New Mountain Finance Corporation 8.250% Notes due 2028 (NMFCZ) Q1 2018 Earnings Report, Transcript and Summary

Good morning and welcome to the New Mountain Finance Corporation’s First Quarter 2018 Earnings Conference Call. All participants will be in listen-only mode. [Operator Instructions]. Please note, that this event is being recorded. I would now like to turn the conference over to Rob Hamwee, Chief Executive Officer of New Mountain Finance Corporation. Please go ahead.

Thank you. Good morning everyone and welcome to New Mountain Finance Corporation’s first quarter earnings call for 2018. On the line with me here today are Steve Klinsky, Chairman of NMFC and CEO of New Mountain Capital; John Kline, President and COO of NMFC and Shiraz Kajee, CFO of NMFC. Steve Klinsky is going to make some introductory remarks. 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 May 7 earnings press release. I would also like to call your attention to the customary Safe Harbor disclosure in our Press Release and on Page 2 of the slide presentation regarding forward-looking statements. Today’s conference call and webcast may include forward-looking statements and projections and we ask that you refer to our most recent filings with the SEC for important factors that could cause actual results to differ materially from those statements and projections. We do not undertake to update our forward-looking statements or projections, unless required to by law. To obtain copies of our latest SEC filings and to access the slide presentation that we will be referencing throughout this call, please visit our website at www.newmountainfinance.com. At this time, I’d like to turn the call over to Steve Klinsky, NMFC 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 net investment income for the quarter ended March 31, 2018 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’s book value was stable at $13.60 per share as compared to $13.63 per share last quarter. We are also able to announce our regular dividend, which for the 24th straight quarter will again be $0.34 per share; an annualized yield of 10.1% based on last Thursday’s close. The company had another productive quarter of deal generation investing $238 million in growth originations versus repayments of $84 million, which keeps us fully invested. Credit quality remains strong as for the fourth consecutive quarter there were no new non-accruals. I and other members of New Mountain continue to be very large owners of our stock with aggregate ownership of 9.6 million shares, approximately 13% of total shares outstanding, an increase of over 0.5 million shares over last quarter. Finally, the broader New Mountain platform that supports NMFC continues to grow with over $20 billion of assets under management and 140 team members. In summary, we are very pleased with NMFCs 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 six of our presentation NMFC is externally managed by New Mountain Capital, a leading private equity firm. Since the inception of our debt investment program in 2008, we have taken New Mountain's approach to private equity and applied it to corporate credit with a consistent focus on defensive growth business models and extensive fundamental research within industries that are already well known to New Mountain or more simply put, we invest in recession resistant businesses that we really know and that we really like. We believe this approach results in a differentiated and sustainable model that allows us to generate attractive risk adjusted rates of return across changing cycles and market conditions. To achieve our mandate, we utilize the existing New Mountain investment team as our primary underwriting resource. Turning to page seven, you can see our total return performance from our IPO in May 2011 through May 3, 2018. In the seven years since our IPO we have generated a compounded annual return to our initial public investors of over 10%, meaningfully higher than our peers in the high yield index and approximately 900 basis point per annum above relevant risk free benchmarks. Page eight goes into a little more detail around relative performance against our peer set, benchmarking against the 10 largest externally managed BDCs that have been public at least as long as we have. Page nine 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 seven years we have been public, we have effectively maintained a stable book value inclusive of special dividend while generating a 10.4% cash-on-cash return for our shareholders. We attribute our success to one, our differentiated underwriting platform; two, our ability to consistently generate the vast majority of our NII from stable cash interest income 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 accepting 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 am pleased to report that there has been no significant negative credit migration this quarter, although first quarter and one of our smaller investments American Tire Distributors, lost one of its largest supplier leading us to reevaluate our investment thesis and ultimately decided to our exist our position at a $6 million loss. If you refer to page 10, we once again lay out the cost basis of our investments, both the current portfolio and our cumulative investments since the inception of our credit business in 2008 and then show what has migrated down the performance ladder. Since inception we have made investments of over $5.5 billion in 229 portfolio companies of which only seven representing just $112 million of costs have migrated to non-accrual of which only four representing $43 million of costs have thus far resulted in realized default loss. Further virtually 100% of our portfolio at fair market value is currently rated one or two on our internal scale. Page 11 shows leverage multiples for all of our holdings above $7.5 million when we entered in investment at leverage levels for the same investment as of the end of the most recent reporting period. While not a perfect metric, the asset-by-asset trend and leverage multiples 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. Only one loan as mentioned, which we restructured in 2015 and as previously in which we recently invested incremental capital to increase our ownership and support an ambitious future growth plan showed negative migration of 2.5 turns or more. We remain optimistic about the long-term prospects for the company and our investments. The chart on page 12 helps track the company's overall economic performance since its IPO. At the top of the page we show how the regular quarterly dividend is being covered out of net investment income. As you can see, we continue to more than cover 100% of our cumulative, regular dividend out of NII. On the bottom of the page we focus on below the line items. First, we look at realized gains and realized credit and other losses. As you can see looking at the row highlighted in green we have had success generating real economic gains every year through a combination of equity gains, portfolio company dividends and trading process. Conversely realized losses including the 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 credits at a material loss prior to actual defaults. 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 depreciation highlighted in grey stands at $25 million and cumulative net realized and unrealized loss highlighted in yellow is at $13 million. The net results of all of this is that in our seven years as a public company we have earned net investment income of $507 million against total cumulative net losses, including unrealized of only $13 million. The cornerstone of our strategy at NMFC has always been to earn our divided with the least amount possible amount of risk. As widely reported, in late March legislation was signed that allowed DDCs to increase their leverage capital from one-to-one to two-to-one. We believe this development potentially gives us an opportunity to earn our dividend with a net reduction in overall corporate risk. Specifically by taking on some amount of incremental leverage we can reduce the required yield on our individual assets. Unbalanced, we believe the incremental risk we add to business over time by increasing our liabilities was more than offset by the lower risk in our asset base. The exactly amount of incremental leverage utilized in this paradigm will be a function of a number of things, including prevailing asset yields and the cost of marginal credit as leverage increases. Our goal as managers of NMFC will be to seek the optimal levels of the leverage and asset yields for any give set of market conditions. In order to procure this enhanced flexibility, we have filed our proxy statements and expect to hold the request meeting in June. There are two important issues to highlight here beyond the fundamental one. First, no matter where we determine the optimal leverage point to be, we will only approach it where we can get there using the historically safe turned out non-mark-to-market financing we have predominantly used in the past. Second, as incremental assets added through increased leverage will be predominately senior, the management fee burden on these assets will be significantly less than our headline 1.75%. Specifically, as discussed many times over the years, on senior assets we charge a management fee only on the implied equity utilized to purchase those assets, which in most cases range from 30% to 50%, therefore we would expect management fees on the vast majority of these incremental assets to generally range from 60 to 80 basis points. We look forward to continuing the dialog on this important opportunity and as always will keep an open line of communication with all stakeholders as we move forward. I will now turn the call over to John Kline, NMFC's President to discuss market conditions and portfolio activity. John.

Thanks Rob. As outlined on page 14, the state of the leverage credit markets is very similar to when we last spoke in March. Despite some equity market volatility throughout the first four months of the year, the leverage of our market has remained remarkably stable. Most deals that we evaluate have strong competitive tension between lenders and at the margin we believe that more middle market executions are being led by syndication agents to maximize the competition between capital providers. Market spreads remain lower than last year, but have remained relatively stable since our March earnings call. NMFC's biggest earnings tailwind remains the upward trend of three months LIBOR, which has increased from approximately 2% at the time of our last call in March to 2.36% today. Additionally, while Q1 is typically slow from a new deal flow perspective, we have seen promising new origination volume thus far in 2018 with a strong forward pipeline in place. Over the last month we have also added a new origination focused team member who will further enhance our client coverage in this completive market. Turning to page 15, NMFC continues to be positively exposed to future rate increases as 85% of our portfolio is invested in floating rate debt and 55% of our liabilities are locked in over the medium term at attractive fixed rates. Three months LIBOR has increased to 2.36%, which is roughly 140 basis points above the average LIBOR floor on our floating rate assets. Moving on to portfolio activity as seen on pages 16 and 17, NMFC had an active quarter with total originations of $238 million offset by $84 million of portfolio repayments and $3 million of sales proceeds, representing $151 million expansion of our investment portfolio. Our new investments were highlighted by a larger size directed origination of a uni-trench loan for benefits, several club deals including a loan to ACA Compliance and one addition to both our net lease portfolio and our SBIC investing program. We believe that the consistency of our deal flow in this competitive market shows the strength of the broad sourcing network that we have built. Since the end of Q1 we have booked $84 million of new investments, including two investments funded by our SBIC programs and the capital contribution for SLP III. These new investments were offset by $48 million of sales in repayments yielding portfolio growth of $35 million. On page 18, we are pleased to announce our third SLP fund. As a reminder our SLP programs, are off balance sheet vehicles which invest in first lien syndicated loans focused in our core defensive growth industry sectors. We seed our SLP funds with equity and utilize long term, non mark-to-market credit facilities. Our past SLP funds have generated yields in the mid-teens and have experienced no credit losses to-date. SLP III is structured as a joint venture between NMFC and SkyKnight Income, LLC. NMFC and its partner have an aggregate capital commitment of $100 million, which will be split 80% to NMFC and 20% to SkyKnight. We have entered into an agreement with Citibank to provide a $300 million five year committed leverage facility with an attractive borrowing cost. The total size of SLP III will be approximately $400 million. Once fully ramped, our goal is to generate a yield to NMFC in the 11% to 13% range, which we view to be attractive on a risk adjusted basis. Turning to page 19, we show that our Q1 originations were weighted towards first lien assets. Inclusive of net lease 61% of our originations were at the top of the capital structure with 39% invested in junior loans. On the right side of the page we show that nearly all of our repayments were first lien assets. As shown on page 20, Q1 asset yields on new originations of 10.1% were somewhat lower than the average yield of the portfolio. This is due primarily to the first lien heavy mix on new originations in the quarter. Overall, we continue to maintain a healthy weighted average interest rate on our investment portfolio, despite the competitive environment. Looking forward we still believe lower spreads on new originations could pressure our portfolio yield as existing higher yielding loans get replaced by lower spread assets. Offsetting this trend we see rising base rates as a valuable tailwind across the majority of our portfolio and over time expect increased earnings from our SBA financing programs, which currently have approximately $150 million of aggregate undrawn capacity. And finally, as Rob mentioned earlier, we believe that accessing additional leverage afforded by the recent change in the 40 Act could provide us with another valuable lever to support our dividend. Page 21 shown that NMFC maintains a balanced portfolio across our defensive growth oriented sectors. In the services section of the pie chart, we breakout subsectors to give better insight into the diversity within our largest sector. On the bottom of the page we show that our portfolio – we show our portfolio by asset type where we continue to maintain a balance split between senior and subordinated investments. As you can see, first lien debt SLP investments and net lease investments represent 45% of the portfolio, with non-first lien oriented investments making up 55% of the portfolio. The pie chart on the lower right shows that we continue to have an exceptionally clean book of investments. Finally as illustrated on page 22, we have a broadly diversified portfolio with our largest investment at 5.3% of fair value and the top 15 investments accounting for 42% of fair value. With that, I will now turn it over to our CFO, Shiraz Kajee to discuss the financial statements and key financial metrics. Shiraz.

Thank you, John. For more details on our financial results in today's commentary please refer to our Form 10-Q that was filed last evening with the SEC. Now I would like to turn your attention to slide 23. Portfolio had approximately $2 billion in investments at fair value at March 31, 2018 and total assets of $2.1 billion. We had total liabilities of $1 billion, of which total statutory debt outstanding was $841 million excluding $150 million of growing SBA guaranteed debentures. Net asset value of $1 billion or $13.60 per share was down $0.03 from the prior quarter. As of March 31 our statutory debt to equity ratio was 0.821 at the high end our target range. Slide 24, we show historical leverage ratios which are broadly consistent with our current target statutory leverage of between 0.7 and 0.821. On this 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 25, we show our quality income statement results. We believe that our NII is the most appropriate measure of our quarterly performance. This slide highlights that while realized and unrealized gains and losses can be volatile below the line, we continue to generate stable net investment income above the line. Focusing on the quarter ended March 31, 2018 we earned total investment income of $52.9 million and total net expenses were approximately $27.2 million. As in prior quarters, the investment advisor continues to waive certain management fees such that the effective annualized management fee is 1.46%. It is important to note that the investment advisor cannot accrue fees previously waved. This results in first quarter NII of $25.7 million or $0.34 per weighted average share, which is within our guidance and covered our Q1 regular dividend of $0.34 per share. In total for the quarter ended March 31, 2018 we had an increase in net assets resulting from operations of $23.8 million. Slide 26 demonstrates how total investment income is recurring in nature and predominately fading fast. As you can see 90% of total investment income is recurring and cash income is 82% this quarter. We believe this consistency shows the stability and predictability of our investment income. Turning to slide 27, as briefly discussed earlier, our NII for the first quarter covered our Q1 dividend, given our belief that our Q2 2018 NII will fall within guidance of $0.33 to $0.35 per share. Our Board of Directors has declared a Q2 2018 dividend of $0.34 per share, which will be paid on June 29, 2018 to holders of record on June 15, 2018. Finally, on slide 28 we highlight our various financing sources. Taking into account SBA guaranteed debentures, we had approximately $1.3 billion of total borrowing capacity at quarter-end with no near-term maturities. As a reminder, our Wells Fargo credit facilities covenants are generally tied to the operating performance of the underlying business that we lend to, rather than the marks of our investments at any given time. With that, I would like to turn the call back over to Rob.

Thanks Shiraz. It continues to remain our intention to consistently pay the $0.34 per share on a quarterly basis for future quarters, so long as 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?

Thank you. [Operator Instructions] The first question will come from Paul Johnson of KBW. Please go ahead.

Hey Paul.

Hey guys. Guys, thanks for taking my question. My first question was on your investment in Edmonton. I know you guys provided some more capital. I saw the press release that I think it was $25 million or so between you and some other investors extended to the company. My question is how much of that funding went into the BDC and the also what was the rational for the investments, just kind of dividends have been struggling, the investment of your.

Yeah, and so we talked a little bit about this last quarter, but that money went in about 12 and change, about half of it from us, half of it from another investor and as well as we’ve seen this maturity and the rational is pretty simple. It’s a business that you know seems to be kind of taking control over it, has done okay and we think it’s now positioned with a little bit of incremental capital to do significantly better than okay. We as I think again, I mentioned in the past, we brought in a very talented new CEO in the summer of last year and based on her plan and execution to-date we have really you know a lot of confidence in where that company is going and so are inclined to be supportive of it if we possibly can be.

Okay, thanks for that. And then my other question was on the third SLF, it’s sort of the side question that you guys formed. I am just kind of curious here, given its you know the same partner and virtually the same FB split as the SLF II, which is why you chose to open up a new JV as opposed to kind of simply just expanding the second one. Is there any sort of advantage to doing that?

Yeah, actually it’s a different credit provider. Wells Fargo is the credit provider for SLP II and as John mentioned Citi is the credit provider for SLP III and we think it’s you know good to have more than one credit provider for these vehicles over time.

Sure, that makes sense, that makes sense. And then lastly I just on your origination to this isolated quarter for you guys, leverage is probably about as high as its been in the BDC. I am just kind of curious, is that an anticipation for the increased leverage that you guys have done. I think the shareholder vote in June or is that more just kind of a timing issue on the strong originations for the quarter?

Yeah, it’s really more of a timing issue. You know the – I mean we didn’t – I don’t think we found out about the change in legislation from late March and you know a lot of it will be too late to influence our behavior in terms of you know what would have been closed by the end of March. So it’s really more idiosyncratic around timing of originations and repayments. You know obviously as we navigate this quarter you know depending on how the process goes around the proxy, that may have an influence on exactly where we wind up at 630.

Okay, that’s all I have. Thanks for taking the questions.

Yeah, anytime. Thank you.

[Operator Instructions] The next question comes from Jonathan Bock of Wells Fargo. Please go ahead.

Good morning and thank you for taking my questions.

Hey Jonathan.

Hey Rob. So if we are able to maybe breakout some things, one you know the credit to you and the board and Steve as you guys are approaching this leverage discussion, what we want to understand is lets imagine that regulatory constraints were no longer an issue today. How quickly would it take to perhaps lever the senior secured assets to a level beyond one-to-one? Do you have current availability to do that and flexibility in your borrowing base and just give us a sense of timing given than folks generally don’t ask for votes unless they believe it to be a positive MPV proposition you know over the next 12 months.

Yeah, no it’s a good question Jonathan. I mean I think – and we can get behind the math a little bit. I think the short answer though is that its quarters, it’s not months, but it’s not years either and of course to go with the hand-on prevailing market conditions and we you know the pipeline of opportunities. But if I had to handicap it, I would say its quarters, because when we think about it right, we have roughly a little over $1 billion equity base. So for every 0.1 of leverage increase you’re talking about a net increment of $100 million or so of assets above our replacement rate. So to go from 0.8 to 1.2, I’ll make that up, is a net increase of $400 million of assets just to put it into context, right. So it’s a decent amount, but it’s not insane in the context of the scale of the market, our footprint in that market, our deal flow and our ability to…

That would make sense. Rob I have no questions about your ability to deploy the capital effectively. I think the question is just in terms of adjusting with your leverage facilities, how long does that typically take?

Yeah, so we are in dialogue around that. I expect that well it’s very doable. I don’t want to get too far you know ahead of those conversations. I would not expect that to be the constraint.

Okay, great. Then maybe one item I know folks appreciate it and are trying to understand kind of incremental math and clearly with the 60 to 80 basis point fee discussion on the new incremental senior secured assets, that’s very helpful and also very attractive. Can you walk us through what you think onboarding yields generally are and financing costs?

Sure, sure. So let’s just to keep the math simple, let’s assume we’re going to onboard $100 million of incremental assets, and that’s also to assume that all those assets are senior assets, lower yielding to higher advance rate. So let’s think about the return side of the equation and let’s think about the cost side of the equation. So for 100 of assets let’s assume that they are going to be – again we make this up, but its ballpark L550. L is you know close to 250, just again to make the math simple. So let’s assume that its 250 base rate, 550 spread, so 8% assets. So on $100 million, that’s $8 million of marginal revenue.

Yep.

On the cost side obviously the first one is the interest expense. So let’s assume those assets has a 60% advance rate on our senior facility and our senior facility is advancing capital at L plus 200. So it’s the same math; that’s $60 million of borrowings at 4.5% and then lets says we borrowed in the unsecured market at some higher price because now we are more levered, but we recently borrowed at just under 5%, so let’s assume its again, I’m going to make this up, but 50 basis point more. I thought I’ll make the math simple, because the treasury rates have going up, less the senior borrowing in the unsecured market on the incremental $40 million at 6%, again its total making these numbers up for illustrative purposes, and I’m doing the math in real time so bear with me. So $60 million at 4.5% is 2.4, 2.7 of costs and 2.4 on the 40, so roughly $5 million of incremental interest expense, right.

Yep.

And on the management fee side, again use the midpoint of that range 70 bips on the $100 million, so another $700,000. So now you are $5.7 million of cost. Interestingly virtually all of our other costs are fixed, right. So maybe a couple, you know $50,000 or $100,000, but you are dropping more than $2 million to the bottom line using this math, which again is illustrative here. And that’s there to effectively allow one to take an average lower yielding asset across the portfolio to the tune of $2 million and/or offset general market spread compression. So that’s the accretive nature of the math given our cost to borrow and given the way our management seeds works, that is a tool.

Right, I appreciate that and that math is – that illustrative math is compelling. Then would you be able to walk us through the next step, which will be – if you look at your off balance sheet JVs, does two-to-one leverage alter your thinking on the net attractiveness that those JVs kind of offer in today’s environment, given while they are a little bit more levered than what you traditionally have on balance sheet. I’m wondering if two-to-one kind of changes that dynamic and their relative attractiveness to something you could put on the balance sheet at a higher leverage.

I think the short answer is no Jonathan because those are fundamentally different assets. Those are the broadly syndicated first liens that today are yielding, L350 and L375 and we are using three-to-one leverage there to make that math work for us in a double-digit return, and we still think that’s the place where we want to be able to active in, because if you remember the original industrial logic all the way to back LOS 1[ph], whatever it was four years ago, is that again – our core competency is our knowledge of businesses that we know really well through private equity. Sometime those businesses are financed, where the only actionable part of the capital structure is an L+375 regular way syndicated loan and we want to have a bucket for that, because again we have such high convection around those businesses that we want to make sure we can express that convection somewhere as long as the return math makes sense which in today’s world is still does.

Yes, yes. Guys, thank you for answering my questions. Thank you.

Thank you Jonathan.

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

Great, thank you. And thank you everyone. We appreciate the time and attention and look forward to speaking again in the weeks ahead. Bye-bye now.

Thank you, sir. The conference is now concluded. Thank you for attending today's presentation. You may now disconnect.