and lower-quality credits have struggled to clear the market.

While we have not yet seen this volatility spread into the core middle market, we believe investor discipline in the syndicated market has helped prevent further spread and structured degradation in the middle market.

Despite heightened broader market uncertainty, most transactions that we evaluate continue to be highly contested, as lenders see quality deals that can perform well in all economic environments. 3-month LIBOR, which had been a meaningful earnings tailwind for NMFC earlier this year, has resumed its increase, rising approximately 25 basis points since our last call to 2.59% as of last Friday.

Recently, we have seen a slight lull in deal flow after a record third quarter, but expect to see our typical seasonal increase in the final months of the year.

Turning to Page 15. NMFC continues to be positively exposed to future rate increases, as 87% of our portfolio is invested in floating rate debt and 56% of our liabilities are locked in over the medium term at attractive fixed rates. As the chart on the bottom of the page shows, given our investment portfolio and liability mix, NMFC's earnings are positively leveraged to any further increase in short-term rates.

Moving on to portfolio activity. As seen on pages 16 and 17, NMFC had a record quarter, with total originations of $489 million, offset by $280 million of portfolio repayments and $11 million of sale proceeds, representing a $197 million expansion of our investment portfolio. Our new investments were highlighted by a number of middle market club deals backed by a diverse group of sponsors and the continued funding of our SLP III loan program

Page 18 shows our origination activity since the end of the quarter, where we have seen net portfolio expansion of $4 million, as we reach the low end of our target leverage ratio.

While the month of October was meaningfully slower than the previous months, we had a strong pipeline heading into year-end, which should translate into more deal closings in November and December.

Turning to Page 19. As Rob mentioned, our mix of originations continues to shift more towards first lien, with first lien assets representing 70% of total new originations this quarter. This shift towards a higher percentage of first lien assets is consistent with our desired asset mix at our target leverage level of 1.2x to 1.4x. On the right side of the page, we show that 58% of our repayments were second lien. Repayments are generally not under our control, which makes the quarter-to-quarter mix less predictable.

As shown on Page 20, Q3 asset yields on new originations of 10.4% were somewhat lower than the average yield of the portfolio. This is due primarily to the senior-heavy mix on new originations in the quarter. Still, we continue to maintain a very healthy weighted average yield on our portfolio of 11%, which is in line with our historical levels.

The top of Page 21 shows a balanced portfolio across our defensive growth-oriented sectors. In the services section of the pie chart, we break out subsectors to give better insight into the significant diversity within our largest sector. The chart on the bottom left of the page presents our portfolio by asset type, where you can see the shift towards first lien assets that we discussed earlier in the call. The chart on the lower right shows that over 99% of our portfolio is performing at or above our underwriting expectations.

Finally, as illustrated on Page 22, we have a broadly diversified portfolio, with our largest investment at 5.1% of fair value and the top 15 investments accounting for 42% of fair value.

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, John. For more details on our financial results in 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 23. The portfolio had approximately $2.3 billion in investments at fair value at September 30, 2018, and total assets of $2.5 billion, with total liabilities of $1.5 billion, of which total statutory debt outstanding was $1.2 billion, excluding $165 million of drawn SBA-guaranteed debentures. Net asset value of $1 billion or $13.58 per share was up $0.01 from the prior quarter. As of September 30, our statutory debt-to-equity ratio was 1.17:1.

On Slide 24, we show historical leverage ratios. Step-up in leverage over the past 2 quarters is in line with our new target statutory debt-to-equity ratio of 1.2 to 1.4x. On the slide, we also show historical NAV adjusted for the cumulative impact of special dividends, which shows the stability of our book value since our IPO.

On Slide 25, 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, 2018, we earned total investment income of $60.5 million, a $5.9 million increase from the prior quarter, primarily due to an increase in other fee income.

Total net expenses were approximately $33.4 million, a $4.6 million increase from the prior quarter, due to higher borrowing costs and higher professional fees. During the quarter, we had nonrecurring legal fees of $1.2 million related to deal expenses. As in prior quarters, the investment adviser continues to waive certain management fees. The effective annualized management fee this quarter was 1.39%. It is important to note that the investment adviser cannot recoup fees previously waived. This results in third quarter NII of $27.1 million or $0.36 per weighted average share, which is above our guidance and more than covered our Q3 regular dividend of $0.34 per share.

In total, for the quarter ended September 30, 2018, we had an increase in net assets resulting from operations of $26.7 million.

Slide 26 demonstrates our total investment income is recurring in nature and predominantly paid in cash. As you can see, 87% of total investment income is recurring and cash income remained strong at 83% this quarter. We believe, this consistency shows the stability and predictability of our investment income.

Turning to Slide 27. As briefly discussed earlier, our NII for the third quarter covered our Q3 dividend. Given our belief our Q4 2018 NII will fall within our guidance of $0.33 to $0.35 per share, our Board of Directors has declared the Q4 2018 dividend of $0.34 per share, which will be paid on December 28, 2018, to holders of record on December 14, 2018.

On Slide 28, we highlight our various financing sources. Taking into account SBA-guaranteed debentures, we had approximately $1.5 billion of total borrowing capacity at quarter end. In Q3, we issued $115 million of convertible notes and $100 million of unsecured notes at attractive rates. As a reminder, our 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.

Finally, on Slide 29, we've added a leverage maturity schedule. As we have diversified our debt issuances, we have been successful at laddering our maturities to better manage liquidity. 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 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?

(Operator Instructions)

The first question today comes from Don Fandetti with Wells Fargo.

Two questions. First, clearly, the way you position your portfolio tends to target more sort of recession-proof companies. But as you think for the next year, what is your confidence in terms of the risk-rating migration and the potential for nonaccruals? And then secondly, can you talk a little bit about what you're hearing from your portfolio companies in terms of revenue growth and sort of on the ground, how they're feeling?

Yes, sure. I often tie those 2 together. In terms of the second question actually, so the portfolio of companies continues to feel quite good, and this is both across our credit portfolio and our private equity portfolio, where on the ground, the forward metrics are pointing towards continued success at the operating company level. And with that, to your first question, I think we have as much confidence as we've ever had that the forward outlook for the portfolio as a whole in terms of avoiding future negative credit migration, is as good as it's ever been. That doesn't mean that tomorrow, we can get some negative news about any individual company, but sitting here today, as reflected in the ratings, we feel quite good.

Okay. And then also on the new origination yields. Obviously, rates have moved around a little bit on the short end. But do you -- it seems like the yields are holding up relatively well despite a pretty significant move of mix into senior? Can you talk a little bit about the originations this quarter and how they might contrast in prior quarters, and how the yields are staying relatively attractive?

Yes. I would say the mix has obviously shifted like we said and you said, to senior, which all else equal, reduces yields. However, we've seen an increase in base rates over prior quarters, which helps yields. Those 2 things have mostly washed. All in though, we have seen a little bit of overall yield deterioration, given the 10.4% versus the 11.2% of the portfolio as a whole. But I think we're still able even on these senior loans to drive yields that are consistent with the objectives we need to reach our financial targets.

Got it. And if I could just wrap up with one other. Obviously, there's a lot of concern in the market with where we are in the cycle. You're focusing on more sort of recession-proof type loans. Are you finding that there's an uptick in competition around those types of loans? Or do you feel like that you're going to be in a position to continue to grow the portfolio?

This is John Kline. And we definitely see very consistent competition in the segment of the market that we like. And we have to fight hard to win deals, which we do very consistently, as you see in our performance in Q3. And so we just have to stay disciplined. I would say one thing that we've really branded ourselves in certain segments. So our sponsor clients really know to go to us in certain segments, which we think is a great competitive advantage for us.

(Operator Instructions) The next question comes from Allison Rudary with Oppenheimer.

So a couple to start out. Can you guys describe what might be driving the kind of excess other income this quarter?

Yes. I mean, it's a combination of meaningful prepayment fees as well as some significant upfront, given the volume of originations. And then there's -- every quarter, there's some random things that come in around some amendments, et cetera. But it's really the big drivers are those first 2.

Okay, awesome. That's helpful. So I guess, my next question sort of kind of revolves around the management fee waiver that you grant for the holding's credit facility. The increased amount of first lien and senior assets that you're putting on the book now that you sort of kind of gone above that 1:1 leverage ratio. And how we as analysts sort of need to think about where you allocate assets, that's kind of something we can't see. It's sort of -- like what I'm driving at is that it makes our like forward look into how to think about your base management fee a little bit difficult. And I would like just maybe you guys could talk a little bit about how as you sort of get closer to that target leverage range, how we should think about that base management fee kind of going forward.

Yes, sure. I mean, I think we did see it come down a little bit this quarter. Now as you know, we use a average over the quarter, so the combination of ramping throughout the quarter as well as using the average over the quarter beginning of period, end of period muted that impact somewhat. So I think over the future quarters, as we further add leverage, it's going to be a combination of 2 things, right. It's going to be how much of the ramp continues to be in senior assets and then how much of those senior assets are qualified for the Wells facility and are in the Wells facility. And I think while we don't have a perfect crystal ball on that, we'd expect the prior trend to continue, where majority of -- significant majority of incremental assets added as we increase the leverage ratio do, in fact, are, in fact, senior. And that the significant portion of those senior assets seen do, in fact, qualify for the Wells facility. In terms of modeling it quarter-to-quarter, it's a little tricky, and I hate to give specific guidance. But I would think that 1.39% blended rate this quarter will continue to tick down modestly from here as we -- if and as we add leverage as anticipated.

Okay, that's super helpful. And then I guess, my final question, and then I'll turn it over to let some other people ask, is we've -- you guys are actually relatively close to that 1.2, 1.4x guidance. And it doesn't kind of -- doesn't really take a lot to see how you could get to there in the next quarter or 2. And I guess, what we're seeing here, even with some of the excess income this quarter, is that your portfolio actually might be throwing off a little bit more income than your guidance. And I guess, my question is at what point might you guys consider thinking about guiding to a $0.36 or $0.37 level as kind of indicating to shareholders that they're going to see some of the benefit of the growing portfolio base?

Yes. Look, I think -- and we've talked about this on a number of occasions. I think what we're trying to do -- because we feel like the 10% yield that we're providing is still quite attractive, given where base rates are. What we're trying to do is earn that yield with as little risk as possible. And so I think we've made -- as articulated, we've made the conscious decision that we can get to that yield level by moving up the capital structure and generally just taking less asset risk, while taking more balance sheet risk. We think that's a good trade. So we are not, again, trying to use the added leverage to increase materially the ROE. So Allison, we're not trying to get to a new plateau of earnings. We are trying to stay, with some margin safety, at the existing level of earnings with as little asset risk as possible. So that's the -- so the way the shareholders are benefiting as we increase the leverage is, we believe, taking less risk in the -- at the asset level, and that's a conscious decision. But we do think that, that $0.34 quarterly dividend, which is almost exactly a 10% ROE at book, is still a very attractive proposition. And the goal here is to not screw that up by generating default losses over time.

The next question comes from Paul Johnson with KBW.

Most of my questions have already been asked, but I'll just kind of leave you with one very broad question. I mean, obviously, the market is very competitive. I mean, it's very well talked about. I'm wondering, I mean, in such a competitive environment. I mean, you even mention it in your presentation that you're finding a lot of strong competition for some of the best financing deals out there. I mean, how can you get investors comfortable with deploying such a large amount of capital like you did this quarter, while still being conservative and disciplined in your approach to doing so? And maybe just give us a sense of what you're looking at for those prospective investments.

Yes, sure. I mean, I think there's a couple of elements to it. I think, one, just as an overlay is in any given quarter, we're never targeting a certain amount of volume production. It's all bottoms up what comes to us. And our biggest driver of safety and what should give the investors confidence is that, again, we're only going to be investing in businesses that sit within our defensive growth criteria, the industries we know and that are already well-researched at the industry level and typically, at the company level by the existing investment team. So that discipline stays strong in all circumstances. And then I would say, the other kind of important overlay is whether we originate $300 million in a quarter or $500 million in a quarter, it's a tiny, tiny fraction of a multi-$100 billion market. So we're still a very small player, which allows us to be very selective and stay focused and disciplined on what we know and what we like. So those are the things, in my mind, that should give investors comfort, that's obviously the length of the track record. But again, we have our #1 priority, as we say over and over again, is to avoid credit impairment. And we're never going to, consciously at least, screw that up. John, I don't know if there's anything you want to add to that.

Yes, I was just looking through our Q3 originations. And when I think about our success, it really comes from a bunch of different places. One, when you look at the deal flow that we've achieved, it's really we're getting returns on being in this business for -- going on 10 years now. And our best software sponsor clients are coming to us on a repeat basis and showing us preferred access to deals. That's not to say that they're not competitive, but they're carving us in, into what we think are great deals at market terms with some of their other good lending relationships. We have one deal actually that was a big origination for us this quarter. That was a deal we wanted to buy for PE, and we developed an amazing relationship with the founder. He did not choose to sell control to our PE group, but instead, chose to refinance his capital structure, and we were a big part of that. So that's just a benefit of being part of a bigger platform and really working well together. And then we have new resources on our team that have enabled us to have more touch points on The Street, and I really think those resources are paying big dividends with regard to the deal volume. So that, hopefully, will give you a sense for just some of the specific areas we're seeing success.

Sure. And when you mentioned new resource, are you talking about professionals that work directly with the BDC and the direct lending platform or is this...

Folks covering sponsors.

Right. As well as just the overall growth in the private equity platform, which continues to be quite strong. It just means we're expanding our universe of companies with diligence for private equity and therefore, expanding our universe of addressable opportunities for the credit business.

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

Great. Thank you. As always, we just want to thank everybody for the interest, the support, and we look forward to speaking again next quarter. Thanks, everyone. Buh-bye.

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