Carlyle Secured Lending, Inc. (CGBD) Q2 2018 Earnings Report, Transcript and Summary

Good day, ladies and gentlemen, and welcome to the TCG BDC Second Quarter 2018 Earnings Call. At this time, all participants are in a listen-only mode. Later, we will conduct a question-and-answer session and instructions will follow at that time. [Operator Instructions] And I would now like to introduce your host for today’s conference Mr. Daniel Harris, Head of Investor Relations. Mr. Harris, you may now begin.

Thank you, Sherry. Good morning and welcome to TCG BDC’s second quarter 2018 earnings call. Last night, we issued an earnings press release and detailed earnings presentation with our quarterly results, a copy of which is available on TCG BDC’s Investor Relations website. Following our remarks today, we will hold a question-and-answer session for analysts and institutional investors. This call is being webcast and a replay will be available on our website. This call and webcast is the property of TCG BDC, and any unauthorized broadcast in any form is strictly prohibited. Any forward-looking statements made today do not guarantee future performance and undue reliance should not be placed on them. These statements are based on current management expectations and involve inherent risks and uncertainties, including those identified in the Risk Factors section of our 10-K and other SEC filings that could cause actual results to differ materially from those indicated. TCG BDC assumes no obligation to update any forward-looking statements at any time. Lastly, past performance does not guarantee future results. With that, I’ll turn it over to our Chief Executive Officer, Michael Hart.

Thank you, Dan. Good morning, everyone and thank you for joining us for our second quarter earnings call. I’m joined today by our management team, including our President, Jeff Levin; our CFO, Tom Hennigan; and our Head of Originations, Grishma Parekh. I'll begin this morning with a brief look at our financial results, and also revisit our discussion from last quarter regarding the adoption of certain provisions of the Small Business Credit Availability Act where is referred to at the BDC leverage bill. I’ll then provide an update on the implementation in the new leverage limitations, which became effective for us on June 7th of this year. As you know from our discussion last quarter, TCG BDC was the leader in seeking approval for the new guidelines from both our board and our shareholder base. I’ll share with you the results of that outreach and how we're thinking about utilization, and talk about an important change to our fee structure as we continue to look for ways to best align our interests with those of our shareholders. Turning to financial results, yesterday, we released our second quarter earnings for the year. All components of our business continue to deliver consistent results including our core portfolio, our joint venture and our strategic partnerships, all of which contributed to a solid quarter performance with net investment income of $0.45 per share an increase of 12.5% from the prior quarter and comfortably covering our second quarter dividend of $0.37 per share, which represented about 9% yield on a trailing 12-month basis. Net asset value per share decline modestly quarter-over-quarter from $18.09 per share to $17.93 driven primarily by some unrealized valuation changes that Tom provide more details on in a moment. Let me shift to our debt-to-equity ratio, as it provides a good segue into the broader comments that I want to make on the topic of the BDC leverage bill. Our debt-to-equity at the end of the second quarter was 0.76:1 up modestly from the 0.7:1 ratio at the end of the first quarter. We previously provided guidance the outer boundary for our owned businesses leverage would be in the area of 1.3:1 to 1.4:1. Obviously we're comfortably inside those levels currently, but we continue to believe that those are prudent out our boundaries given the overall risk in our portfolio today. Regarding some of the bill specifics, as you're well aware the bill permits BDC is to reduce the minimum asset coverage ratio from 200% to 150%, which translates into a potential increase in the debt-to-equity ratio from 1:1 to 2:1. When the passage of the bill was announced we carefully considered what the new law provided for both in terms of increased regulatory cushion and the potential for increased profitability for our company and so it’s adoption would be significantly positive for our shareholders. The bill provided two avenues for approval an adoption, either going the board route and receiving an affirmative vote by a majority of the independent directors in which case the new leverage parameters would go into effect one year from the date of approval or take into a shareholder vote and receive approval with an affirmative vote by majority of the shareholders in which case the new leverage limitation would go into effect one day after the shareholder meeting. In evaluating the provisions of the bill and potential impact, not only in our business, but also on the industry as a whole, we concluded that the best path forward was to seek the approval of both our board and shareholders, it's a decision that we felt was too important not to have those two constituencies weigh in regardless of the timing implications. In April, our Board of Directors unanimously approved the adoption of the new BDC leverage bill and our shareholders overwhelmingly approved its adoption through a proxy process that coincided with our year-end annual shareholder meeting, and resulted in the 150% asset coverage ratio becoming affective on June 7th this year. As we've mentioned previously we don't anticipate the adoption to the reduced asset coverage requirement to influence or change of the investment thesis that we've applied since our company's inception. We'll continue to invest where we see best relative value and our portfolio construct shouldn't change in any material way going forward. We obviously believe the adoption of the new leverage guidelines represent an opportunity to deliver increased returns to shareholders. However, even in the absence of the increased leverage the reduced asset coverage ratio provides immediate operational flexibility, and increased cushion to the regulatory leverage limit, which would be invaluable in the event of more volatile markets. Many aspects of the new builds impact will play out overtime and many of the decisions in the future will be market dependent. However, is the final point of emphasis as it relates to Carlyle out ongoing commitment to the alignment of interest with shareholders affected retroactively to July 1st of this year our investment advisor and has reduced the base management fee from 1.5% to 1% on all assets financed with greater than 1:1 leverage. This reduction in management fee, which as you know has been implemented post the shareholders approval of the new leverage guidelines is another good example of Carlyle's philosophy around shareholder alignment. With that I’ll turn it over to Jeff who will provide some additional color on the overall state of the market and how this is influencing our investment selection. Jeff?

Thanks, Mike. In the middle market operating teams remains relatively unchanged during the second quarter as compared to the first quarter including high leverage multiples and private equity firms paying full purchase prices. Substantial dry powder held by both private credit and private equity managers coupled with the strong underlying U.S. economy continues to drive this dynamic. Loans to finance LBOs continue to have substantial equity value below them and in the middle market the average equity contribution was 42% at the end of June, which is significantly higher than it was at the peak of the last credit cycle when it was 32% in 2007. Second quarter sponsored loan volume was roughly flat with the first quarter with approximately two thirds driven by new money activity. The syndicated loan market experienced some volatility in June with 42 deals flexing pricing wider versus 18 flexing tighter during the month. That said, we have not yet seen this volatility significantly impact the middle market loan asset class. Given the competitive environment that persists, we continue to be focused on optimizing our ability to source as many high quality investments as possible to generate strong risk adjusted returns for shareholders. Several critical elements support our ability to achieve these returns including having highly flexible capital to invest throughout the capital structure based on where we find the best value delivering differentiated industry intelligence from the vast Carlyle network to help the sponsors we partner with create equity value for their portfolio companies, and ensuring our direct lending business has substantial scale and the ability to deliver full financing solutions for middle market borrowers. Given the importance of scale, one theme we want to address that has become increasingly beneficial to TCG BDC is the growth across the direct lending business managed by Carlyle Global Credit. In many instances sponsor show deal flow only to those lenders that can commit large quantum's of credit, resulting in scale being a differentiator to optimize investment sourcing. Given this dynamic, we benefit from Carlyle’s platform, which continues to raise capital in both [indiscernible] and managed account formats to further bolster the whole sizes of middle market loans, which allows us to maximize our origination funnel and have improved influence on terms. To continue to expansion of Carlyle Global Credit platform allows us to take larger positions in individual transactions and when lead manage roles while maintaining prudent diversification levels, which is a key tenant of our risk management strategy. A couple of recent examples include our investments in [indiscernible], in each of these transactions our direct lending platform committed significantly more capital and what is held in TCG BDC. Our scale combined with other funds managed by our investment advisor was critical and winning these co-lead mandates and allowed us to size investment positions that are consistent with our diversification strategy. With that I will hand it over to Grishma to provide the details of our origination activity this quarter.

Thanks, Jeff. Overall we had a strong capital deployment quarter on a number of fronts. During the second quarter, we made 29 new commitments totaling $394 million with 25 private equity sponsors. In past quarters, as I've noted that the vast majority of our investment activity has supported our existing sponsor base. That encompass is over 100 U.S. middle market private equity firms with whom we have closed transaction. This quarter we added several new clients. These are firms that we have identified as important to our platform, and have known for many years, but for one reason or another have not transacted with until now. Continue to expand our market reach is an important part of our origination strategy, but we do so with great care especially in a hyper competitive market like we have today in order to avoid any adverse selection issues. Our focus remains resolute on the top part of the capital stack. This quarter, more than 95% of our new loans were in a first lien position. Similar to past quarters, our capital is in supportive buyouts [ph] with substantial fresh equity is coming in and for acquisitions that propelled a gross of our portfolio companies. In the second quarter, LBO and acquisition financing represented 80% of our investment activity. Approximately a third of our investments weren’t supported by our existing portfolio companies as they saw additional debt financing for acquisitions and investments. This is an important benefit of having such a large and diversified portfolio. We view incremental financing as among the best risk adjusted deployment of our capital. These are companies that we know well, and often tend to be our best performing credits. For example, during the second quarter we will co-led the first lien credit facility is in support of the acquisition of teaching strategies. Teaching strategies have been an existing portfolio company and provide a curriculum, assessment of professional development to the early education market. It's a market leader that should benefit from secular tailwinds in the early education space irrespective of the economic environment. Based on the information as we had due to incumbent position we were able to provide certainty and speed of execution to the sponsor, and were awarded this mandate. Well, we've seen a general weakening of credit terms, our new investment in overall portfolio metrics remain highly attractive. The loan to value of our new investments was 45% largely flat in the prior quarter and in line with the overall portfolio. The weighted average net debt-to-EBITDA this quarter was 5.5 times also in line with the portfolio as a whole. The weighted average interest coverage for the quarter was about 2.5 times. Covenant light volume represented less than 10% of our new investment activity and is less than 10% of our portfolio as well. Shifting to the middle market credit fund the JV currently stands at $1.1 billion and comprises 10.7% of TCG BDC's total investment. Net portfolio growth was 4.2% quarter-over-quarter. On a combined basis for the total investment portfolio TCG BDC and the JV increased to $2.9 billion. The unlevered weighted average yield of investments in the JV is approximately 7.1% compared to 9.3% in TCG BDC. This vehicle highlights our ability to produce the high quality return with more leverage while investing in lower risk underlying investments. Finally, loan sales and repayments were $209 million weighted toward TCG BDC. Despite the heavy repayment activity TCG BDC experienced modest net portfolio growth just under 2% quarter-over-quarter. The asset mix also shifted further in favor of first lien as two sizable second lien positions where we stand. This mix-shift is a perfection of our investment approach in this proxy market where we're seeing more opportunistic transactions and aggressive behavior by market participants. I'll now turn the call over to Tom Hennigan.

Thanks, Grishma. Today, I want to discuss our second quarter financial performance, the current portfolio and our financing facilities. I’ll begin with the discussion of our financing facilities given we’ve had a very active last few months in conjunction with approval by both our board and shareholders of the increase to our statutory leverage limit. Last week, we successfully priced the reset of our 2015 vintage CLO. we are upsizing the CLO from $400 million to $550 million establishing a new five-year reinvestment period and increasing total debt issued by $176 million, all were slightly improving our overall cost of capital. In the next week, we expect to close on an amendment to our SPV financing facility that will reset the three-year period, maintain pricing at LPLUS 200 [ph] and importantly, permit the new statutory leverage level. In addition, we’ve made great progress with the lenders under our corporate revolver facility on an amendment that would provide us with similar flexibility. Regarding future additions to our debt capacity, we’re looking at both upsizing our current secured facilities as well as tapping the unsecured markets. On that note, we finished the second quarter with total debt outstanding of about $860 million up about $60 million from $331 million [ph]. It’s driven by the net deployment activity highlighted by Grishma. As of $630 million, we had approximately $230 million of total unused commitments under our credit facilities and that will grow to over $400 million followed in the closing of the CLO upsizing later this month. Regarding the portfolio, the weighted average internal risk rating kicked up modestly to 2.3, total watch list transactions that was rated 4 or worse on our internal risk rating scale, kicked down by a net $29 million. However, two loans migrated to the six category indicating probable loss while non-accruals increased to 1.7% of total fair value. In terms of the credit metrics, our portfolio continues to experience annualized LTM revenue and EBITDA growth of over 10% on a year-over-year basis. Our portfolio weighted average net leverage dinged up modest in this quarter, primarily due to repayment of loans that it previously deleveraged since the time of our national investment. In regards to valuations, the total aggregate realized and unrealized net loss was about $15 million for the quarter. Evaluations again, benefitted from continued tightening and secondary spreads for the middle market index we track and we have successful realization on our equity coinvestment and global software. Offsetting these were some additional markdowns notably on Product Quest and 12. Turning to the financial results for the second quarter. Total investment income was $52 million, up about $5 million versus the first quarter. This increase was split roughly evenly between interest income and other income, which was aided by higher arranger fees. Total income from the JV was roughly flat quarter-over-quarter. Net expenses were $24 million for the second quarter compared to $22 million in the first quarter. The largest component of the increase was higher interest expense driven by both higher average debt outstanding and increasing LIBOR. Net result was net investment income for the quarter of about $28 million or $0.45 per share, which compares to our regular declared dividend of $0.37 per share. And of note, on August 6, our Board of Directors declared the regular dividend for the third quarter at the same $0.37 per share, payable to shareholders of record as of the close of business on September 28. Regarding JV returns, the second quarter dividend yield on our equity in the JV was about 15%, down from the 19% achieved in the first quarter. But as I mentioned on last quarter’s call, we expected this normalization following some one-time items in the first quarter and we expect to achieve similar mid-teen results in future quarters. That concludes our prepared remarks. Thank you everyone for joining us today. And with that, I’ll let the operator to open the line for questions.

Thank you. [Operator Instructions]. Our first question comes from Fin O'Shea with Wells Fargo Securities.

Hi, guys. Good morning and thanks for taking my questions. I guess just a start broadly; you highlighted sort of the platform growth and your ability to spread deals around your various funds. The origination size in TCG BDC as the larger deals look, roughly similar, so can you give some color on are you winning larger shares of consistent nature deals or are you going up to larger EBITDA enterprise value for example type companies.

Sure. Thanks for the question, Fin. It’s Jeff Levin. Our origination strategy hasn’t changed in terms of the target market, the sponsors in the size of the businesses that were looked to finance. The ability though to commit to the entire financing anywhere between $100 million and $300 million dollars or so in a single name allows us to drive better terms have more impact than economics and widen the deal front I referenced. Sponsors in certain instances, show deals to only a few different lenders that can provide certainty and can do it quickly to derisk the liability side of an LBO. And so we – given the growth of the platform across commingled funds and estimates across the credit platform here, we’re able to commit much larger quantum than we could have even a year or two years ago and be able to drive better risk-adjusted returns and the diversification across the various pools of capital, given the size of the balance sheet, we’re able to continue to drive typical positions – anywhere between 1% and 2%, given the growth of the business.

Okay, very well makes sense. And on – is there – is this inclined with your higher arranger fees as outlined this quarter or was there some sort of one-off, should we expect that to remain consistent or this kind of a pop quarter.

Yes. I think… I’m sorry Mike.

Hey, Fin. It’s Mike. Thanks for the question. I wouldn’t – I would view the fee income this quarter as a bit of an anomaly. We don’t look at that as a primary source of income although there’s clearly opportunities there, but that’s not – that’s not something that we look at in driving the overall strategy.

Okay, very well. One more on the – on the CLO upsizing, is that the credit funder or is that the balance sheet CLO? Sorry, I missed that one.

Hey, Fin, it’s Tom. That’s the balance sheet CLO.

Okay. So, does that mean you refinanced it and the SEC issue, I’m sure you’re familiar with I’m a less so on the nuances, but in terms of the SEC not allowing the 40 Act vehicle et cetera to run CLO financing, is that solved at this point or did your upsize – was that outside of the framework for the SEC rule there? That was all done at our end for the – for the risk for tension issues that previously had just delayed activity in the market.

No. That was hold on, on our end for the risk retention issues that previously had, I guess, delayed activity in the market.

Okay, very well. just one more question on – sorry, product quest, it looks like you paid – if I’m correct you paid down the front-end of the insurance financing and did this hit a buyout trigger type provision or is this something that you Trident naturally wound down, given it’s a little bit seasoned here.

No. Fin, on that transaction, you see two-line items, one is a super priority revolver that all the vendors contributed to about a year ago, that’s the first out piece. That’s independent from the original unit tranche loan that we made back in 2015. The original loan from 2015 when we hold the last outrisk that remains in place today, that’s the position that you see, that’s just experience marked down sequentially in the quarter.

Okay. It makes make sense. Thank you guys so much.

Thanks, Fin.

Thanks.

Thank you. [Operator Instructions]. Our next question comes from Rick Shane with JPMorgan.

Hey, guys. It's Melissa on for Rick today. Quick question for you about potential impact from increase and allow the leverage? Are you thinking that your average hold size could skew upwards as a result of this, especially given this – the breadth of the platform across Carlyle that you guys highlighted just few minutes ago?

Hi Melissa. It’s Mike. Thanks for the question. Melissa, we look at the increase leverage opportunity in a couple of ways. First and foremost, as I mentioned in my comments, a nice cushion to the regulatory leverage limit and that certainly as we look at potentially increased while market impacts on valuation, that’s a nice thing to have. As we consider putting on additional leverage, we’ve always considered where we are today, which is about $0.76 debt-to-equity, comfortably moving into the 1.3 times to 1.4 times. So, just mathematically that creates for us $700 million to $800 million dollars of capacity if you will. And we look at it in that context. So, the capacity in terms of the single holds or individual holds with respect to the BDC, grows in a linear manner relative to that. So, if holding all other things constant if you look at just applying the leverage to our portfolio today of about $2 billion, taking it 2.8 within the constraints of the leverage limits as we look to apply them, would simply allow for that increased commitment size in a linear manner from where we are today based on that sort of 30% increase in overall portfolio size.

Okay, okay. And then one follow-up, do you guys have any line of sight into any large expected repayments that you’re willing to adjust for 3Q?

Hi, Melissa. This is Tom. I’d say in the regular course, there are expected repayments. But I think, our active pipeline should result in net positive deployments for the quarter, nothing of note to significantly impact our innings.

Got it. Thanks guys.

Thanks, Melissa

Ladies and gentlemen, thank you for participating in today’s question-and-answer portion of the call. I would now like to turn the call back over to management for any closing remarks.

Thank you and thanks everyone for joining. We really appreciate your time this morning. If you have further questions, please don’t hesitate to reach out to us. I would be happy to speak with you. But again, thanks. Enjoy the rest of your summer.

Ladies and gentlemen, thank you for participating in today’s call. This does conclude the program. You may all disconnect and have a wonderful day.