New Mountain Finance Corporation 8.250% Notes due 2028 (NMFCZ) Q3 2018 Earnings Report, Transcript and Summary

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

Thank you and good morning everyone and welcome to New Mountain Finance Corporation’s third 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. 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 if any unauthorized broadcast in any form is strictly prohibited. Information about the audio replay of this call is available in our November 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 would 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 net investment income for the quarter ended September 30, 2018 was $0.36 per share above our guidance of $0.33 to $0.35 per share and more than covering our quarterly dividend of $0.34 per share. New Mountain Finance’s book value was stable at $13.58 per share as compared to $13.57 per share last quarter. We are also able to announce our regular dividend, which for the 27th straight quarter will again be $0.34 per share, an annualized yield of over 10% based on last Friday’s close. The company had a very productive quarter of deal generation, investing $489 million in gross originations versus repayments of $280 million as we continue to deploy the incremental leverage approved by shareholders last quarter. Once again, we were able to access the debt capital markets at attractive rates issuing two new notes. Credit quality remains strong with no new non-accruals. I and other members of New Mountain continue to be very large owners of our stock with aggregate ownership of 9.7 million shares, approximately 13% of total shares outstanding. Finally, the broader New Mountain platform that supports NMFC continues to grow with over $20 billion of assets under management and over 145 team members. In summary, we are very 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 models and extensive fundamental research within industries that are already well known to New Mountain. Fourth, 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 7, you can see our total return performance from our IPO in May 2011 through November 2, 2018, in the seventh and a half year since our IPO we have generated a compounded annual return to our initial public investors of over 10%, meaningfully higher than our peers and the high yield index and approximately 900 basis points per annum above relevant risk free benchmarks. Page 8 goes into a little more detail around the relative performance against our peers set, benchmarking against the ten largest externally managed BDCs that have been public at least as long as we have. Page 9 shows return attribution, the 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 7 years plus 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. We attribute our success to; one, our differentiated underwriting platform, two, our ability to consistently generate the vast majority of our NII stable cash interest income in 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 interest. Our highest priority continues to be our focus on risk control and credit performance which we believe over time is a single biggest differentiator of total return in the BDC space. Credit performance continues to be strong with no new non-accruals during the quarter and no material quarter-over-quarter credit deterioration in any single name. 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 $6.3 billion in 248 portfolio companies, of which only eight representing just $125 million of costs have migrated to non-accrual of which only four representing $43 million of costs have thus far resulted in real-life default losses. 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 over $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 and leverage multiple is a good snapshot of credit performance and helps to 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 are trending in the right direction with only a few exceptions. The only loans with negative migration of 2.5 turns or more are the same three loans discussed last quarter, none of which had experienced material changes in current leverage ratios or medium-term prospects. These three loans include the previously restructured and maintained, where prospects remain bright, National HME where we expect an imminent closing on the balance sheet restructuring discussed last quarter and a third issuer where we continue to believe the likelihood of payment default is low. The chart on Page 12 helps track the company’s overall economic performance since its IPO. At the top of the page, we show having a 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 will get 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 gain every year through a combination of equity gains, portfolio company dividend 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 credits at a material loss prior to actual defaults. As highlighted in blue, we continue to have a net cumulative realized gain, which currently stands at $9 million. Looking further down the page, we can see that cumulative net unrealized appreciation highlighted in grey stands at $25 million and cumulative net realized and unrealized loss highlighted in yellow is at $16 million. The net result of all of this is that in our 7.5 years as a public company we have earned net investment income of $560 million against total cumulative net losses, including unrealized of only $15 million. Turning to Page 13, we have seen significant growth in the portfolio over the last two quarters as we have increased our statutory leverage from 0.81 to 1.17. Consistent with the strategy we articulated when we received shareholder authorization to increase leverage, the preponderance of our asset increase has been in the form of senior loans. In fact over the 6-month period more than 100% of the growth in assets has come from senior security as through repayments and sales, non-first liens have actually shrunk on an absolute basis by $75 million, while first lien assets have grown by $380 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 14, the market environment across leverage credit has been relatively stable. Spread levels and leverage structures on middle-market loans, where we see the majority of our deal flow has been consistent through the first three quarters of the year. However in recent weeks, we have observed pockets of volatility in the syndicated new issue market, where certain aggressive debt structures and lower quality credits have struggled to clear the market. While we have not yet seen this volatility spread into the core middle-market, we believe investor discipline in the syndicated market has helped prevent further spread and structure degradation in the middle-market. Despite heightened broader market uncertainty, most transactions that we evaluate continue to be highly contested as lenders see quality deals that can perform well in all economic environments. 3-month LIBOR which had been a meaningful earnings tailwind for NMFC earlier this year has resumed its increase rising approximately 25 basis points since our last call to 2.59% as of last Friday. Recently, we have seen a slight low in deal flow after record third quarter, but expect to see our typical seasonal increase in the final months of the year. Turning to Page 15, NMFC continues to be positively exposed to future rate increases as 87% of our portfolio is invested in floating rate debt and 56% of our liabilities are locked in over the medium-term at attractive fixed rates. As the chart on the bottom of the page shows, given our investment portfolio and liability mix, NMFC’s earnings are positively leveraged to any further increase in short-term rates. Moving on to portfolio activity as seen on Pages 16 and 17, NMFC had a record quarter with total originations of $489 million offset by $280 million of portfolio repayments and $11 million of sale proceeds, representing a $197 million expansion of our investment portfolio. Our new investments were highlighted by a number of middle-market club deals backed by a diverse group of sponsors and the continued funding of our SLP III loan program. Page 18 shows our origination activity since the end of the quarter, where we have seen net portfolio expansion of $4 million as we reached the low end of our target leverage ratio. While the month of October was meaningfully slower than the previous months, we have a strong pipeline heading into year end which should translate into more deal closings in November and December. Turning to Page 19, as Rob mentioned our mix of originations continues to shift more towards first lien, with first lien assets representing 70% of total new originations this quarter. This shift towards a higher percentage of first lien assets is consistent with our desired asset mix at our target leverage level of 1.2x to 1.4x. On the right side of the page we show that 58% of our repayments were second lien. Repayments are generally not under our control which makes the quarter-to-quarter mix less predictable. As shown on Page 20, Q3 asset yield on new originations of 10.4% were somewhat lower than the average yield of the portfolio. This is due primarily to the senior heavy mix on new originations in the quarter. Still we continued to maintain a very healthy weighted average yield on our portfolio of 11%, which is in line with our historical levels. The top of Page 21 shows a balanced portfolio across our defensive growth oriented sectors. In the services section of the pie chart we break out sub-sector to give better insight into the significant diversity within our largest sector. The chart on the bottom left of the page presents our portfolio by asset type where you can see the shift towards first lien assets that we discussed earlier in the call. The chart on the lower right shows that over 99% of our portfolio is performing at or above our underwriting expectations. Finally, as illustrated on Page 22, we have a broadly diversified portfolio with our largest investment at 5.1% 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 and today’s commentary, please reform to the Form 10-Q that was filed last evening with the SEC, Now, I would like to turn your attention to Slide 23. The portfolio had approximately $2.3 billion in investments at fair value at September 30, 2018 and total assets of $2.5 billion. With total liabilities of $1.5 billion of which total statutory debt outstanding was $1.2 billion excluding $165 million of growing SBA guaranteed debentures. Net asset value of $1 billion or $13.58 per share was up $0.01 from the prior quarter. As of September 30, our statutory debt to equity ratio was 1.17 to 1. On Slide 24, we show our historical leverage ratios. The step-up in leverage over the past two quarters is in line with our new target statutory debt to equity ratio of 1.2x to 1.4x. On the slide we also show our historical NAV adjusted for the cumulative impact of special dividends which shows the stability of our book value since our IPO. On slide 25, we show our quarterly 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 continued to generate stable net investment income above the line. Focusing on the quarter ended September 30, 2018, we earned total investment income of $60.5 million, a $5.9 million increase from the prior quarter primarily due to an increase in other fee income. Total net expenses were approximately $33.4 million, a $4.6 million increase from the prior quarter due to higher borrowing costs and higher professional fees. During the quarter, we had non-recurring legal fees of $1.2 million related to deal expenses. As in prior quarters the investment advisor continues to waive certain management fees. The effective annualized management fee this quarter was 1.39%. It is important to note that the investment advisor cannot recoup fees previously waved. This results in third quarter NII of $27.1 million or $0.36 per weighted average share which is above our guidance and more than covered our Q3 regular dividend of $0.34 per share. In total for the quarter ended September 30, 2018, we had an increase in net assets resulting from operations of $26.7 million. Slide 26 demonstrates our total investment income is recurring in nature and predominantly paid in cash. As you can see 87% of total investment income is recurring and cash income remains strong at 83% 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 third quarter covers our Q3 dividend. Given our belief that our Q4, 2018 NII will fall within our guidance of $0.33 to $0.35 per share. Our Board of Directors has declared the Q4, 2018 dividend of $0.34 per share, which will be paid on December 28, 2018 to holders of record on December 14, 2018. On Slide 28, we highlight our various financing sources. Taking into account SBA-guaranteed debentures were approximately $1.5 billion of total borrowing capacity at quarter-end. In Q3 we issued $115 million of convertible notes and $100 million of unsecured notes at attractive rates. 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 investments at any given time. Finally, on Slide 29, we have added a leverage maturity schedule. As we have diversified our debt issuances, we have been successful at laddering our maturities to better manage liquidity. 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 for long as 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. We will now begin the question-and-answer session. [Operator Instructions] The first question today comes from Don Fandetti with Wells Fargo. Please go ahead.

Hi, good morning.

Good morning.

Two questions. First, clearly the way you position your portfolio tends to target more sort of recession-proof companies. But as you think for the next year, what is your confidence in terms of the risk rating migration and the potential for non-accruals? And then secondly, can you talk a little bit about what you’re hearing from your portfolio companies in terms of revenue growth and sort of on the ground how they’re feeling?

Yes, sure. And I obviously tie those two together. Starting with the second question actually, so the portfolio companies continue to feel quite good and this is both across our credit portfolio and our private equity portfolio, where on the ground the forward metrics are pointing towards continued success at the operating company level. And with that to your first question, I think we have as much confidence as we’ve ever had that the forward outlook for the portfolio as a whole in terms of avoiding future negative credit migration is as good as it’s ever been, that doesn’t mean that tomorrow we can get some negative news about any individual company. But sitting here today as reflected in the ratings we feel quite good.

Okay. And then also on the new origination yields obviously rates have moved around a little bit on the short end, but can you – it seems like the yields are holding up relatively well despite a pretty significant move of mix into senior. Can you talk a little bit about the origination for this quarter and how they might contrast in prior quarters and how the yields are staying relatively attractive?

Yes. I would say the mix has obviously shifted like we said and you said to senior, which all else equal reduces yields. However, we’ve seen an increase in base rates over prior quarters which help yields. Those two things have mostly watched, all-in though we have seen a little bit of overall yield deterioration given the 10.4% versus the 11.2% of the portfolio as a whole. But I think we’re still able even on these senior loans to drive yields that are consistent with the objectives we need to reach our financial targets.

Got it. And if I could just wrap up with one other, obviously, there’s a lot of concern in the market with where we are in the cycle, you’re focusing on more sort of recession-proof type loans. Are you finding that there is an uptick in competition around those types of loans or do you feel like that you’re going to be in a position to continue to grow the portfolio?

This is John Kline. We definitely see very consistent competition in the segment of the market that we like. And we have to fight hard to win deals as we do very consistently as you see in our – as you see in our performance in Q3. And so, we’re sort of say disappointed, I would say one thing that we really branded ourselves in certain segments. So our sponsored clients really know to go to us in certain segments, which we think is a great competitive advantage for us.

Thank you.

Great. Thank you.

[Operator Instructions] The next question comes from Allison Rudary with Oppenheimer. Please go ahead.

Hi, Allison.

Hi, good morning. Thanks for –

Good morning.

Hey, thanks for taking my questions.

Okay.

So a couple to start out. Can you guys describe what might be driving the kind of excess other income this quarter?

Yes. I mean, it’s a combination of meaningful prepayment fees, as well as some significant upfronts given the volume of originations and then there is – every quarter there was some random things that come in around some amendments et cetera, but it’s really the big drivers are those first two.

Okay, that’s helpful. So I guess my next question sort of kind of revolves around the management fee waiver that you grant for the Holdings Credit facility, the increased amount of first-lien and senior assets that you’re putting on the book now that you’ve sort of kind of gone above that 1 to 1 leverage ratio. And how we as analysts sort of need to think about where you allocate assets, that’s kind of something we can’t see, it’s sort of like what I’m driving at is that it makes our like forward look into how to think about your base management fee a little bit difficult. And I would like to – like maybe you guys can talk a little bit about how – as you sort of get closer to that target leverage range, how we should think about that base management fee kind of going forward?

Yes, sure. I mean, I think we did see it come down a little bit this quarter. Now as you know we use a average over the quarter, so the combination of ramping throughout the quarter as well as using the average over the quarter beginning of period – end of period muted that impact somewhat. So I think over the future quarters as we further add leverage, it’s going to be a combination of two things, right. It’s going to be how much of the ramp continues to be in senior assets and then how much of those senior assets are qualified for the Wells facility or in the Wells facility. And I think well we don’t have a perfect crystal ball on that. We’d expect the prior trends to continue where the majority of – significant majority of the incremental assets added as we increase the leverage ratio do in fact – are in fact senior and that the significant portion of those senior assets do in fact qualify for the Wells facility. In terms of modeling it quarter-to-quarter, it’s a little tricky and I hate to give a specific guidance. But I would think that 1.39% blended rate this quarter will continue to tick down modestly from here as we – if and as we add leverage as anticipated.

Okay. That’s super helpful. And then I guess my final question and then I’ll turn it over to let some other people ask. We’ve – you guys are actually relatively close to that 1.2 times, 1.4 times guidance and it doesn’t kind of – doesn’t really take a lot to see how you can get to there in the next quarter or two. And I guess what we’re seeing here even with some of the excess income this quarter, is it your portfolio actually might be throwing off a little bit more income than your guidance. And I guess my question is at what point might you guys consider thinking about guiding to a $0.36 or $0.37 level as kind of indicating to shareholders that they’re going to see some of the benefit of the growing portfolio base?

Yes. Look, I think we’ve talked about this a number of occasions. I think what we’re trying to do because we feel like the 10% yield that we are providing is still quite attractive given giving where base rates are. What we are trying to do is earn that yield because little risk is possible. And so I think we may – as articulated we have made the conscious decision that we can get to that yield level by moving up the capital structure and generally to taking less asset risk, while taking more balance sheet risk. We think that’s a good trade. So we are not again trying to use the added leverage to increase materially the ROE. So often we are not trying to get to a new plateau of earnings, we are trying to say with some margin safety at the existing level of earnings with a little asset risk as possible, so that’s the – shareholders are benefiting as we increase the leverage is we believe taking less risk at the asset level. And that’s the conscious decision. But we do think that that 34% quarterly dividend which is almost exactly 10% ROE at book is still a very attractive proposition and the goal here is to not screw that up by generating default losses over time.

It makes a lot of sense. Alright. Thanks so much guys.

Yes. You are welcome. Thank you.

The next question comes from Paul Johnson with KBW. Please go ahead.

Good morning guys. Thanks for taking my questions. Congratulations on a good quarter. Most of my questions have already been asked, but I will just kind of leave you with one very broad question, I mean obviously the market is very competitive, I mean it’s very well talked about, I am wondering I mean in such competitive environment, I mean you have mentioned in your presentation that you are finding a lot of strong competition for some of the best financing deals out there, I mean how can you get investors comfortable with the point no such a large amount of capital like you did this quarter, while still being conservative and disciplined in your approach to doing so, maybe just give us a sense of what you are looking at for those prospective investments?

Yes. Sure. And I think there as a couple of elements to it. I think one, just as an overlay is in any given quarter we are never targeting a certain amount of volume or production, it’s all bottoms up what comes to us and our biggest driver of safety and what, to give you that jus confidence is that, again we are only going to be investing in businesses that fit within our defensive growth criteria, the industries we know and that are already well researched at the industry level and typically at the company level by the existing investment team, so that discipline stayed strong and also our consensus. And then I would say the other kind of important overlay is whether we originate $300 million in a quarter or $500 million in a quarter, it’s a tiny, tiny fraction of a multi-hundred billion dollar market. So we are still a very small player which allows us to be very selective and stay focused and disciplined on what we know and what we like. So those are the things in my mind that should give investors comfort but obviously in the length of the track record. But again we have our number one priority as we say over and over again is to avoid credit impairment and we are never going to cautiously at least screw that up. John, I don’t know if you want to add to that?

Yes, I was just looking through our Q3 originations. And when I think about our success, it really comes from a bunch of different places. One, when you look at the deal flow that we have achieved, it’s really we are gaining returns on being in this business for going on 10 years now. And our best software sponsor clients are coming to us on repeat basis and showing us preferred access to deals, that’s not fit to say that they are not competitive, but they are carving us into what we think are great deals at market terms with some of their other good lending relationships. We have one deal actually there was a big origination for us this quarter that was the deal we want to buy for PE and we have developed an amazing relationship with the founder. He did not choose to sell control to our PE group, but instead shows to refinance this capital structure and we were a big part of that. So that’s just a benefit in being part of a bigger platform and really working well together. And then we have new resources on our team that have enabled us to have more touch points on the street. And I really think those resources are paying big dividends with regard to the deal volume. And hopefully we will give you a sense for just some of the specific areas we are seeing success.

Sure. When you mentioned new resources are you talking about professionals that work directly with BDC in the direct lending platform or is that…

Folks covering sponsors.

Right. As well as just the overall growth in the private equity platform, it’s continued to be quite strong. It just means we are expanding our universe of companies with diligence to private equity and therefore spending our universe of addressable opportunities for the credit agreement.

Sure. Thanks again guys. Those are all my questions.

Great. Thank you.

[Operator Instructions] Since it appears there are no further questions, this concludes our question-and-answer session. I would now like to turn the conference back over to Rob Hamwee for any closing remarks.

Great, thank you. As always, we just want to thank everybody for the interest, the support and we look forward to speaking again next quarter. Thanks everyone. Bye-bye.

This conference has now concluded. Thank you for attending today’s presentation. You may now disconnect.