New Mountain Finance Corporation 8.250% Notes due 2028 (NMFCZ) Q2 2017 Earnings Report, Transcript and Summary

Good morning and welcome to the New Mountain Finance Corporation’s Second Quarter 2017 Earnings Conference Call. All participants will be in listen-only mode. [Operator Instructions] After today’s presentation, there will be an opportunity to ask questions. [Operator Instructions] Please note that this event is being recorded. I would now like to turn the conference over to Mr. Rob Hamwee, CEO. Please go ahead.

Thank you and good morning, everyone and welcome to New Mountain Finance Corporation’s second quarter earnings call for 2017. On the line with me here today are Steve Klinsky, Chairman of NMFC and CEO of New Mountain Capital; John Kline, President and COO of NMFC; and Shiraz Kajee, CFO of NMFC. Steve Klinsky is going to make some introductory remarks, but before he does, I’d like to ask Shiraz to make some important statements regarding today’s call.

Thanks, Rob. Good morning, everyone. Before we get into the presentation, I would like to advise everyone that today’s call and webcast are being recorded. Please note that they are the property of New Mountain Finance Corporation and that any unauthorized broadcast in any form is strictly prohibited. Information about the audio replay of this call is available in our August 8 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 details in a moment, but let me start by presenting the highlights of another strong quarter for New Mountain Finance. New Mountain Finance’s adjusted net investment income for the quarter ended June 30, 2017, was $0.34 per share in the middle of our guidance of $0.33 to $0.35 per share and once again covering our quarterly dividend of $0.34 per share. New Mountain Finance’s book value was $13.63 per share as compared to $13.56 per share last quarter, or $0.07 increase per share. We’re also able to announce our regular dividend for the current quarter, which will again be $0.34 per share and annualized yield in excess of 9% based on last Friday’s close. The company had another productive quarter of deal generation invest in $258 million in gross originations. Repayments in the quarter were $182 million. We continue to be fully invested and credit quality remains strong. I and other members of New Mountain continued to be very large owners of our stock with aggregate ownership of 9.1 million shares approximately 12% of total shares outstanding. 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 model and extensive fundamental research within industries that are already well known to New Mountain. Or more simply put, we invest in recession resistant businesses that we really know and that we really like. We believe this approach results in a differentiated and sustainable model that allows us to generate attractive risk adjusted rates of return across changing cycles and market conditions. To achieve our mandate, we utilized 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 August 4, 2017. In the six plus years since our IPO, we have generated a compounded annual return to our initial public investors of 11.5%, meaningfully higher than our peers in the high yield index and well over 1000 basis points per annum above relevant risk free benchmarks. Page 8 goes into a little more detail around relative performance against our peers that benchmarking against the ten 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 illustrates, over the six plus years we have been public, we have effectively maintained a stable book value, inclusive of special dividend, while generating 10.4% cash on cash return for our shareholders, fully supported by net investment income. We attribute our success to one, our differentiated underwriting platform; two, our ability to consistently generate the vast majority of our NII from stable cash interest income, and 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 interests. Our highest priority continues to be our focus on risk control and credit performance, which we believe over time, is the single biggest differentiator of total return in the BDC space. I’m pleased to report that there has been no significant negative credit migration this quarter. If you refer to page 10, we once again layout 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 is migrated down the performance ladder. Since inception, we have made investments of nearly $4.9 billion in 205 portfolio companies, of which only seven representing just $112 million of cost have migrated to non-accrual of which only four, representing $43 million of costs have thus far resulted in realized default losses. Approximately 98% of our portfolio at fair market value is currently rated one or two on our internal scale. Page 11 shows leverage multiple for all of our holdings above $7.5 million when we entered an investment and leverage levels for the same investment as of the end of the most recent reporting period. While not a perfect metric, the asset by asset trend in leverage multiple is a good snapshot of credit performance and helps provide some degree of empirical fundamental support for our internal ratings and marks. As you can see by looking at the table, leverage multiples are roughly flat or trending in the right direction with only a few exceptions. Three loans show negative migration of 2.5 terms or more. One, which we have discussed for a number of quarters, is Sierra Hamilton, which completed its restructuring in July and where underlying business trends continue to improve. The second is a high quality business that has face certain end market challenges and where the company expect financial metrics to improve in coming quarters. The company has significant cash flow and liquidity and should have no issue servicing its debt for the foreseeable future. The third company, Edmentum, which we restructured in 2015, is performing inline with its restructuring plan. The chart on Page 12 helps track the company’s overall economic performance since its IPO. At the top of the page, we show how the regular quarterly dividend is being covered out of net investment income. And 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 non-accruals by selling poor credit at a material loss, prior to actual default. As highlighted in blue, we continue to have a net cumulative realized gain of $12 million. Looking further down the page, we can see that cumulative net unrealized appreciation highlighted in grey stands at $22 million and cumulative net realized and unrealized loss highlighted in yellow is at $10 million. The net result of all of this is that in our six plus years has a public company we have earned net investment income of $428 million again a total cumulative net losses including unrealized of only $10 million. I will now turn the call over to John Kline, NMFC’s President to discuss market conditions and portfolio activity. John?

Thanks, Rob. As outlined on Page 13, the credit markets are stronger today than they have been since we went public in 2011. Even since our last call we have seen credit spreads continue to tighten in this competitive market. Leverage levels for high quality sponsor-backed companies continue to be fall. However, we’re still seeing equity contributions of 45% to 60% of total enterprise value, representing meaningful capital at risk below our debt. We’ve experience a tailwind and base rates with three-month LIBOR now at 1.3%. This base rate increase has provided NMFC with a small or dyeable offset to the spread compression we have experienced. Looking forward, we believe there’s currently a high-level of sponsored activity in the market, which should lead to very strong deal flow this fall. We have some hope that more leverage buyout transactions will cause the aforementioned spread tightening to lesson or reverse. However, we’re prepared to operate our business successfully in the event the existing environment persists. More than ever, we rely on the importance of our disciplined focus on defensive growth industries and differentiated access to deal flow afforded to us by the broader New Mountain platform. Turning Page 14, NMFC continues to be well positioned in the event of future rate increases, as 86% of our portfolio is invested in floating rate debt. Meanwhile, we have locked in 49% of our liabilities at fixed rates to ensure attractive borrowing costs over the medium term. Three-month LIBOR has increased to 131 basis points, which is roughly 30 basis points above the average LIBOR floor on our floating-rate assets. As the chart on the bottom of the page shows, given our investment portfolio and liability mix, NMFC is very strongly positioned in the event of an increase in short-term rates. Even a moderate increase in the base rate of 100 basis points adds $0.10 or 7.5% to our annual net investment income. Moving on to portfolio activity, as seen on pages 15 and 16, NMFC had an active quarter for new investments. Total originations were $258 million, offset by $182 million of repayments and $13 million of sale proceeds, yielding net new investment of $63 million. Our new originations were spread fairly evenly across 16 obligors, including two transactions purchased by our SBIC subsidiary. We saw high-quality investments within most of our key verticals highlighted by bilateral financing, Ferrellgas [ph], and participation in several high-quality middle-market club deals. The breadth of our deal flow this quarter is a testament to the broad sourcing network that we have built. Since the end of the quarter, despite the very competitive deal environment, we have continued our strong investment pace with $98 million of new investments, offset by $142 million of sales and repayments. These repayments are a result of a combination of M&A and opportunistic refinancings, both of which, are inevitable in a strong market. It is worth noting that NMFC will benefit from incremental fee income on repayments based on – and based on our deal pipeline, we expect to reinvest the proceeds in the short-term. Turning to Page 17, we show the breakout investments by asset type. On the left side of the page, we show our new originations skewed slightly towards first lien, while on the right side, we show that our repayments were rated materially towards first lien. While the repayment mix changes the composition of our investment portfolio slightly, we don’t anticipate a material change in our overall investment mix in the coming quarters. As shown on Page 18, in Q2, asset yields on new originations of 9.5% were somewhat lower than the average yields on our portfolio. This is due primarily to the first lien heavy mix on new originations in the quarter, and secondarily, due to the spread compression we have experienced in the marketplace. Looking forward, we seek to maintain our historical credit standards and to avoid stretching for more yield on risk year loans. As a result, spread compression will continue to be at risk due to the portfolio. With this in mind, we do see an opportunity to mitigate more potential spread compression through higher income from rising base rates, fee generation on new deals and prepayments and further – and significant further investments in our FDIC program. On the top of Page 19, we show a balanced portfolio across our defensive growth-oriented sectors. In the services section of the pie chart, we now show a breakout of subsectors to give better insight into the diversity within our largest sector. On the bottom of the page, we continue to maintain our targeted mix between senior and subordinated investments, and on the lower right, we show that the vast majority of our portfolio continues to perform at or above our expectations. Finally, as illustrated on Page 20, we have a broadly diversified portfolio with our largest investment at 5.6% of fair value, and the top 15 investments accounting for 41% of fair value. With that, I will now turn it over to our CFO, Shiraz Kajee, to discuss 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’d like to turn your attention to Slide 21. The portfolio had approximately $1.88 billion in investments at fair value at June 30, 2017 and total assets of $1.95 billion. We had total liabilities of $919 million, of which total statutory debt outstanding was $752 million, excluding $127 million of drawn SBA-guaranteed debentures. Net asset value of $1 billion or $13.63 per share was up $0.07 from the prior quarter. As of June 30, our statutory debt to equity ratio was 0.73 to 1. On Slide 22, we show our historical leverage ratios, which are broadly consistent with our current target statutory leverage of between 0.7 and 0.8 to 1. On the slide, we also show the historical NAV adjusted for the cumulative impact of special dividends, which portrays a more accurate reflection of true economic value creation. On Slide 23, we show our quarterly income statement results. We believe that our adjusted 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 June 30, 2017, we earned total investment income of approximately $50 million. This represents an increase of $6.7 million from the prior quarter, largely attributable to an increase in prepayment income an increase in investment income from a larger asset-based. Total net expenses were approximately $24.2 million, an increase of $4.3 million from the prior quarter, due primarily to an increase in incentive fees and no incentive fee waiver this quarter. As in prior quarters, the investment advisers continue to waive certain management fees, such that the effective annualized management fee is 1.4%. It is important to note that the investment adviser can not recruit fees previously waived. This results in first quarter adjusted NII of $25.8 million or $0.34 per weighted average share, which is in line with guidance and covered our Q2 regular dividend of $0.34 per share. In total, for the quarter ended June 30, 2017, we had an increase in net assets resulting from operations of $27.3 million. Slide 24 demonstrates our total investment income is recurring in nature and predominantly paid in cash. As you can see, 90% of total investment income is recurring and cash income remains strong at 87% this quarter. We believe this consistency shows stability and predictability of our investment income. Turning to Slide 25, as briefly discussed earlier, our adjusted NII for the second quarter covered our Q2 dividend. We now believe that our Q3 2017 adjusted NII will fall within our guidance of $0.33 to $0.35 per share. Our board of directors has declared a Q3 2017 dividend of $0.34 per share, in line with the past 21 quarters. Q3 2017 quarterly dividend of $0.34 per share will be paid on September 29, 2017 to holders of record on September 15, 2017. Finally, on Slide 26, we highlight our various financing sources. During the quarter we issued $55 million of five year unsecured notes and an attractive rate of 4.76%. Taken into account SBA-guaranteed debentures, we had approximately $1.1 billion of total borrowing capacity at quarter end with no near-term maturities. 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 investment at any given time. With that, I’d like to turn the call back over to Rob.

Thanks, Shiraz. It continues to remain our intention to consistently pay the $0.34 per share on a quarterly basis for future quarters so long as the adjusted NII covers the dividend in line with our current expectations. In closing, I would just like to say that we continue to be pleased with our performance to date. Most importantly, from a credit perspective, our portfolio overall continues to be 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?

We will now begin the question-and-answer session. [Operator Instructions] And our first question comes from Jonathan Bock of Wells Fargo Securities. Please go ahead. Fin O’Shea: Hi, guys, Fin O’Shea on for Jonathan this morning, thanks for taking our question. Awesome. We saw in June, you guys received – presented relief to coinvestment other funds. Can you kind of give us some color as to whether these are – this is kind of funds in place on the platform or whether you intend to build out beyond the BDC a larger direct lending apparatus?

Yes. So we have a relatively new fund – a private fund, that had its first closing earlier in the year, we’re at about $250 million of commitments to that fund and we’re open for another couple of months here. So we are building out a little bit on the private side. We do feel our deal flow and the opportunities set continues to increase to the point where our broader capital base makes sense. So that’s what really that speaks to. Fin O’Shea: Very well. And then just a question, I’m sure you hear from time to time, given the defensive nature of your selection. We hear sectors like software, for example, because they are defensive and study going at very elevated multiples, the leverage attachments can get pretty high, too. Can you kind of give us a feel what you’re seeing in those verticals and, which maybe sub-verticals you find attractive today?

Yes, absolutely. I mean, we have definitely seeing purchase price multiples in the private equity in general and they’re certainly exception to that. But in general these attractive defensive areas, purchase price multiples have continue to expand. What’s interesting is that leverage multiples haven’t expanded on a ratable basis. I mean, there’s real cap on the leverage multiple side. So we have just seen increasing sponsor equity contributions. To give you some sense, we have seen purchase multiples in some deals, 14x, 15x, 16x, 17x, with leverage multiples typically capped in somewhere between 6x and 7x. So you’re seeing sponsor equity contributions well north of 50% in many of the deals that we are involved with. Fin O’Shea: Thank you so much.

You’re welcome.

[Operator Instructions] Our next question comes from Paul Johnson of KBW. Please go ahead.

Good morning, guys. Thanks for taking my questions.

Yes, no problem, Paul.

I had a question, you guys mention Sierra Hamilton, it was restructured post quarter end. Can we expect that the second quarter 2017 fair value mark is reflective of what you will receive out of that restructuring?

Yes, absolutely at any mean – there’s been restructuring we’ve been talking about now for two or three quarters. So the mark has reflected that for some time and certainly the Q2 mark is fully reflective of the reorganized securities that we have not received.

Okay, thanks. And then, another portfolio company Pinnacle software I saw what you guys took a pretty nice markup in the quarter. Can you guys give any color around that company? Has there been a recovery in the business? Or anything that you can provide there would be nice too.

Yes, so the color that we can provide is that there was a Wall Street Journal article. And this is – can provided, because it’s public. The Wall Street Journal article in late in the quarter, some mid-June, that talked about some possible M&A around that company and that led to an increase in the visible marks on that – that we use as a part of our valuation process for those valuations. So it’s really the speculation about a possible sale of that enterprise and a pretty high-value that led to that. Obviously, we have no color beyond that, as to the likelihood or the lack of likelihood of any type of transaction coming there.

Okay great. And then, another one I just had kind of quickly back into this, but I kind of wanted to see if you guys were able to provide exactly what the income from the net lease assets on your portfolio was? I know you’ve got a slide in there with the SLF and the net lease income combined, if I sort of do some rough math, I get about $1 million or so for the quarter, does that sound right?

Net income from the lease – from the REIT, that’s a little high, about 700,000 or so roughly.

700,000, Okay.

So, it’s still a pretty small.

Sure. That’s fine. Okay, and my last question just to be sort of a general question, which is you guys were able deploy nice amount of capital in the quarter. I’m just curious at a time with high refi activity M&A, a lot of BDC managers seeing net repayments versus net originations. What allowed you to really be able to successfully deploy that amount on capital in the quarter? And I guess on top of that, is there any particular part of the market that you guys are seeing value or particular asset that you’re targeting?

Yes. I think John touched on a little bit, which is – it’s really the breath of the – and the increasing breath of the New Mountain platform, that allows us, I think, to both see and evaluate, perhaps more opportunities than some of our brethren. We haven’t changed anything, we’re still only doing investments in businesses that we know and like from our New Mountain platform, but that platform has continued to grow and that generates increased looks, as well as increased areas, subareas within our broader verticals of expertise. So in terms of what we like in this environment, it’s still the same type of defensive growth businesses of the same attributes of high free cash flow, a cyclicality recurring revenue, that we have talked about in the past. And really, it’s that expanded platform that allows us to see a lot of good looks and we continue to maintain great discipline around the quality of the business and the loan to value proposition that we’re willing to accept. We have seen some, as John touched some modest spread compression within that and that we can live with, but we will never lived with is meaningfully changing our underwriting standard. John, if you want to add anything to that?

That’s right on.

Okay, thank you very much.

Great, thank you.

[Operator Instructions] This concludes our question-and-answer session. I would like to turn the conference back over to Mr. Rob Hamwee for any closing remarks.

Well, thanks, everyone. Appreciate the time and interest and look forward to speaking again next quarter. Bye-bye.