SLR Investment Corp. (SLRC) Q2 2018 Earnings Report, Transcript and Summary

Good day, ladies and gentlemen, and welcome to the Q2 2018 Solar Capital Earnings Conference Call. [Operator Instructions]. As a reminder, this call is being recorded. I would like to turn the call over to Michael Gross, Chairman and Chief Executive Officer. You may begin.

Thank you very much, and good morning. Welcome to Solar Capital's earnings call for the quarter ended June 30, 2018. I'm joined here today by our Chief Operating Officer, Bruce Spohler; and Richard Peteka, our Chief Financial Officer. Rich, before we begin, would you please start by covering the webcast and forward-looking statements.

Of course, Michael. Thank you. I would like to remind everyone that today's call and webcast are being recorded. Please note that they are the property of Solar Capital Ltd. 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 replay 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 involving a number of risks and uncertainties. Additionally, past performance is not indicative of future results. 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 Ltd. 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. In the second quarter, Solar Capital delivered solid operating results and extended our long-running strong fundamental performance as measured by credit quality, NAV preservation and earnings power. At June 30, 2018, Solar Capital portfolio was 100% performing, and our net asset value was $21.93 per share, up $0.06 per share from the prior quarter. During the quarter, we generated $0.45 of net investment income per share, consistent with the prior quarter. Fundamental credit performance continued to be strong, supported by stable economic conditions and corporate earnings growth. At June 30, over 98% of Solar Capital's highly diversified comprehensive portfolio was comprised of senior secured cash flow and asset-based loans, with 78% of them in floating rate loans. During these frothy market conditions in cash flow lending, our asset-based lending businesses, including Crystal, Nations Equipment Finance and Life Science, facilitated portfolio expansion via loans with strong structural protections. Not only do our asset-based loans carry credit protections and yields superior to those available in the capital market, but the higher income we receive from our asset-based loans enabled us to be more highly selective in underwriting middle-market cash flow transactions. Our barbell approach to portfolio construction has allowed Solar Capital to maintain a weighted average comprehensive portfolio yield at fair value close to 11% in the face of continued spread compression in cash flow lending. In addition, approximately 65% of our comprehensive portfolio assets in the second quarter are from structurally financed investment strategies. Yesterday, we announced that Solar Capital's board approved the reduction in the asset coverage requirements under Small Business Credit Availability Act. As a result, on June -- on August 2, 2019, Solar Capital's asset coverage requirements will change from 200% to 150% and the company will target a range of 0.9 to 1.25x debt to equity. Given our history of a very conservative use of leverage, we expect to operate at a substantial cushion to the new allowable regulatory limits. In order to potentially accelerate the adoption, Solar Capital's board authorized the submission of a proposal for voting shareholders to approve the modified asset coverage requirement. If passed, the change is going to effect the day after the shareholder meeting. Solar Capital's board also approved an amendment to the investment advisory agreement, reducing the annual base management fee to 1% on assets financed using leverage over 1x debt to equity. The asset coverage modification will not change our investment strategy, but it will enhance Solar Capital's ability to further expand our specialty finance asset-based lending platform. The additional flexibility will also enable Solar Capital to simplify our business model. Specifically, we expect to bring the SSLP assets onto the company's balance sheet. In the program's current format, SSLP equity is included in our portfolio of the nonqualified assets, which is capped at 30% of our gross assets. By consolidating the SSLPs, our portfolio of cash flow senior secured loans will have approximately the same leverage on balance sheet as the current look through leverage but will count as a qualified asset. This will free up 30% capacity, and once the new asset coverage requirements are in place, we will have even greater strategic flexibility to make acquisitions and expand our speciality finance platform. Collapsing the SSLPs will also result in enhanced transparency, simplicity of reporting and streamlined decision-making. We intend to move closer to our new target leverage range by growing our portfolio organically over time but only when the market opportunity permits. Consistent with our longstanding conservative investment approach, we will be prudent with the use of leverage. We view the increased leverage flexibility as simply another investment and risk management tool. As you've seen from our conservative historical approach to leverage, if the market opportunity does not merit increased leverage, then we will not incur it. We will continue to be highly disciplined in deploying our available capital. When combined with the management fee reduction, we believe the additional leverage flexibility provides Solar Capital with the potential to generate incremental long-term returns to shareholders. Importantly, Solar Capital has sufficient debt capacity in place today to operate within the range of targeted debt to equity without having to raise additional equity or debt. At this time, I'll turn the call over to our Chief Financial Officer, Rich Peteka, to take you through the financial highlights.

Thank you, Michael. Solar Capital Ltd. net asset value at June 30, 2018, was $926.8 million or $21.93 per share compared to $924.3 million or $21.87 per share at March 31. At June 30, Solar Capital's on-balance sheet investment portfolio had a fair market value of $1.40 billion in 100 portfolio companies across 32 industries compared to a fair market value of $1.47 billion in 100 portfolio companies across 33 industries at March 31, 2018. The weighted average yield on our income-producing portfolio was 10.1% at June 30, 2018, compared to 10.6% at March 31, measured at cost. At June 30, Solar Capital had $473.6 million of debt outstanding and leverage of 0.5x net debt to equity compared to $545.5 million and 0.58x at March 31. Subsequent to quarter end, the company utilized the accordion feature under its revolving credit facility and further expanded revolving commitments by $35 million up to now $480 million in total revolving commitments. When considering available capacity from the company's credit facility, combined with available capital at 6/30 from the nonrecourse credit facilities like Crystal, Nations Equipment Finance and the SSLPs and including the $35 million of expanded balance sheet revolver commitments, Solar Capital had more than $675 million to fund future portfolio growth, subject to borrowing base limits. Turning to the P&L. For the 3 months ended June 30, 2018, gross investment income totaled $39.2 million versus $39.0 million for the 3 months ended March 31, 2018. Expenses totaled $20.0 million for the 3 months ended June 30 compared to $20.1 million for the 3 months ended March 31. Accordingly, the company's net investment income for the 3 months ended June 30, 2018, totaled $19.2 million or $0.45 per average share compared to $18.9 million or $0.45 per average share for the 3 months ended March 31. Below the line, the company had net realized and unrealized gains for the second fiscal quarter totaling $0.6 million versus net realized and unrealized gains of $1.2 million for the first quarter. Ultimately, the company had a net increase in net assets resulting from operations of $19.8 million or $0.47 per average share for the 3 months ended June 30. This compares to an increase of $20.0 million or $0.47 per average share for the 3 months ended March 31. Finally, our Board of Directors recently declared a fiscal third quarter distribution of $0.41 per share payable on October 2, 2018, to shareholders of record on September 20, 2018. With that, I'll turn the call over to our Chief Operating Officer, Bruce Spohler.

Thank you, Rich. Overall, the financial health of our portfolio companies remained sound, reflecting our disciplined underwriting and focus on downside protection. At June 30, the weighted average investment risk rating of Solar's portfolio was just under 2x when measured at fair market value, based on our 1 to 4 risk rating scale, with 1 representing the least amount of risk. As further indication of the strong underlying fundamentals of our portfolio, only 1% of our portfolio at fair value was on watch list status. This is near historic close. Additionally, 100% of our portfolio was performing at quarter end. At June 30, over 78% of Solar's income-producing portfolio was floating rate when measured at fair value. The fixed rate loan exposure principally comes from NEF's short-duration equipment financings with an average life of just over two years. At quarter end, our comprehensive portfolio encompassed 230 distinct issuers across 97 industries. The average investment per issuer was just over $7.5 million or 0.4% of the overall portfolio. Also at June 30, over 98% of our portfolio consisted of senior secured loans comprised of approximately 83% first lean senior secured loans and just under 15% in second lien secured loans. While our exposure to higher-risk and higher-yielding second lien loans is down from approximately 20% in the first quarter, the weighted average yield of our portfolio was 10.9% compared to 10.8% in Q1. We have been able to maintain this yield of close to 11% at the asset level in spite of spread compression in the cash flow lending market and have replaced our second lien exposure with lower-risk, high-return commercial finance investments. Including activity across our 4 business lines, originations totaled approximately $260 million and repayments were approximately $295 million, resulting in net portfolio reduction of approximately $35 million. Given the continued heated cash flow market conditions, we intentionally allowed that portfolio to shrink. The modest decline in our cash flow portfolio was predominantly from the repayment of second lien assets and, again, was partially offset by growth through our ABL strategies, which, today, offer more favorable risk return characteristics. Now let me give a brief update on each of our 4 investment verticals. Our cash flow business invests in senior secured loans, which are predominately first lien and stretched first lien, to sponsor-backed companies in the upper mid-market with average EBITDA of approximately $70 million today. Included in this vertical are senior secured cash flow loans held both on balance sheet as well as in our SSLPs. During the second quarter, we originated cash flow investments of approximately $45 million and had repayments of approximately $122 million. At June 30, our cash flow loan portfolio was just over $600 million, representing 34% of our $1.8 billion total portfolio. Our exposure to second lien loans declined again to 15% of this portfolio, down from 20% in Q1. We expect this to continue to decline during the remainder of 2018. At June 30, the weighted average trailing 12-month revenue and EBITDA for our issuers were up mid-single-digits, reflecting continued positive fundamental trends for our portfolio companies. In the cash flow segment, leverage to our security was just under 5x, slightly lower than first quarter, and interest coverage was approximately 2.3x. In addition, the weighted average yield on our cash flow investments was 9.6%, consistent with the prior quarter. Turning to our asset-based lending business, Crystal Finance. These loans, as you may recall, are made up of loans against realizable liquidation value of -- and underlying borrowers' assets, and they come with meaningful upfront and prepayment fees as well as structural protections. During the second quarter, we funded $108 million of new asset-based investments and had repayments of approximately $67 million, resulting in portfolio growth of just over $40 million. At June 30, the senior secured asset-based portfolio was approximately $567 million, representing 32% of our total portfolio. The weighted average yield of the asset-based portfolio was 12.3%, up slightly from the first quarter of 12.1%. Our ABL platform paid Solar Capital a second quarter dividend of $7.5 million, equating to a 10.7% yield on cost. Moving on to our equipment finance business, NEF. Solar Capital entered this business through the acquisition of NEF last year. Included in this business are equipment financings held both directly on Solar's balance sheet as well as in our wholly owned subsidiary, NEF Holdings, that for tax efficiency, holds certain of these investments. During the second quarter, NEF had new investments of approximately $60 million and had portfolio repayments of approximately $25 million. At quarter and, our equipment finance strategy had a total portfolio of approximately $350 million of funded assets to 136 different borrowers with an average exposure $2.6 million. The equipment finance asset class represents approximately 20% of our total portfolio. 100% of NEF's investments are first lien loans and approximately 95% are fixed rate. The interest rate risk is mitigated through the relatively short holding period of just over two years as well as our efforts to match fund NEF's assets with our unsecured fixed rate liabilities of approximately $250 million. The weighted average yield on our equipment finance portfolio was 10.5% at quarter end, consistent with the prior quarter. Finally, a brief update on our life science lending business. As a reminder, these are first lien senior secured loans and typically come with either success fees or warrants to enhance our yield. During the second quarter, our team originated just under $50 million of new senior secured life science loans. Repayments totaled approximately $80 million. Our life science portfolio totaled approximately $204 million at quarter end across 19 borrowers with an average investment size of just over $10 million. Our life science loans represent just over 11% of our total portfolio. The weighted average yield on the life science portfolio is approximately 12% and, again, excluding any exit, success fees and warrants. As Michael mentioned, the middle-market cash flow lending environment remains frothy. We have solid benefit from our diversified origination sources across not only cash flow but also asset-based lending vertical, which allow us to allocate capital to investments that meet our strict underwriting criteria regardless of market conditions. We will continue to be prudent and highly disciplined in deploying our substantial available capital. Now I'll turn the call back to Michael.

Thank you, Bruce. From the inception of Solar Capital 1two years ago, our investment and management decisions have focused on building long-term shareholder value, protecting capital and maintaining alignment with our shareholders. We have been disciplined in the face of sustained frothy credit markets and have remained patient and disciplined in not compromising credit quality for yield. We have been thorough in analyzing and reaching our decision to reduce the asset coverage requirements. We studied how the increased leverage flexibility could impact Solar Capital's strategic priorities and long-term value creation for our shareholders as well as assessed the associated risks and how they can be managed and mitigated. As you know, we have never allowed leverage to drive our investment decisions. For Solar Capital, our board's decision to modify the asset coverage requirement focused on the opportunity for balance sheet optimization, portfolio and financing flexibility and risk management and not on maximizing leverage. The greater flexibility will not change our investment strategy. However, it meaningfully enhances our ability to grow, build and potentially acquire a niche specialty financed businesses as we continue to broaden our diversified commercial finance platform. Importantly, the reduced asset coverage requirement allows us to operate with an increased cushion to the regulatory leverage threshold, which should be a significant benefit in more volatile markets. We have maintained an investment philosophy of assuming we are late in the credit cycle, and we believe that in the current investment environment, it pays to be cautious. No one knows how long seemingly inflated enterprise values, loose structures and low price will persist or whether correction will come. We believe our differentiated origination platform and diversified portfolio position us well to navigate in any environment we face. At 0.5x net debt to equity, we are underlevered and have substantial dry powder to deploy via our differentiated investment verticals. We believe Solar Capital has a clear path to a run rate quarterly net investment income per share in the mid- to upper 40s. As the rates increase on sustainable basis, our Board of Directors will further evaluate increasing our distribution to shareholders. At 11:00 this morning, we'll be hosting an earnings call for the second quarter results of Solar Senior Capital, or SUNS. Our ability to provide traditional middle-market senior secured financing through this vehicle continues to enhance our origination ability to meet our clients' capital needs and we continue to benefit from the value proposition in Solar Capital's deal flow. We thank you very much for your time this morning. Operator, could you please open the line for questions?

[Operator Instructions]. Our first question comes from Chris York of JMP Securities.

So maybe I will begin with Mr. Peteka. Embedded in your interest income is unamortized loan fees and prepayment fees. So how much accelerated OI fees, prepayment fees were in the interest income this quarter?

Accelerated? Hold on. If we include some of the life science income that we get, it would be -- one second. Accelerated, about $0.02 a share.

And then shifting to strategy a little bit. So as I analyze recent drivers of portfolio growth and maybe say realize two years, the main drivers have been your commercial finance niches, the growth has been welcomed. But how should investors balance the lack of growth in sponsored cash flow lending with the near-term growth potential being provided with more leverage?

I think to echo Michael's comments, Chris, what we would say is we think that we are well positioned for growth across all the verticals but don't want to be reliant on growth in any one vertical. And as you and everyone around our industry knows, the cash flow sector has become somewhat frothy while fundamentals are strong, structures have been weakened at the levels that we've never seen in our 30-year career. And so we like the ability that we can be opportunistic and deploy the capital across a variety of strategies. I think near term, we wouldn't expect any meaningful growth in cash flow unless some recent transactions actually turned into a trend and we saw some better conditions in the cash flow business. We continue to see growth opportunities in our specially finance, to your point. And by putting the SSLPs on balance sheet and adopting the 2:1, albeit with a much lower target of not 0.9 to 1.25, it really frees us up to do what we've done well over the last couple years in terms of acquiring and adding and incubating other specialty finance businesses. So I think if you're looking for near-term growth, that's where it most likely come from.

Got it. Okay. And then I guess you talked a little bit about collapsing the JVs. How will that work? And then what is the timing for the on balance sheet of these assets presuming you get shareholder approval?

So we do not need shareholder approval to bring these on balance sheet. And shareholder approval is likely to happen early in the fourth quarter. But we will bring these on balance sheet by the end of the third quarter. So when you see our Q3 10-Q, what will look different is all the assets within the SSLPs will show up on our schedule of investments because that will be consolidated onto our balance sheet, and all the liabilities of the SSLPs will show up as debt on our balance sheet.

But had we done that, Chris, just for illustration purposes, at June 30 and actually collapsed, then our 0.5 leverage would be 0.65 with the SSLPs consolidated our pro rata share.

Okay. So just to confirm, so at the end of Q3, you'll collapse, bring all the assets on, bring the liabilities on the balance sheet. And then Q4 is when the special meeting will occur. So you don't -- that's not the impediment, the approval. You're going to move forward the collapse.

We're going to collapse at the end of Q3. We're not going to know what the outcome of the shareholder vote is at the time. We fully expect to get it, but that's a part of our strategy.

Got it. Okay. Last question, then I'll -- can't say hop back in queue. So what are your target ROE thresholds? Or how should investors think about the additional leverage capacity that should accrue to investors in that incremental return? I believe you had targeted 9% ROE at 0.7x under the 1:1 frame marks. I'm just curious on how [indiscernible].

I think the simplest way to answer that the most meaningful, I think, for our shareholders is that where we do achieve our debt to equity target assuming the environment we're in today where we're seeing returns we're seeing today, we will have an earnings power of around $0.50 on net investment income on a quarterly basis. So a significant upside than where we are today.

[Operator Instructions]. Our next question comes from Ryan Lynch of KBW.

With passing the 2:1 leverage, you guys set out a target of 0.9 to 1.25. That feels like a pretty ambitious target given that historically, you guys have really never run closer to your previous target and always run with pretty low leverage. And additionally, you guys have the cash flow lending portion of your portfolio continues to shrink. I think you said that you expect it to shrink in the second half of the year. So I guess, just what are the prospects that you guys hitting within your guys target leverage ratio of 0.9 to 1.25 in the next, say, 12 to 18 months? And if it's a low probability of hitting that, I guess, wouldn't collapsing the SSLPs onto your balance sheet give you the flexibility to further utilize your 30% bucket and would only increase your debt to equity to 0.65, as you mentioned and it -- without actually passing the 2:1 and not giving you guys any sort of risk of potential downgrade from the rating agencies?

So two parts to your question. Yes, as Michael mentioned, we are going to collapse the SSLPs. It will only take us to 0.65. But just to reiterate our comments around the 2:1, today, we would tell you, near term, we don't expect to grow much beyond that unless conditions were to change in the cash flow market, although we do continue to see growth in our specialty finance verticals. What the 2:1 does in connection with bringing the SSLPs on balance sheet is to your -- the rest of your question, over 12 to 18 months, we would expect to utilize that additional flexibility to expand our commercial finance platform. And I think as part of that, you would see an expansion of our leverage. So this is more about strategically being able to take advantage of additional acquisitions, additional teams in commercial finance that we can onboard to grow that part of our platform and then opportunistically continue to grow our cash flow business as well. So near term, you're right, we're probably not going to reach that 0.9 to 1.25 target. The caveat is we want our team out there aggressively looking for additional commercial finance platforms. And as you know, that can happen at any time.

Okay. That's helpful. And, obviously, you guys have the asset-based lending. You have the equipment finance. Sounds like you guys intend to grow those 2 current verticals that you have. What other areas -- speciality, finance or commercial finance areas you guys are looking to potentially make acquisitions? Is it to further boost -- bolster your current strategies, equipment financing and asset-based lending? Or are there any other verticals you guys are potentially looking, at least exploring or wanting to potentially get into?

Sure. The only one that you left off there is our life science lending business, where we're basically lending against cash and IP. We think of that as an ideal platform that is also poised for additional growth with additional 30% flexibility. But I think it's a combination of adding to the existing platforms. We're viewed as a strategic buyer. Our teams are deep, and we think they can handle additional both portfolios as well as teams where we can diversify geographically. So we would like to grow that as well as look at new platforms. As you know, very often, historically, we've gotten into these businesses by being a lender first and then an owner second. And so even a loan into these businesses uses up 30% capacity, so this frees us up to plant some seeds across a variety of ABL platforms.

[Operator Instructions]. Our next question comes from Fin O'Shea of Wells Fargo Securities.

Just to explain a little bit on what Ryan was just asking, can you kind of touch on the opportunity set for ABL platforms, vehicles, et cetera, assuming that those 2 are very expensive? Should -- is this something you're willing to go forward with, pay a premium for a book? Or if you can kind of explain what you see is the opportunity set out there.

I think, again, because historically, we've been very successful in not paying a substantial premium, at least relative to market premiums, if you look at Crystal, if you look at NEF, I think the history of the team, senior management having worked together with a number of other senior members here at Solar in their formative days back at GE Capital, help drive very attractive pricing, also providing certainty of closure. So we feel very good about the premiums paid in our life science business. We were able to bring the team on and incubate them and, basically, create a business at book value. But again, because we are a strategic buyer, we feel that we can add on to the existing platforms at more favorable prices and actually buy down our multiple. But clearly, we need to be selective.

Sure. And just kind of with the collapse of vehicles moving presumably up market on your core balance sheet, this will probably look to be a step closer to SUNS. Is that -- I know that call is in a few minutes, but is the SUNS platform, too, going to evolve like this? Or are they going to look a bit more light?

So we'll talk at SUNS later. But for both Solar and SUNS, the adoption of the new leverage regime is not changing the target investment strategy at all. So the casual strategy for Solar will continue to be stretched first lien, not unitranche, not second lien. We're not -- our average EBITDA already is very significant, so we're not changing the size we're going after. Importantly, though, what we are taking advantage of for Solar is the fact that our capital base across our platform has grown, so we can take down larger transactions for the same-sized companies and spread it across our different vehicles and yet keep our diversification. So this is very important for everyone to know that, again, the adoption of this new leverage regime is not changing investment strategy at all. It's the same strategy regarding cash flow. We're just waiting for a better environment to be more aggressive in that market. And it's the same strategy for asset-based lending strategy to continue grow those businesses and then, again, to Bruce's point earlier, to take advantage of the fact that we've now created in excess of $400 million of capacity for 30% asset to be able to become more acquisitive.

And just to clarify, the Solar first lien assets, as Michael mentioned, are stretched first lien, whereas Solar Senior is traditional lower leverage first lien, lower return. So they don't overlap that often.

Very well. One last question on the dividend, forgive me if you mentioned it. It's -- you've been at $0.45 now, and it sounds like it's only getting better. Surely don't expect it to get worse near term, so any outlook on another bump near term on the dividend?

Yes. I think, as Michael mentioned in his closing remarks, we are, as you know, looking for sustainable earnings as we did this first quarter when we raised the dividend to the $0.41. I think as we continue to drive sustainable earnings above the mid-40s, you should see us follow with a step-up in the dividend.

So are you generally going to keep a large cushion? Or are you going to raise it from $0.41 to the mid-40s?

We're going to keep a cushion. We haven't decided how much, but there will be a cushion. We want to make sure we have adequate dividend coverage, especially because there will be quarters where earnings may dip. If we don't have -- they can consist of prepayment fees, but there could be quarters where we don't have any. And we want to be able to make sure we continue to earn our dividend.

[Operator Instructions]. Our next question comes from Chris York of JMP Securities.

Just one follow-up. So in your strategic review, presumably, consideration was given to the reduction in base management fees at other PCs like Aries, TPG and maybe even Goldman. So I'm curious whether the conversation came up with the board, whether it was prudent to further align the base management fee to maybe a 1.5% level now that the management fee benefits to shareholders from the off-balance sheet arrangement will be reduced.

Yes, as you know, we just lowered our base management fee to 1.75% at the beginning of the year. So it was our intention to reflect a sharing and, hopefully, an increase in ROE for the shareholders were we to increase our leverage above 1:1. And that was really the primary focus.

There are no further questions at this time. I'd like to turn the call back over to Michael Gross, Chairman and Chief Executive Officer, for any closing remarks.

We thank you for all your time. If you have any follow-up questions, please feel free to follow up directly. And for those who would be on our SUNS call, we'll talk to you in 20 minutes.

Ladies and gentlemen, thank you for participating in today's conference. This does conclude the program, and you may all disconnect. Everyone, have a great day.