New Mountain Finance Corporation (NMFC) Q3 2012 Earnings Report, Transcript and Summary

Good morning, everyone, and welcome to the New Mountain Finance Corporation Third Quarter 2012 Earnings Call and Webcast. [Operator Instructions] At this time, I would like to turn your conference call over to Mr. Rob Hamwee, CEO. Mr. Hamwee, please go ahead.

Great. Thank you, and good morning, everyone. With me here today are Steve Klinsky, Chairman of NMFC and CEO of New Mountain Capital; and Adam Weinstein, CFO of NMFC. Steve is going to make some introductory remarks. But before he does, I'd like to ask Adam to make some important statements regarding today's call.

Thank you, Rob. I would like to advise everyone that today's call and webcast is 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 earnings press release. I would also like to call your attention to the customary Safe Harbor disclosure in our November 6, 2012, 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 these statements and projections. We do not undertake to update our forward-looking statements or projections unless required by law. Any references to New Mountain Capital or New Mountain are referring to New Mountain Capital, LLC, or its affiliates, and may be referring to our investment advisor, New Mountain Finance Advisers BDC, LLC, where appropriate. To obtain copies of our last SEC -- latest SEC filings and to access the slide presentation that we'll be referencing throughout this call, please visit our website at www.newmountainfinance.com or call us at (212) 720-0300. At this time, I'd like to turn the call over to Steve Klinsky, the Chairman of New Mountain Finance Corporation, who will give some highlights beginning on Page 4 of the slide presentation. Steve?

Thanks, everybody. Before turning the call back over to Rob and Adam, I wanted to welcome you all to New Mountain Finance Corporation's Third Quarter Earnings Call for 2012. Rob and Adam will go through the details, but I am pleased to present the highlights of another strong quarter for New Mountain Finance. New Mountain Finance's adjusted net investment income for the quarter ended September 30, 2012, is $0.32 per share, consistent with our previously announced guidance of $0.31 to $0.33 per share. The company's book value on September 30 was $14.10 per share, an increase of $0.27 per share, primarily reflecting stronger credit markets. We are also able to announce our regular dividend for the quarter -- the current quarter ending December 31, 2012. The regular dividend will again be $0.34 per share, consistent with our previously communicated view that we have reached a fully ramped steady-state dividend level. The credit quality of New Mountain Finance's loan portfolio continues to be strong with, once again, no new issuers placed on nonaccrual. As a reminder, we built our models based on a 3% assumed annual default rate and a 1% annual loss assumption from the date of the IPO. In fact, we have had only 1 issuer default since October 2008, when the debt effort began, and it represented just 0.7% of the cost basis of our existing portfolio and less than 0.4% of cumulative investments made to date. New Mountain Finance's pace of new investments continues to be robust. The company invested $173 million in gross originations in Q3, largely deploying the proceeds from July's capital raise. As discussed on our last call, earlier in the quarter, we raised approximately $85 million of new equity capital and increased our credit facilities by $50 million. In September, we continue to increase the company's float by selling into the market 4 million shares previously owned by New Mountain's private equity fund. Just to remind everyone, we, as management, were significant buyers personally in the IPO, and we sold none of those shares in these offerings. Targeted yields on new investments continue to be consistent with our previously communicated expectations. Our portfolio continues to emphasize positions in recession-resistant acyclical industries pursuant to New Mountain's overall strength and strategy. We continue to be very pleased with the progress of New Mountain Finance to date, and we are pleased to address you as fellow shareholders, as well as management. With that, let me turn the call over to Rob Hamwee, New Mountain Finance Corporation's Chief Executive Officer.

Thank you, Steve. As always, I'd like to start with a brief review of NMFC and our strategy. As outlined on Page 5 of our presentation, NMFC is externally managed by New Mountain Capital, a leading private equity firm with approximately $9 billion of assets under management and over 90 staff members, including nearly 60 investment professionals. NMFC takes New Mountain's approach to private equity and applies it to corporate credit with the consistent focus on defensive growth business models and extensive fundamental research. Some of the key hallmarks of defensive growth business models include acyclicality, sustainable secular growth drivers, high barriers to competitive entry, niche market dominance, repetitive revenue, variable cost structure and strong free cash flow. With this historically successful business model focus approach in mind, our mandate since the inception of New Mountain's debt investment program in 2008, has been to target high-quality businesses that demonstrate most or all of the defensive growth attributes that are important to us and to do so within industries that are already well researched by 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 will allow us to generate attractive risk-adjusted rates of return plus [ph] changing cycles in market conditions. To achieve our mandate, we utilized the existing New Mountain investment team as our primary underwriting resource. Turning to Page 6. You can see our total return performance from our IPO in May 2011 to November 5, 2012. We continue to be very pleased with both our absolute and relative return on performance. As outlined on Page 7, credit markets have been very strong since our last call. QE3 and the promise of extraordinarily low risk-free rates…

Thank you, Rob. For more details on our financial results and commentary, please refer to the Form 10-Q that was filed last evening with the SEC. Before we turn to Slide 20, I want to mention that we've included a structured chart as Appendix A in the presentation. And so similar to our last call, I will only spend a moment reviewing our structure as a brief refresher and also how our structure was impacted by the share issuance and share sales in the current quarter. Our structure was set up similar to an upreach [ph] structure, whereby the public company, PubCo, has no direct operations of its own, and its sole asset is its units of our operating business, OpCo. Today, the other units of OpCo are held by a private BDC, owned by New Mountain's private equity fund, AIV Holdings. During the current quarter, and as a result of: a, the primary share issuance of PubCo shares in July of 5,926,802 shares; b, AIV Holdings' secondary sale of 4 million shares in September; and, c, 66,142 shares issued in our DRIP to PubCo shareholders, the ownership has shifted from PubCo owning 34.6% and AIV Holdings owning 65.4% at June 30 to PubCo and therefore, the public shareholders, now owning 56.1% and AIV Holdings owning 43.9% of OpCo at September 30. Our structure is a master-feeder, whereby the financial statements for OpCo flow to PubCo and AIV Holdings per rata based on their respective ownership. All discussion throughout this call and presentation is focused on OpCo and its operations. Additionally, OpCo owns the equity of a nonrecourse vehicle, the SLF. This vehicle originates lower yielding's first lien loans, but with greater leverage at 2:1. For GAAP, asset coverage and presentation purposes, we consolidate this SLF vehicle into the operations…

Thanks, Adam. While, once again, we do not plan to give explicit forward guidance, 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 run rate NII falls between $0.33 and $0.35 per share in line with our current expectations. In closing, I would just like to say that we continue to be extremely pleased with our performance [Technical Difficulty]

Ladies and gentlemen, the speakers have been reconnected to the conference.

Thanks, Jamie. Apologies, everyone, still suffering the post-Sandy hangover. But in any event, we're just finishing up. In closing, I would just like to say that we continue to be extremely pleased with our performance to date. Most importantly, from a credit perspective, our portfolio 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] And our first question comes from Ryan Lynch from Stifel, Nicolaus.

This quarter, you guys had your strongest quarter in terms of originations, and it looks like that's going to have an equally strong quarter in -- in fourth quarter from what you guys have updated us with. We've kind of heard from market participants the market's kind of had some tightening spread and getting a little more issuer-friendly. Can you guys kind of talk about your -- why you guys put so much capital work and are putting so much capital work in Q4?

Yes. I mean, I think it's -- as I've touched on in the comments, we're seeing a tremendous amount of deal flow which allows us to be very, very highly selective. And really, this is where the affiliation and being part of the New Mountain platform is so important, that we're still seeing businesses that we really know and that, we, based on that knowledge, feel very, very comfortable investing in and having a strong and informed view on the prospects of those businesses. Now are spreads down 50, 75 bps? They are, but we're still able on an absolute basis to get spreads that make sense for us and allow us to support the net income levels we're looking at and really not take on, or we believe, not take on any incremental credit risk. So we're happy with that. And again, I don't think it would be possible if we weren't part of New Mountain and weren't been -- hadn't seen these businesses from a private equity perspective and have that intimate knowledge. But that's really allowed us, I think, to maybe have a differentiated view as to the ability to deploy capital, frankly.

Then also in Q3, it looks like you guys primarily originated first-lien loans. And then in Q4, quarter-to-date, all your originations have been in second-lien loans. Is there something you guys are seeing on the second lien going forward which is giving you better risk-adjusted returns? Or can you kind of talk about that?

I think it's really a combination of 2 things. I think one is, as you know, we strive to maintain a balance. We've always talked about being ultimately 50-50, but we've always skewed a little more heavily toward 60-40, which is where we were at prior to the start of the fourth quarter, in terms of first lien, second lien -- first-lien, nonfirst-lien mix. And part of that is the way we utilize the SLF. And then that sort of capacity gets stilled up, we're more of a sell-and-replace mode vis-a-vis first lien. So we used some of the new capital to allocate in that way in the third quarter. As we've entered the fourth quarter, we're pretty well stilled [ph] up there. And again, we're more in a sale-and-replace mode. And then the other thing, again, is the market has moved, as we talked about. And so there's frankly less compelling spread opportunities available in first-lien loan land. But again, as I've stated previously, we are seeing the attractive opportunities on an absolute basis in the second-lien arena. So we're really -- we don't set out with a quota or any perceived view that, hey, we're going to originate x million dollars of any specific type of loan. We really are more focused on, where can you find absolute value? And where we do, that's where we execute.

Okay. And then one last question. Your investment in MACH Gen was ringed down a little bit further in Q3 and is currently marked at 67% of your cost basis. Is there any update you can give us on how that business is performing?

Yes. I mean, that's a little bit artificial, right, because MACH Gen did a couple of tenders recently at $0.90. So obviously, the -- if it was $0.75 and you sold 1/4 of your position into the tender at $0.90, the stub gets an implied value of $0.65 or what have you. So when you factor in the $0.90 pieces that we've gotten through the 2 tenders, MACH Gen's actually up modestly from our purchase and from recent marks. So I would say, that asset really is, and I can't get too much into because of confidentiality, but we're very comfortable with that asset. And at the same time, we've made it a smaller position through the tenders, as well as actually won its open market sale earlier on.

[Operator Instructions] And our next question comes from J.T. Rogers from Janney Capital Markets.

I had a -- just a question on what you all's view is on keeping the base [ph] of capacity available, if we run into, I guess, the talk now is fiscal cliff issues in January. Just having dry powder available to take advantage of any mispricing that might appear versus keeping fully levered and which obviously is driving consistently strong NII?

Yes, it's an interesting trade-off and one we talk a lot about. And I guess, the way we analyze it is really 2 things, J.T. I think, on one end, we have just a hard time viewing ourselves as sort of macro guys and trying to outguess the market. Because things, they get worse, but they can also get better, right? We've all been surprised about that, and spreads could tighten that much more. So in that sense, we view it as our mission is to be invested in such a way that we are, with the least risk possible, able to generate the net income to support the dividend that people are relying on, as opposed to trying to get an extra score by guessing the direction of the market and keeping material dry powder to execute on that if that were to happen. That being said, we do have reasonable visibility into some material repayments that are coming in, based on some M&A processes we're aware of at our underlying portfolio of companies. So to some degree, we're a little bit hedged in that we have pretty high expectations, that even if we do nothing, that we will be net long some meaningful amounts of cash early in the first quarter and we'll deploy that. That gives us an opportunity to execute on some optionality that may come up in the -- if that market were to go in that direction.

Okay, great. That makes a lot of sense. And just -- so honing up, I figured I'd just say, you're not macro investors, any view on the sort of -- on the macro environment, at least from what you're seeing from deals you're looking at and the companies in the portfolio?

Yes. I mean, while we don't act on it, it doesn't mean we don't have opinions, and we do. I think our perspective is that we're very cautious, frankly, and that we are seeing fine results out of our portfolio of companies, as we've shown in the data. But when we talk to the management teams, they're cautious, they're concerned. Obviously, we just had an election yesterday, and the implications of that are not necessarily pro-business, but we will see what comes out of that. And we're concerned that the policies of the Fed are perhaps propping up an economy that otherwise may be not as strong. So we're -- that's why we rely frankly on the acyclicality, the defensive growth nature of the underlying businesses. Because we start from a position as a firm of being generally concerned about the world. And I think that concern is just heightened, based on the world as it exists today and some of the specific comments we're hearing out of our management team.

Okay, great. That's really helpful. In terms of the portfolio companies that you're exiting and you have some visibility into, can you give us a sense of what the yield is on those companies that you're exiting, going in the fourth quarter that you do see an exit from?

Yes. I mean, there's a handful of them. The biggest one is actually one of our lowest-yielding assets. So it would be -- it's a nice one to get to redeploy. Around -- beyond that, it's sort of a mixed bag. There's one that is -- it's that slide where we showed that 10.2% portfolio level yield, asset level yield. There's one that's a few hundred bps ahead of that, and then there's one that's sort of right in line with that. But the biggest one is actually a couple of hundred bps below that. So we actually think that on the margin, the money we'd expect to get back will have a blended yield that is lower than the 10.2% yield. And as you can see, even in this somewhat compressed-spread environment, the money we're putting out in the fourth quarter is higher than the 10.2% yield. So we hope to kind of slowly rebuild that number. Although we peaked, as you can see on Page 18, at the 10.5%, which is a very good level for us. So we're comfortable with anywhere in the low to mid-10s.

Okay, great. And then just for the portfolio that you're exiting, I think you -- so it's a little bit lower than your current blended yield. Is it materially below enough that you would expect to see a, maybe, a meaningful pickup in rated average yield? Or is it going to be small, on the margin?

Yes, it's on the margin. And obviously, the other side of the equation is how the capital gets redeployed. Again, our best guide for that is what we've -- the data points we showed you for Q4 activity to date. But it's -- this is all around the margin, given that the portfolio has now grown to $900 million. So even a -- if you look at our concentration, even selling one of our bigger assets generates $30 million. So it doesn't move the needle dramatically.

Okay, great. And just one more question, if I could. Any view as to the M&A environment?

Yes, the M&A environment is incredibly robust. I mean, we're -- we know that from our private equity activities, and we know that from the calls we're getting in terms of looking at deals across all sizes. So this is going to be a very busy quarter for everybody, I believe, in terms of M&A. And I think, the first quarter is hard to predict given, again, some of the things we're all staring at right now. But I know there's a lot of activity trying to get done this quarter.

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

Rob, first question, and I know you alluded a little bit to it, saying that it's a robust environment. But portfolio velocity and how we can perhaps model and look at potential loans that will be coming back at you. And more importantly, what the outlook on those loans has been from a prepayment fee and/or a onetime fee standpoint, maybe boost in the NII line a little bit?

Yes, sure. So the rule of thumb I was using in this environment -- so assuming the environment doesn't change dramatically one way or the other, I sort of just use kind of a 3-year weighted average life assumption. So we have a $900 million portfolio entering 2013. I would expect over the course of 2013 to get $300 million of that paid back. Could it be $200 million? Could it be $400 million? Absolutely. But that's sort of, I think, been a pretty good rule of thumb for us. And then there are clearly fees associated with those prepayments at times, not always, but often times. I know we disclosed the exact prepayments we got in this -- fees from prepayments in this quarter. I don't know if you have that number.

Yes, yes. So it was really $1.1 million, which is exactly the same as last quarter. It was $1.1 million, roughly the same exact number.

I think that's a good number to think about going forward. Again, those things tend to be a little lumpy. Could be 700K, could be $1.4 million. But it's that magnitude, it's not -- it's unlikely to be $3 million, and it's unlikely to be 0. So we, I think, consistently benefit a little bit from that. And obviously, the flip side is we need to redeploy that capital in assets we like just as much as the assets that we're -- that are being monetized.

Okay, great. And also, Rob, your comments on second lien were very interesting, and that you're seeing a good risk adjusted returns there relative to the senior asset class. Maybe a few technical questions. First, what is that average leverage level you're looking at in those types of investments? How has that trended recently? And more importantly, would the majority of those second-lien investments also be affiliated with the private equity firm that would be taking capital off the table in the form of a dividend recap?

Yes. And let me just -- I'll address those questions. But let me just be clear, we're being very selective in the second-lien market. The majority, the vast majority of deals, we don't think are interesting. And we think there is significant stretching being done in that market. So we're investing in the deals we're investing in, because we know those companies intimately and have great confidence in our ability to predict their future operating prospects. So I'm not saying at all that, oh, the second-lien market, as a market, is a compelling buy sitting here today. I think we've been -- it just so happens that because of our being part of the New Mountain platform, we've been able to see [ph] things that we have great insight into. So that is just a overall caveat just to make sure we're clear about that. So to your specific question, the leverage multiple is a kind of custom suit, right? So if you look at the things we've done, and I can't -- just from confidentiality match leverage multiples to deal. But to give you a range, we've got second liens as low as low to mid-4s, and then as high as high 6s. So as I've always said, I'd rather be high 6s on a business I think is worth 12x, than low 4s on a business I think is worth 6x. We're ultimately underwriting enterprise values and stability of future cash flows, and that really drives us in terms of how we think about leverage multiples as opposed to having absolute rules about, oh, 5.5 or 6 or 4, whatever it may be. But that's the data around the recent second liens that we've done. In terms of which -- how many are sponsored dividends versus M&A, again, it's a mixed bag. I'll give you the exact number in a second. So the recent deals, it was about half and half.

And at this time, I'm showing no additional questions. I'd like to turn the conference call back over to management for any closing remarks.

All right, great. Thanks. Nothing really else to say. Just want to thank everybody, and look forward to talking again at the end of the calendar year when we have our next call. And obviously, in the interim, as always, we're all accessible any time for any questions anybody may have. Thanks very much. Bye-bye.

Ladies and gentlemen, that concludes today's conference call. We do thank you for attending. You may now disconnect your telephone lines.