SLR Investment Corp. (SLRC) Q3 2016 Earnings Report, Transcript and Summary

Good morning, ladies and gentlemen, and welcome to the Third Quarter 2016 Solar Capital Limited Earnings Conference Call. At this time, all participants are in a listen-only mode. Later, we will conduct a question-and-answer session and instructions will follow at that time. [Operator Instructions] As a reminder, this conference call is being recorded. I would now like to turn the conference over to your host, Michael Gross, Chairman and Chief Executive Officer.

Thank you very much and good morning. Welcome to Solar Capital Limited’s earnings call for the quarter ended September 30, 2016. I’m joined here today by Bruce Spohler, our Chief Operating Officer; and Richard Peteka, our Chief Financial Officer. Rich, before we begin, could you please start off by covering the webcast and forward-looking statements?

Of course. Thanks, Michael. I’d like to remind everyone that today’s call and webcast are being recorded. Please note that they are the property of Solar Capital Limited and that any unauthorized broadcasts, in any form, are strictly prohibited. This conference call is being webcast on our website at www.solarcapltd.com. Audio replays of this call will be made available later today as disclosed in our earnings press release. I would also like to call your attention to the customary disclosures in our press release regarding forward-looking information. Statements made in today’s conference call and webcast may constitute forward-looking statements, which relate to future events or our future performance or financial condition. These statements are not guarantees of our future performance, financial condition or results and involve a number of risks and uncertainties. Actual results may differ materially as a result of a number of factors, including those described from time to time in our filings with the SEC. Solar Capital Limited undertakes no duty to update any forward-looking statements, unless required to do so by law. To obtain copies of our latest SEC filings, please visit our website or call us at 212-993-1670. At this time, I’d like to turn the call back to our Chairman and Chief Executive Officer, Michael Gross.

Thank you, Rich. As conservative credit investors, our investment philosophy centers on preservation of capital. We believe this prudent approach has served us well throughout the past several years of heated credit market condition as evidenced by our near non-existent nonaccrual rate and stable net asset value. Consistent with the prior quarter, Q3 recurring net investment income per share meaningfully exceeded our quarterly distribution. We expect this trend of overearning our distribution to continue. Specifically for the third quarter, net investment income per share totaled $0.45, excluding $0.05 per share net impact of one-time expenses related to the amendment and extension of our credit facility. A portion of our outperformance came from income associated with investments repaid during the quarter. As you know, portfolio activity in our business tends to be lumpy. However, over the long-term redemptions are a regular source of our incremental income. For the fourth quarter, we continue to expect net investment income per share to exceed our $0.40 per share distribution. Our current run rate of net investment income is approximately $0.42 per share. As we achieve portfolio growth we expect our run rate of net investment income to reach the mid-to high 40s per share. We believe growing net investment income into the mid-to high 40s per share is achievable through the allocation of our available capital across our strategic initiatives, namely Crystal Financial, life science lending, and our [stressed] senior loan program. Including expected leverage on our interest in SSLP and SSLP II we have approximately $800 million of capital available to invest as of September 30. Given the low to mid-teen expected return on equities for all these ventures, as well as [$1] risk senior secured nature of the underlying investments, we believe that investing through our proprietary channels enable us to deliver attractive returns for maintaining our conservative investment philosophy. Equally important to be able to grow our net investment income is our credit quality. Our book value per share of $21.72 represents a 1% increase over the prior quarter. At September 30, over 99% of our portfolio was performing under fair market and cost basis. Furthermore, we continue to have no direct exposure to the energy or the commodity sectors. Our September 30, our comprehensive portfolio stood at $1.6 billion with approximately 96% senior secured and approximately 95% floating rate. The increase in these percentages from the prior quarter was primarily the result of the repayment of a large unsecured fixed rate loan, which Bruce will discuss. This August we expanded our stressed senior loan program with a new strategic partner. Solar Capital’s equity commitment to SSLP II is $75 million, $43.6 million of which we funded during the third quarter. We anticipate beginning to utilize leverage in the fourth quarter, and we expect to achieve a low to mid-teens return on equity once the vehicle is fully ramped. Our stressed senior loan program includes our partner’s ownership and – including our partner’s ownership anticipated leverage as the capital base exceeding $725 million. When considering our strategic partner’s appetite for investing alongside the program, we have the capital necessary to successfully compete in the upper middle-market, where we believe investments offer better risk reward. Overall we anticipate growth in both net investment income and net asset value, and once we believe we have achieved a sustainable level of net investment income that exceeded distribution, we will increase our quarterly payout. At this time, I’ll turn the call back over to our Chief Financial Officer, Rich Peteka, to take you through the financial highlights.

Thanks again, Michael. Solar Capital Limited’s net asset value at September 30, 2016 was $917.6 million or $21.72 per share compared to $908.8 million or $21.51 per share at June 30. During the third quarter we amended our credit facility. The amendment extended the maturity to September 2021. We modified the rate to a grid of LIBOR plus 2.25%, and increased the size of the credit facility at closing from $540 million to $555 million. The credit facility continues to include its accordion feature going to $800 million. At September 30, our investment portfolio had a fair market value of $1.36 billion in 66 portfolio companies across 26 industries compared to a fair market value of $1.48 billion in 74 portfolio companies across 30 industries at June 30. At September 30, 2016 the weighted average yield on our income producing portfolio measured at fair value was 10% compared to 10.2% at June 30. The weighted average yield on a cost basis at September 30, 2016 was 10.3% compared to 10.5% at June 30. For the three months ended September 30, gross investment income totaled $39.8 million versus $41.4 million for the three months ended June 30. Net expenses totaled $22.8 million for the three months ended September 30 compared to $21.8 million for the three months ended June 30. The increase in expenses for the three months ended September 30 was primarily related to the nonrecurring costs of the amendment and extension of our credit facilities during the quarter. The company’s net investment income for the three months ended September 30, 2016 totaled $17.0 million or $0.40 per average share versus $19.5 million or $0.46 per average share for the three months ended June 30. Excluding the net effect of the $2.7 million of nonrecurring expenses related to the amendment and extension of our credit facility, net investment income for the three months ended September 30 would have totaled $19.1 million or $0.45 per average share. Net realized and unrealized gains for the third quarter 2016 totaled $8.6 million versus net realized and unrealized gains of $15.6 million for the second quarter 2016. Ultimately the company had a net increase in net assets resulting from operations of $25.6 million or $0.61 per average share for the three months ended September 30. This compares to a net increase of $35.2 million or $0.83 per average share for the three months ended June 30. Finally, our Board of Directors declared a Q4 distribution of $0.40 per share payable on January 4, 2017 to shareholders of record on December 15, 2016. With that, I'll turn the floor over to our Chief Operating Officer, Bruce Spohler.

Thank you, Rich. I’d like to begin by providing an update on the credit quality of our portfolio. Overall, the financial health of our portfolio companies remained sound with the trends of continued modest growth and deleveraging continuing through the third quarter. On average, including our stretch first lien senior secured program, the most recently reported organic LTM revenue and EBITDA for our portfolio companies were up around 7% and 11% respectively year-over-year. Measured at fair value, weighted average interest coverage for our portfolio companies was just under 3 times. At the end of the third quarter, the fair value weighted average EBITDA across our portfolio was just over $90 million, and the average leverage through our investment security was just under five times. At September 30, the weighted average investment risk weighting of our total portfolio was 2.0 based on our one to four risk rating scale with one representing the least amount of risk. Measured at fair value, 99.9% of our portfolio was performing at 9/30. On a cost basis, our one investment on non-accrual accounted for 63 bps of the portfolio. Excluding this one legacy asset from 2007 Direct Buy our portfolio is performing very well. On a current cost basis, the weighted average yield on our income producing portfolio was 10.3%. Our average mark on our income producing debt investments as a percentage of par increased to 97.7% of par at 9/30. We believe there is additional net asset value upside above our current [$1.72] per share as our loans that are marked below par due to technical factors are repaid in full. Now I’d like to provide some color on the composition of our comprehensive investment portfolio, which includes Crystal Financial’s portfolio as well as our stressed first lien senior secured loan program. At the end of the third quarter, our $1.6 billion comprehensive investment portfolio included 95 borrowers across 36 industries, with no exposure to direct energy or commodities. The average investment side per borrower is $16.7 million or just over 1% of the comprehensive portfolio, indicating a high degree of diversification. Our single largest loan is 3.2% of the portfolio. Measured at fair value, roughly 96% of our portfolio consisted of senior secured loans, a 3% increase from the June quarter. The remainder of our portfolio was comprised of roughly 2% subordinated debt and 2.5% equity and equity like securities. At September 30, approximately 95% of our income producing portfolio was floating rate on a fair value basis. Before I turn to our investment activity, let me provide a brief update on our strategic initiatives. During the third quarter, SSLP funded $5 million of new stretch senior loans, bringing the total portfolio size to just under $140 million. At the end of September, we had just over $42 million drawn under our new $200 million credit facility on this joint venture. Our annualized yield was 6.4% for the quarter, up from 5.8% in the prior quarter. We continue to expect to achieve a low teens ROE on this vehicle once it is ramped. Also during the third quarter we created a new SSLP II which invested over $65 million in stretch senior loans. We expect to close on our credit facility for this joint venture in the current quarter, and also expect to achieve a low-to-mid teens ROE once the vehicle is fully ramped. At the end of the third quarter, together SSLP and SSLP II had over $200 million of stretch senior secured loans to 11 different borrowers. As of the end of the third quarter, 100% of this portfolio was performing. Now let me turn to life sciences. At the end of the quarter, our life science portfolio totaled approximately $215 million at fair value and consists of first lien senior secured loans across 25 issuers with an average investment size of just over $8.5 million. During the third quarter, our life science team originated approximately $24 million of new senior secured loans. Repayments and amortization totaled just over $37 million during the same period. The average yield at cost, excluding potential exit or success fees as well as any potential warrant gains is running at 12%. The blended IRR on our realized life science investments to date is just under 24%. Now let me give you a quick update on Crystal Financial. At September 30, Crystal had a diversified portfolio consisting of approximately $480 million of funded senior secured loans across 29 borrowers with an average exposure of approximately $16.5 million. During the third quarter, Crystal funded new loans totaling approximately $33 million and had reductions totaling approximately $70 million. All of Crystal’s investments are senior secured loans and over 99% of their portfolio is floating rate. For the third quarter, Crystal paid Solar a cash dividend of $7.9 million, consistent with the prior quarter. Now I would like to turn to our third quarter portfolio activity. During the third quarter, Solar Capital originated approximately $54.5 million consisting predominantly of senior secured floating rate loans across 9 different borrowers. Investments repaid during the quarter totaled $158 million. Starting with originations, we originated a $12 million investment in the first lien loan, Polycom, a manufacturer of voice and video communication equipment. Across the entire solar platform, we invested just under $40 million in this loan, which has a yield of approximately 8.5%. The financing [Indiscernible] of this company by Siris Capital, which has demonstrated expertise in telecommunications, media and technology companies. The EBITDA is approximately $275 million for this company and leverage through our investment is 2.5 times. Additionally our life science team originated a $15 million investment in the first lien term loan of Scynexis. Scynexis is currently developing a novel drug for the treatment of life-threatening invasive fungal infections. Our loan carries a yield in excess of 11%. Now let me touch on our repayments during the third quarter. Our most significant repayment was the repayment of our $48 million investment in the unsecured fixed-rate private note of WireCo. These notes were issued at par – redeemed at par, which resulted in an IRR in excess of 11%. Equally important, the repayment of this investment significantly reduced our exposure to both unsecured and fixed rate assets in our portfolio. Also during the third quarter, our $30 million commitment to Aeropostale, which was sourced through Crystal Financial, was repaid, resulting in an IRR in excess of 40%, albeit only over a 5-month investment period. We were also repaid at par on our $16 million investment in the second lien loan to [Indiscernible]. Rather than rolling our proceeds into the company’s new covenant like dividend recapitalization transaction, we decided to allocate these proceeds to our strategic initiatives, which we believe have more attractive risk reward profiles. The IRR on our investment in [Indiscernible] was over 8.75%. And finally, we repaid on our $18.5 million investment in the second lien loan to Concentra, which was repaid at a premium to par in connection with the company’s refinancing. Similar to [Landesk], we chose not to roll our proceeds into the new second lien transaction. Instead we intend to reinvest the proceeds in [dollar one] risk assets via our proprietary sourcing channels. The realized IRR on this loan to Concentra was just over 11%. As evidenced by our decision not to reinvest proceeds from these investments back into the company’s refinancings, we are focused on originating first lien loans with more attractive pricing and terms through our strategic initiatives. Overall the middle market environment remains competitive given muted sponsor activity year-to-date. In the advanced stages of the current credit cycle, we believe it is imperative to remain highly disciplined in our investment process and exceptionally prudent in deploying our available capital into new investments that meet our strict underwriting criteria. Our strategic initiatives with life science lending and Crystal platforms create attractive growth opportunities, while reducing our reliance on the sponsor-backed community. Longer term, we believe the record amounts of private equity dry powder that has been sitting on the sidelines and the continued retreat of banks from midmarket leverage lending create a very attractive supply demand dynamic for cash flow lending to middle market companies. Our current portfolio leverage is 0.48 relative to our target leverage of 0.65 to 0.75. Including the available capital through our strategic initiatives, Solar has ample capital and the diversified origination engine to continue to grow its portfolio. We have originated on average just over $475 million per year in new investments over the last five years, and our portfolio has grown over 33% since the beginning of last year. Importantly, we have more than doubled our assets in the stretch senior loan programs in 2016 and grew our life science portfolio to over $215 million from a standing start two years ago. We are encouraged by the pickup in sponsor driven M&A activity during this current quarter, and we remain confident in our ability to prudently grow the portfolio in the near term. Thus far during the fourth quarter, we have visibility on only $70 million of repayments and continue to expect portfolio growth in the fourth quarter. Now let me turn the call back over to Michael.

Thank you, Bruce. As we have outlined, the third quarter marked another successful one for Solar Capital. By staying true to our investment discipline and strategic vision we have constructed a comprehensive investment portfolio that is extremely defensive in nature with approximately 96% in senior secured loans and 95% in floating-rate loans. We built our diversified sourcing engines in partnership that should enable us to increase return on equity for our shareholders while maintaining a conservative investment approach. In the coming quarters, we expect to continue to ramp our stretch senior loan program as well as our life science loan program. We believe that the senior secured investment profile of these strategic initiatives provide us with the best risk reward in today's investing climate. Additionally, Crystal Financial remains well positioned to generate an attractive return on our investments. Based on current visibility, we expect our net investment income in the fourth quarter to also exceed our $0.40 per share quarterly distribution. As we grow our portfolio, we believe we will achieve a sustainable level of net investment income in the mid-40s per share. At that time, we currently anticipate raising our quarterly distribution. Our shareholders have reaped the benefit of our disciplined underwriting as evidenced by the low nonaccrual rate, strong overall credit performance and stable net asset value per share. For those investors who've been with us since they bought the shares at our IPO, we provided a 77% total return or a 12.2% annual internal rate of return based on last night's closing share price. Importantly, our net asset value has increased over 4% since our IPO representing top tier performance relative to our peers over the same timeframe. We've always taken a long term view in managing our business including our people, our balance sheet and our portfolio. It truly is a marathon and not a sprint. We think the future is even more promising given their earnings power of our current portfolio, the capacity of our future growth and a diversified origination engines. The management team 5.7% ownership in Solar, we remain tightly alighted with our fellow shareholders and are focussed on building long term value. At 11 o' clock this morning, we'll be hosting an earnings call for the third quarter 2016 results of Solar Senior Capital or SUNS as we call it. Our ability to provide traditional middle market senior secured financing for the vehicle continues to enhance our origination team's ability to meet their clients capital needs. We continue to see benefits of the value proposition in Solar Capital deal flow. Thank you all for your time. Operator could you please open up the line for questions?

[Operator Instructions] Your first question comes from Jonathan Bock from Wells Fargo Securities. Your line is open.

Good morning. Joe Mazzoli filling in for Jonathan Bock here.

Good morning, Joe.

The first question, we see that you've assigned 50 million commitment to a new SSLP III. So, that there is really two questions here. Are you actively seeking a new partner for this third fund, is the first question. And then the second question is, from a lenders perspective, is it more difficult to obtain a credit facility for a smaller fund like this, would pricing be more expensive or is it similar to the SSLP, the first SSLP as long as you kind of meet the diversification requirements.

Yes. I think, really good question. In terms of SSLP III, we will continue to be opportunistic and look at ways to optimise the use of that capital. So, more to come, stay tuned. I think in terms of credit facilities, that's actually a good question. The challenge in getting credit facility is not necessarily the size of any individual joint venture. We have large and small as you know across the entire Solar platform. But I think it does highlight a bigger question which is as Rich mentioned we were successful in terming out Solar's revolver during this period. We opened a facility at the SSLP I, we will be opening SSLP II's credit facility this quarter as you mentioned. And as we talk about with SUNS shortly, this morning. We also expand credit facilities there. I think the answer though is that we were finding is that credit providers to entities such as ourselves are being that much more selective. I think they're taking their lead from the rating agencies as well as the equity markets as to backing certain managers. And I think it will be more challenging for some platforms going forward to tap into bank capital. I think it's less about the size of the facility to your specific question and more about the breadth of the platform and the platforms performance. We get the benefit of our corporate pricing across the credit facility regardless of whether in account 50 million or 100 million, 200 million.

Okay. That totally makes sense. Thank you. And just to clarify. You mentioned you haven’t start yet, you don’t have a credit facility yet, at SSLP II. What's the difference between the 54 million of equity committed as of 930 and then the 68 million of assets? Is there leverage there at all?

Not in SSLP II yet. Yes, it's probably their share versus the total assets. The 54 is our 68 the total with the 14 being the partner, our partnership.

Okay. Fantastic. Just one more question here. You're obviously in an enviable position with the platform easily exceeding the dividend over the next several quarters by quite a bit but by most folk's estimates. Now, how do you balance retaining spill over income which a lot of folks in this community view as an attractive way to kind of retain capital and redeploy into the platform versus increasing the distribution of shareholders. How do you kind of think about that from a broad perspective?

Yes, good question. We don’t frankly don’t look at it as retains to lower capital. It never actually entered our conversation. For us, it's more about we want to make sure that we have a portfolio in place that can demonstrate consistent earnings so that we're comfortable to raise a dividend to a certain level. We've not seen a dividend last two quarters, I think you want to see another quarter or two of that before we consider raising your dividend to that level.

Fantastic. Thank you both, so much. And congrats on a great quarter.

Thank you.

Thanks for your questions.

Your next question comes from Ryan Lynch from KBW. You line is open.

Good morning, gentlemen.

Good morning.

My first question relates to just competition, you guys earned a position where you guys have a lot of capital to deploy both, some on the balance sheet as well as the SSLP and other funds. So, as you look at the earning environment support capital into and we've seen private funds being raised, we've seen different competitors coming back into the market and maybe that was we can see a little bit of that maybe in the big repayment you guys experienced this quarter. So, just how did you guys think about going forward with a significant amount of capital raise and maybe a more increasingly competitive environment?

Sure. I think from 30,000 feet, we find that the competitive environment in the sponsor business is driven more by the dearth of deal activity this year as it is by the capital that's out there to be deployed. I think that once deal activity picks up, we've begun to see it take up this quarter. But I think that it's more about deals because the amount of banks capital has been exiting the system meaningfully towards any capital raise. And particularly where we play at the large end to mid-market, our focus continues to be playing for those larger companies where the ability to be relevant to the borrower can take larger and larger hold positions. And so, that's our strategic direction with the creation of these joint ventures is to expand our balance sheet and we see less competition up there. But I think the real driver is going to be deal flow picking up. We've seen that this quarter it will continue over time, it's hard to predict pick the predict the quarter. But given that there is substantial amount of un-invested private equity on the sideline that will get invested overtime and that will really be what drives the investment opportunity for us in that vertical. As you know we're blessed with having diverse origination engines with our life science business as well as Crystal's asset based lending platform, both of which go to a different issuer based and borrowers than this sponsor back community. And so, as we've seen year-to-date, that has allowed us to continue to grow our portfolio in spite of muted sponsor activity. So, we feel very good long term. And really feel blessed short term by having the diverse origination engines and asset niches.

Okay, great. Yes, understood. You guys, your guys portfolio is actually changed significantly over the last couple of years and you guys are diverse side but from an investment standpoint but, also you guys have a couple of different investment strategies or verticals in your guys portfolio with the middle market loans, you guys holding your balance sheet, you guys had the SSLP funds, you guys have a Life Science's portfolio and then the Crystal portfolio. So, as we see here today you guys have a current mix in those deferrals four different strategies or funds. How does the portfolio look in a year from now? Do you guys expect that that same sort of mix that we have going on today or are you guys expecting to grow any one of those strategies more than others going forward?

Crystal tends to bounce around between your four and 550, may we get the business to 600. So those are kind of what we think those will grow too. The middle market direct stress senior lending business, frankly have a lot more growth ahead of it. And if you look at the capital we have available that’s where you'll see the vast majority of it coming from. So, as a percentage that will increase as those other two businesses kind of get capped out.

Okay, yes, that make sense. And then just one last one, you mentioned the 7% and 11% revenue in EBITDA growth which is very strong in this environment, I understand you guys don't have any energy or commodity exposure of your portfolio. So, that's certainly beneficial. But are you guys seeing the 7% and 11% growth is very strong in this environment, but are you guys seeing any particular weakness or slowdown in any particular industry?

No, we are not actually. We're not seeing outside growth necessarily. I think that growth was broad-based, but I would say across the portfolio, no real systemic signs of how to slowdown or acceleration. But as you know we have a very defensive portfolio in addition to not having any energy or commodities. We really don't have much in the way of anything cyclical or consumer discretionary. So, really what we're seeing is the benefit of high free cash flowing businesses being able to drive EBITDA to both the top line as well as economy to scale dropping down to the EBITDA line.

And to just put it a little more bluntly, I think, we're seeing to benefit of the assets unless we put in place. I think the reason why we are outperforming in the middle market from our committed doing at 7% and 11% is that we have been very picky about the comments we put into our portfolio that are defensively build. And I think we are also benefiting from the fact that we are at the upper end of middle market where having EBITDA of $95 million and those companies have tend to do better than the smaller companies in general.

Okay, great. Thank you. Those were all the questions from me and are really excellent quarter, guys.

Thank you.

Thank you.

[Operator Instructions] Your next question comes from Casey Alexander from Compass Point Research & Trading. Your line has open.

Yes, hi, good morning. I think you did answer my question, I mean, I was going to ask what Crystal and Life Science and the three SSLPs. If that was sort of a reverse commentary about the traditional middle market lending market, but it seem that if understood your answer right, it was more kind of an issue of current deal flow, is that, did I - I got that right?

Yes, exactly.

Okay. In the traditional middle market deal flow that you are seeing, what are some of the competitive in credit dynamics that you are seeing in the market right now as compared to what you maybe saw six months ago?

Yes. I would say it hasn't changed much over the past six months. Early days, but I think as we mentioned in the quarter, we are starting to see a little bit more activity particularly at the large end of mid-market, which is where we play and where there is generally less competition just because of the capital base that a lender would need to have in order to take down large loan hold positions for these larger companies. So, we see a little bit more activity which had been consistently quite throughout 2016. Again we don't look at this as a quarterly business because it does have inflow and it's extremely lumpy, but we do look at the fundamentals that drive this sector and that is a combination of sponsored dry powder that is looking to invest in middle market companies that drive the M&A transactions. I think as we talked about throughout this year, a lot of the volume that we have seen has been driven by add-on acquisitions into these sponsor companies rather than the creation of new platforms. And we think that's in large part of sponsors are trying to add value and equity value for themselves and their investors by growing these businesses and driving down their investment multiple from the original acquisition that they have made a year or two ago. So, I think a lot of add-on acquisitions which drive beneath for additional debt capital as well as retooling their existing capital structure. So, that is still a significant driver and we see tremendous opportunity as a result of that. Again, tough to predict which quarter but we are seeing some pick up this quarter. And then secondarily as we touched on earlier, the competition is driven by the creation of capital that can play in these large loans and can actually provide large capital basis. And there are few platforms that can do that. And we're blessed by the fact that the banks are not competitors from that perspective. They have very small hold positions given their regulatory pressures. So, we feel very good long-term about the competitive dynamics but it's really about watching the flow pickup.

And great. Thank you for taking my question.

Our pleasure.

[Operator Instructions] I am showing no further questions at this time. I'll turn the conference back over to Michael Gross, Chairman and Chief Executive Officer.

Thank you all for your time and attention this morning. And we look forward to talking to those who are involved in Solar Senior in 15 minutes. Thank you. Bye-bye.

Ladies and gentlemen, this concludes today's conference. Thank you for your participation and have a wonderful day. You may all disconnect.