MidCap Financial Investment Corporation (MFIC) Q2 2018 Earnings Report, Transcript and Summary

Good morning and welcome to Apollo Investment Corporation’s Earnings Conference Call for the period ended September 30, 2017. At this time, all participants have been placed in a listen-only mode. The call will be opened for a question-and-answer session following the speakers’ prepared remarks. [Operator Instructions] I will now turn the call over to Elizabeth Besen, Investor Relations Manager for Apollo Investment Corporation.

Thank you, operator, and thank you, everyone, for joining us today. Speaking on today’s call are Howard Widra, President; Tanner Powell, Chief Investment Officer; and Greg Hunt, Chief Financial Officer. I’d like to advise everyone that today’s call and webcast are being recorded. Please note that they are the property of Apollo Investment Corporation and that any unauthorized broadcast in any form is strictly prohibited. Information about the audio replay of this call is available in our earnings press release. I’d also like to call your attention to the customary Safe Harbor disclosure in our press release regarding forward-looking information. Today’s conference call and webcast may include forward-looking statements. Forward-looking statements involve risks and uncertainties, including, but not limited to, statements as to our future results, our business prospects and the prospects of our portfolio companies. You should refer to our registration statement and shareholder reports for risks that apply to our business and that may adversely affect any forward-looking statements we make. We do not undertake to update our forward-looking statements or projections unless required by law. To obtain copies of our SEC filings, please visit our website at www.apolloic.com. I’d also like to remind everyone that we posted a supplemental financial information package on our webpage, which contains information about the portfolio as well as the Company’s financial performance. At this time, I’d like to turn the call over to Howard Widra.

Thanks, Elizabeth. Good morning, everyone, and thank you for joining us for our quarterly earnings call. I’ll begin today’s call by briefly discussing the market environment, followed by an update on the progress we have made executing on our strategy including a brief overview of our results for the quarter. Tanner will then cover our investment activity for the period and provide an update on credit quality. Finally, Greg will review our financial results in detail. We will then open the to questions. Beginning with the environment, middle market private credit remains highly competitive for lenders as robust middle market loan fund raising has contributed to spread compression and competitive terms and supplies are dominated by dividend and refinancing activity. We believe that our size relative to our funnel of investment opportunities allows us to remain selective and find attractive opportunities even in today’s market. That said, we tapped on many deals that do not provide adequate risk-adjusted returns and allow [ph] the leverage ratio to decline. Moving to an update on the execution of our strategy. We believe that we are now more than halfway through our repositioning plan. I will now discuss the progress in detail. First, we continue to deploy capital into our core strategies, which include middle market corporate loans sponsor backed companies as well as opportunities in life sciences lending, asset based lending, lender finance. We believe these three specialty areas can generate good deal flow with pricing that is less impacted than sponsor backed corporate lending. We are also benefiting from our ability to co-invest with other Apollo funds or entities managed by Apollo. Since commencing our repositioning strategy last year, we have funded over $1 billion into our core strategies including $417 million or 38% of our total deployment into co-investment transactions. Core strategies now account for 73% of the portfolio including 16% in co-investment at fair value. Second, we continue to reduce our exposure to non-core and legacy assets, which now account for 27% of the portfolio at fair value. In aggregate, non-core and legacy assets have decreased by $432 million since commencing our repositioning strategy and now totaled $633 million at fair value. Oil and gas exposure has declined to 6.9% of the portfolio at fair value; structured credit exposure has declined to 3.3%, renewables exposure has declined to 8.2%, and legacy and other exposure has declined to 3.6% of the portfolio. These are all down significantly from when we commenced our repositioning strategy. Recall, these non-core assets are higher on the risk spectrum and have more volatile returns. Third, we continue to make steady progress to improve the overall risk profile of our portfolio by increasing our exposure to first lien and floating rate loans, and decreasing our average borrower exposure. As of the end of September, first lien debt had increased to 48% of the total portfolio. The floating rate portion of our corporate debt portfolio is increased to 91% and our average borrower exposure decreased to $27.1 million all at fair value. Next, moving to an overview of our results. During the quarter, we invested $255 [ph] million of which nearly half of investments made pursuant to the co-investment order. Repayment activity was elevated and net investment activity was negative $74 million. Net leverage as of the end of the quarter was 0.59. In today’s market, we believe it is prudent to have dry powder. Net investment income for the quarter was $0.16 per share. Net asset value declined $0.01 to $6.72 per share as gains on investments were offset by losses and there was a $0.01 per share unrealized loss from our oil hedge, which Tanner and Greg will discuss later. Regarding the distribution, the Board approved a $0.15 distribution to shareholders of record as of December 21, 2017. In summary, we’re pleased with our progress to-date and we’ll continue to focus on executing our strategy. We remain disciplined and not reach [ph] for yield. That said, there are several levels we can pull, including increasing our leverage to our target range, redeploying sub-yielding assets and refinancing some of our more expensive debt. With that, I’ll turn the call over to Tanner.

Thanks, Howard. During the quarter, we invested in $265 million in 12 new portfolio companies and 11 existing companies with the focus on senior floating rate debt in our core strategies. Nearly half of our investments were made pursuant to our co-investment exempted relief order. In this competitive environment, we are focused on opportunities to capitalize on Apollo’s scale and areas of expertise and can also take advantage of our ability to co-invest with other funds and entities managed by Apollo. Given the continued strength in credit market, repayment activity was elevated. Exits totaled $340 million, which consisted of $328 million of repayments and $12 million of sales. Net investment activity before repayments was $254 million and net investment activity after repayments was negative $74 million for the quarter. The weighted average yield on investments made during the quarter was 10% and the weighted average yield on sales and repayments was 10.3%. I will now discuss our activity in greater detail. During the quarter, we deployed $124 million or approximately 47% of total deployment in investments made pursuant to the co-investment order. Co-investments during the period included RA Outdoors, Electro Rent, RiteDose, Wright Medical, Purchasing Power, and simply Simplifi among others. Turning to aircraft leasing, which continues to be one of our larger industry concentrations, we continue to be pleased with our investment in Merx Aviation as the underlying portfolio continues to perform well. As of the end of September, our investment in Merx was $429 million, representing 18.2% of the total portfolio at fair value. Merx continues to see attractive opportunities to add to its portfolio with high-quality aircraft and machines [ph] as well as opportunities to monetize select aircraft in the portfolio. During the period, we deployed approximately $10 million into Merx and were repaid $41.5 million of capital, resulting in net repayment of 31.5 million. Merx also paid a $2.25 million dividend to us during the quarter. The balance of our investment activity was spread across several secured debt floating rate corporate loans within our core strategies. In addition to the repayment from Merx, repayments included the partial repayment of our investment in U.S. Security Associates. We received $55 million repayment on our unsecured debt investment, reducing our position from $135 million to $80 million. This repayment reduced an outsized position and improved the portfolio’s concentration risk, which is one of our stated objectives. Repayments also included the full repayment of our investments in My Alarm Center, SCM Insurance, and MW Industries among others. Regarding our energy portfolio, at the end of September, oil and gas represented 6.9% of our portfolio at fair value or a $163 million across three companies. During the quarter, we’ve funded $2.5 million into Glacier Oil & Gas. We continue to work closely with the respective management teams and may deploy some additional capital into these names during the coming quarters, to support accretive development projects. During the quarter, we hedged our oil exposure by entering a costless collar. More specifically, AINV purchased put options and sold call options on WTI. The options were structured so that the premium paid for the put options offset the premium received from selling call options producing a costless collar. If oil prices decline, the gain on our hedge should mitigate the losses on our underlying investments. If oil prices rise, the loss on our hedge should be offset by an improvement in our underlying investments. Now, let me spend a few minutes discussing credit quality and the overall portfolio. No investments were placed on or removed from non-accrual status during the period. At the end of September, investments on non-accrual status represented 1.3% of the portfolio at fair value and 1.9% at cost. The risk of our portfolio as measured by weighted average leverage and interest coverage for our portfolio companies was unchanged compared to the prior quarter. The current weighted average net leverage of our investments remained at 5.5 times and the current weighted average interest coverage remained at 2.7 times. With that, I will now turn the call over to Greg who will discuss financial performance for the quarter.

Thank you, Tanner. Total investment income for the quarter was $66.5 million, essentially unchanged quarter-over-quarter. a decline in recurring interest income and dividend income was offset by higher fee and prepayment income. Recurring interest income declined due to lower average portfolio balance, dividend income, which is primarily derived from our aviation and shipping investments, as well as our remaining CLO investments was $4.3 million for the quarter, down from $5.9 million last quarter. The decrease was primarily due to a lower dividend from Merx. We receive a $2.25 million dividend from Merx, $6 million last quarter. Prepayment income was $4 million in the quarter, compared to $3 million in the June quarter. Fee income was $2.6 million in the quarter, compared to $800,000 in the June quarter. Expenses for the September quarter totaled $32.3 million, compared to $33.4 million in the June quarter. Expenses are down slightly quarter-over-quarter due to lower interest expense and lower G&A expenses. The incentive fee rate for the quarter was 15%. Net investment income was $34.2 million or $0.16 per share for the quarter. This compares to $33.3 million or $0.15 per share for the June quarter. For the quarter, the net loss on the portfolio totaled $2.4 million compared to a net loss of $4.5 million for the June quarter. Included within the $2.4 million net loss is an unrealized mark-to-market loss of $1.9 million or $0.01 per share on our oil and gas option contracts. However, assuming we hold these contracts until maturity and oil remains within the strike price range, we will not ultimately recognize any gain or loss on these contracts. Excluding the unrealized loss on the oil hedge, the net change in NAV on the portfolio was essentially flat. In total, our quarterly operating results increased net assets by $31.8 million or $0.14 per share, compared to an increase of $28.8 million or $0.13 per share for the June quarter. Consequently, net asset value per share declined $0.01 to $6.72 per share during the quarter, primarily as a result of the mark-to-market on our option contracts. Turning to portfolio composition. At the end of September, our portfolio had a fair value of $2.4 million and consisted of 87 companies across 24 industries. First lien debt represented 48% of the portfolio, second lien debt represented 32%, unsecured debt represented 5%, structured products 5%, and preferred and common equity 10%. We were able to avoid yield compression as the weighted average yield on the debt portfolio a cost was 10.3%, unchanged quarter-over-quarter. On the liability side of the balance sheet, we had $865 million of debt outstanding at the end of the quarter. Our net leverage, which includes the impact of cash and unsettled transactions stood at 0.59 at the end of the September, compared to 0.6 times at the end of June. We have also made some modifications to our liability. During the quarter, we increased the commitments under our revolving credit facility by $50 million, bringing total commitments to $1,190 million with the addition of a one new lender. Subsequent to quarter-end in October, we redeemed all of our $150 million of our 6.625% unsecured note that was due in 2042. We will recognize a realized loss of approximately $5.8 million on extinguishment of these notes in the December quarter due to the acceleration of the associated unamortized debt issuance costs. This is an approximate one-year payback period -- there is approximately one-year payback period for this loss, given that the redemption of these notes will result in interest expense savings going forward. It is our current intention to redeem our 2043 notes when they become callable in July of 2018. Regarding stock buybacks, during the period, we repurchased approximately 660,000 shares at an average price of $5.99 inclusive of commissions for total cost of $4 million. We have continued to repurchase our shares subsequent to quarter and under our 10b5 plan. Since the inception of the program a year ago and through yesterday, we have repurchased approximately 18.3 million shares or 7.7% of initial shares outstanding for a total cost of $108 million, leaving approximately $42 million available for future purchases under the current Board’s authorization. This concludes our prepared remarks, operator, and please open the call to questions.

[Operator Instructions] Our first question comes from the line of Rick Shane of JP Morgan.

Hey, guys. Thanks for taking my questions this morning. Just want to talk about a couple of different things. When we look at the yield, it was flat quarter-over-quarter at 10.3%. Three months LIBOR was up on average probably about 15 basis points. You’re at a point now where you should be off of the floors on most of the assets, you’re now 91% floating rate. Is the offset here just spread compression and reinvestment risk on the new investments?

Correct. That is exactly right. And as we alluded to in the prepared remarks, we’ve allowed leverage to come down a little bit as we’ve encountered some of that spread compression. And your comments about off the LIBOR floor are correct, given where current three-month sits today.

Got it. And then, the next thing related to that on the liability side, obviously you’re redeeming some of the high cost notes -- high cost fixed rates notes and essentially moving to more floating rate debt. So, partially offsetting some of the asset sensitivity that you created by the portfolio shift, is the idea that you just think that LIBOR rates are going to stay low enough that even though you’re going to give up a little bit of that asset sensitivity, you’re going to pick it up on margins?

Yes. Rick, I think that’s a logical conclusion as we look at it at this point. I think it is our long-term goal as we manage our balance sheet, you have a mix between fixed and floating. But, in this current environment, I think moving to floating on -- using our credit facility is the prudent measure.

Got it. And then, the last question, is it going to turn out to be that it is more efficient to lock in some of that financing to increase your asset sensitivity in the swaps markets, is that a stability going forward?

Yes. I mean, it is an option as we look at it. You could swap to a floating, you could swap -- we could do that -- or to a fixed in that. So, we are always obviously kind of looking at that based upon our different options.

Because I’m just thinking, the current environment where volatility is low reducing swap cost or maybe even swaptions costs that might make -- that that might be what you’re thinking about in terms of reducing some of those long-term notes?

Yes. I mean, Rick, I think these are very good ideas and we will continue to look at them. It’s a good idea.

Our next question comes from the line of Leslie Vandegrift of Raymond James.

The first one, I know you mentioned in the prepared remarks on how much was co-invested with MidCap. Was it 133, what was that number?

The overall co-investments were about $125 million, roughly. That includes not just MidCap but also co-investments with other...

Okay. And then, for this coming quarter, is the outlook about the same, about half and half or are you guys seeing more opportunities with them right now as the rest [ph] after the prepayment activity last quarter?

Yes. I mean, without predicting for [ph] the quarter, our intent is for, like as large opportunity is possible to be co-invested and as much as possible MidCap, because it is more protected from certain volatility or from the pressure in the overall sponsored market, so it’s our intent to have that number be as highs as we possibly can.

And then on the rotation out of the non-core assets, obviously there is a lot of movement this quarter out of those. I think you said the 73% core now of the whole portfolio. Now, for the remaining of that, what’s kind of the -- how do you think, you’re looking at for the next few quarters, another year or so before we thought most of that rotation is done?

Yes. So, again, like -- this is the key question. We don’t expect it to get to zero when we’re sort of settled in because there are certainly assets that either are too compelling to get rid of or the prices don’t match what we sort of understand as the underlying value. So, let’s start with that. So, we’re not done when it’s gets to zero. I think there is some significant exposures that we’re focused on. So, one is Solarplicity, which we’ve talked about before on the renewables side and then the other sort of generally our oil and gas exposure. So, those are the ones we’re focused on. So, if we look at Glacier and start Spotted Hawk, Solarplicity combined, you’re talking about roughly $300 million of our book. And those are the ones we’re focused on, on ultimately being able to move out of, or at least being able to be comfortable with sort of complete stability there. On the oil and gas side for Glacier and Spotted Hawk, given where oil prices are, things have been on the operator side very good this quarter. And so things are going the right way. And so, we put our hedge on in order to sort of try to lock some of that in. I think they’re also doing at the company level, Solarplicity in active auction process. So, what I would say is moving out of one of those oil and gas names, if you think about Solarplicity, we would then sort of probably focus everybody on how we want them to think about it going forward. Like, let’s put that behind us and just assume we’re -- it’s going to dribble out and stop thinking about that as a separate strategic challenge. So, when will that happen, not sure but hopefully sooner, rather than later.

Okay. And then just last question on -- you mentioned wanting to stay at the leverage, right now below target because of the spread compression you’re seeing kind of weighted out of it. Do you see yourselves for the next couple of quarters probably staying at that lower level or is that something you’re just going to wait, maybe one more quarter for it?

Yes. I think it’s tough to say definitively when it will change. I think in this current environment, as other of our peers have also recognized, it makes a lot of sense to be prudent and it will be market dependent on when and how we approach our leverage over the coming quarters.

Our next question comes from the line of Kyle Joseph of Jefferies.

Hey. Good morning, guys. And thanks for taking my questions. Just first, in terms of the yield trends, I know you mentioned on call, you’re about half way through sort of going through into the new strategy, but we thought yields sort of -- we did see yields actually increase Q-on-Q. Just given your evolution and the fact that we are seeing yield stabilizes, is this a good run rate from here or do you still anticipate a little bit of contraction, given the strategy shift?

I think we would assume some contraction assuming flat LIBOR.

Okay. Got it.

So, obviously, we should benefit from LIBOR increases versus that contraction, but we’d still -- I mean, again, hard to know exactly. But I think we sort of stayed around 10 and I think that’s still sort of prudent to use.

Got it. And then, in terms of the industry, it’s been kind of a challenging few quarters. Are you guys seeing any consolidation opportunities out there?

I think all the BDCs out there, public or private that are exploring strategic alternatives we’re focused on. And you could presume, we’re taking attire as sort as ultimately if anybody else is. And I think for us, given what we perceive as our long-term size of our pipeline versus our current balance sheet, it will benefit from us from -- to have more capital because we think we could sort of put that to use, just by sort of expanding our whole sizes into larger equity base. And so, we do think there is opportunities but it’s not like a secular thing; it’s anecdotal thing. So, there are few that this quarter have clearly said that they’re looking at things. And so, we will be as evolved as anybody else is for sure.

Got it. And then, one last question for me in terms of the deals you’re passing on, is it pricing, covenant or leverage issue, a combination of all three? And then as a follow-up to that, are you seeing these deals sort of get done at those levels that they’re asking you for?

The answer is yes. In any one unique situation, it might be more so one or the other. But broadly speaking, this type of environment which is not only been marked by quite a bit of demand but less supply and I think that’s been well-published, particularly in the market, you have a number -- any number of those that you enumerated have affected. And frankly to last part of your question, in these sorts of environments, not only are we also -- not only are we competing with other private credit managers and the new fund formation there has introduced new entrants to that space, but so to, do we compete with the syndicated market. And then when we -- so to answer the last part of your question, in those deals that are getting syndicated, you’re seeing a lot of those deals get flexed tighter and far inside of where we would have been evaluating that opportunity on a private basis.

[Operator Instructions] Our next question comes from the line of Jonathan Bock of Wells Fargo.

Can you walk me through this, when we look at move your long-term dated debt options, why we haven’t seen the prospect for potential refinancing, just given that costs for some long dated issues have really come in and given your size and strength it’s highly possible, you could borrow cheaper than what -- in the issues that you have outstanding on the balance sheet?

I think, Jonathan, it’s a good question. I think if you think about the size and doing on different and getting the best rates, I think what we’d like to do is get closer to the 2043 bond, taking that out. And then, we’ve always been pretty clear that we like to have about 40% floating, 60% fixed and unsecured. And so, we’ll look to do that. And I think there will be a better opportunity. I think you just look at what’s been done in the marketplace, size has been -- attracted considerably different rates when you look at the current deals that were done in the different spreads by the different companies. I think it’s prudent to weigh on and use our revolver and that’s kind of why we have the facilities, five-year facilities. So, we’re very comfortable with using it at this time.

Our last question comes from the line of Ryan Lynch of KBW.

First one is kind of a broader question. Can you -- how would you describe the competitive environment right now that we’re seeing in the middle market? Obviously that’s competitive. But, how would you kind of compare that with the competitive environment and the deals that you’re seeing in the life sciences, asset-based and lender finance versus the middle market kind of cash flow based loans?

It is significantly different. I think the first thing is that new entrants into leverage loan market are significant and constant and there is not nearly as many barriers to entry. And so, you’re finding almost every asset manager being able to sort of form some capital around that and focus on it and sort of believe they know how to do it. For a bunch of reasons. One, because generally those asset managers and borrowers in that space, so they think they know how to do it; and two, it’s easier to originate frankly than the other more proprietary stuff. So, people stuff is cheaper to do. In the other areas, the competition happens less linearly, it’s more if somebody significant decides to enter that market. And so, if you look at those few markets over the past three or four years, there is more competition today than there was three or four years ago, certainly in the life sciences space but you see two or three people who have entered over the last few years that have compressed that. But on the flipside on the asset base, for healthcare asset base, the people we’ve competed with the most over the last few years have generally exited the market, GE Capital for example, and that had a better opportunity. And in general asset based lending, there have been a few entrants over the past year. So, it really is much more anecdotal, which makes it much more appealing because obviously anecdotal things [indiscernible] there could be a lot of them. But, right now, there is so much capital formation in the leverage loans sponsored coverage, they by definition have to be better. And by and large, the platforms that are looking to sort of get a piece of the private credit work, because that’s where LPs want to put their money, will only do in leverage loans, because it’s cheaper and easier. And so, that’s what you’re seeing.

At this time, I would like to turn the floor back over to management for any additional or closing remarks.

Thanks. On behalf of our team, we thank all of you today for your continued support. Please feel free to reach out to any of us, if you have any questions. Have a great day.

Thank you, ladies and gentlemen. This does conclude today’s conference call. You may now disconnect.