Sunrise Realty Trust, Inc. (SUNS) Q4 2016 Earnings Report, Transcript and Summary

Good day, ladies and gentlemen and welcome to the Solar Senior Capital Ltd. Fourth Quarter 2016 Earnings Conference Call. At this time, all participants are in a listen-only mode. [Operator Instructions] As a reminder, this conference is being recorded. I would now like to turn the conference over to your host for today, Michael Gross, Chairman and Chief Executive Officer. You may begin.

Thank you very much and good morning. Welcome to Solar Senior Capital Limited’s earnings call for the fiscal year ended December 31, 2016. I am joined here by Bruce Spohler, our Chief Operating Officer and Richard Peteka, our Chief Financial Officer. Rich, would you please start off by covering the webcast and forward-looking statements?

Sure. Thanks, Michael. I would like to remind everyone that today’s call and webcast are being recorded. Please note that they are the property of Solar Senior Capital Ltd. and that any unauthorized broadcast, in any form, are strictly prohibited. This conference call is being webcast on our website at www.solarseniorcap.com. Audio replays of this call will be made available later today as disclosed in our 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. Additionally, past performance is not indicative of future results. Actual results may differ materially as a result of the number of factors, including those described from time-to-time in our filings with the SEC. Solar Senior 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 would like to turn the call back to our Chairman and Chief Executive Officer, Michael Gross.

Thank you, Rich. We are pleased with our performance in the fourth quarter, which capped off a strong 2016, during which we grew our comprehensive investment portfolio by 25%, increased our net asset value by 3%, fully covered our distributions with GAAP and net investment income and increased our capital base. Equally important, we believe that our portfolio of senior secured floating rate loans provides us with a solid foundation for significantly growing investment income in 2017 through further investment in our existing strategic initiatives, as well as two new platform strategic developments which I am pleased to now discuss. First, as you may have seen from our press release yesterday morning, we have entered into a new life science lending joint venture with our sister company, Solar Capital, affiliated to the joint venture between Solar Capital Partners and PIMCO and Deerfield Management. Solar Life Science loan program is expected to invest the majority of its assets in first lien loans to publicly traded companies in the life science industry and will be incremental to our existing life science loan strategy. Aside from the larger enterprise value of the target companies, the business model will be consistent with the loans currently originated by Solar Capital Partners’ life science teams. To-date, our team has achieved a weighted average internal rate of return on all exit investments for the solar platform of 18.6%. We are pleased to be partnering with Deerfield Management, a top tier private investment firm with over $8 billion in assets under management. The firm specializes in healthcare investing from seed stage to mature companies across all segments of healthcare and has a tremendous track record. Solar has committed $75 million to the $350 million equity committed to the JV. With anticipated leverage of up to 1:1 debt to equity, the venture is expected to have total investable capital of approximately $700 million. Once fully ramped, the LSJV is expected to generate a mid-to-high teens return on equity. Second, at the end of 2016, our advisors, Solar Capital Partners, formed a joint venture with PIMCO. This initiative should provide significant benefit to SUNS. And through an expected larger investable capital base across the Solar platform, SUNS will become more of a full solutions provider. This should result in greater deal flow for Solar Senior. As an example, an equity commitment arising from the strategic partnership with PIMCO has helped make the Solar Life Science program larger and more relevant. Similarly, with a larger capital base, we anticipate having access to more sponsor-backed first lien loan investment opportunities for both FLLP and our SUNS balance sheet portfolio. Furthermore, the partnership with PIMCO provides access to the credit research resources of a world-class credit manager, which has invested $300 billion in corporate credit and currently employs over 50 credit research analysts. We anticipate investing our available capital via our new life science lending program. The incremental investment opportunities are expected to rise in conjunction with the joint venture with PIMCO and the continued expansion of FLLP, Gemino and our core SUNS portfolio. Through these proprietary sourcing channels, we believe we can continue to expand the portfolio via first lien senior secured loans with attractive risk profiles, which should translate into meaningful growth in investment income over the coming quarters. We have recognized the importance of preserving full net investment income coverage of our distributions as we deploy approximately $140 million of available capital. As a reminder, last year, we committed to waiving our earned incentive and management fees as needed to support distribution to shareholders through June 30, 2017. In the fourth quarter, we waived the majority of our management fees and all of our performance-based incentive fees. For the year, total fees waived by us, the manager, were approximately $2 million. As a result of the support, we believe we can consistently deliver a monthly distribution of $0.1175 per share, while we grow our portfolio and resulting net investment income. Lastly, our Board of Directors declared a monthly distribution for March 2017 of $0.1175 per share payable on April 4, 2017 to stockholders of record on March 23, 2017. At this time, I would like to turn the call over to our Chief Financial Officer, Rich Peteka.

Thank you, Michael. Solar Senior Capital Limited’s net asset value at December 31, 2016 was $269.1 million, or $16.80 per share. This compares to a net asset value of $268.9 million, or $16.78 per share at September 30. SUNS’ investment portfolio at December 31, 2016 had a fair market value of $365.5 million in 51 portfolio companies operating in 22 industries compared to a fair market value of $327.9 million in 49 portfolio companies operating in 22 industries at September 30. At December 31, the weighted average yield on our income producing portfolio was 7.8% measured at fair value. During the fourth quarter, we have placed one asset on non-accrual, which accounted for approximately 1.8% of the cost of our portfolio. Subsequent to year end, the company completed its restructuring and we removed the assets from non-accrual. At December 31, net leverage increased to 0.32 times from a modest 0.14 times at September 30, which reflected the net leverage post the company’s follow-on equity offering in September. I would like to note that we will continue to target leverage at 0.8 times as we deploy our available capital. From a P&L perspective, gross investment income for the three months ended December 31, 2016 totaled $7.2 million on a larger average portfolio versus $7.0 million for the three months ended September 30. Net expenses for the three months ended December 31 were $1.5 million compared to $2.5 million for the three months ended September 30 as we waived the majority of the management fees and all of the performance-based incentive fees totaling $870,000 for Q4. For the full year 2016, we waived approximately $2 million of management and performance-based incentive fees. Accordingly, net investment income for the quarter ended December 31, 2016 was $5.6 million or $0.35 per average share compared to $4.5 million or $0.37 per average share for the quarter ended September 30. Below the line, SUNS had a net realized and unrealized gain for the fourth fiscal quarter of $0.3 million. This compares to net realized and unrealized gains of $0.6 million for the quarter ended September 30. Ultimately, the company had a net increase in net assets resulting from operations of $6 million or $0.37 per average share for the three months ended December 31. This compares to an increase in net assets from operations of $5.2 million or $0.42 per average share for the three months ended September 30. Lastly, I would like to add that in January 2017 we increased lender commitments on our credit facility by $25 million bringing the facility’s total commitment size up to $200 million. At December 31, pro forma for the $25 million increase, SUNS had approximately $102 million of unused capacity under its revolving credit facility. And when considering the unused debt capacity of the FLLP credit facility, combined with the company’s balance sheet as well as anticipated leverage on the $75 million of equity raised in September, available capital is approximately $140 million at December 31, subject to borrowing base limitations. At this time, I would like to turn the call over to our Chief Operating Officer, Bruce Spohler.

Thank you, Rich. Let me begin by providing a portfolio update. At year end, the credit fundamentals and financial performance of our portfolio companies remained solid, reflecting our disciplined underwriting, seniority in the capital structure and focus on downside protection. At the end of Q4, the weighted average EBITDA of our first lien investments in SUNS portfolio, including our ownership of FLLP, was $75 million. Additionally, on a fair value weighted average basis, leverage to our investment was 3.9 times and our interest coverage was just under 3 times. Related 12-month revenue for our portfolio of companies grew approximately 7.5% and EBITDA has been stable on a fair value basis. At year end, SUNS’ approximately $430 million comprehensive portfolio included loans held in FLLP and had loans to 57 issuers across 25 different industries, with an average investment of $7.5 million or 1.8% of the portfolio. Virtually 100% of the comprehensive portfolio is invested in senior secured loans, including our investment in Gemino whose portfolio consists entirely of senior secured loans. Including our equity investment in Gemino, over 97% of our income-producing portfolio is floating rate. At year end, the weighted average yield on this portfolio was 7.8%. Our internal risk assessments remained at approximately 2, measured at fair market value and based on our 1 to 4 risk rating scale with 1 representing the least amount of risk. We continue to have no direct exposure to the oil and gas or commodity sectors. As Rich mentioned, during the fourth quarter, we placed one loan on non-accrual, which comprised 1.8% of our portfolio cost and 90 basis points of our portfolio’s fair value. In January, the company completed a consensual lender-led restructuring at a value modestly above our year end mark. As a result of the restructuring, the loan is no longer on non-accrual. Given SUNS’ history of strong credit performance, we are disappointed with this development. However, we are optimistic that over time, our ultimate recovery on this investment will be in line with the historical recovery value for mid-market senior secured loans. Before I give an overview of our fourth quarter activity, let me provide an update on our strategic investments. As a reminder, Gemino focuses on providing senior secured asset-based loans to small and mid-sized U.S. based companies in the healthcare industry. Gemino’s expertise in asset-based lending platform creates a risk return profile that has a low correlation to SUNS’ traditional underwriting of senior secured cash flow loans. At year end, Gemino’s portfolio totaled just over $114 million of funded loans across 35 borrowers, with an average balance of approximately $3.3 million. All of the commitments at Gemino are floating rate senior secured cash-pay loans. For the fourth quarter, Gemino paid a distribution of $924,000 to SUNS, equating to an 11.25% annualized distribution yield on our cost. Since acquiring Gemino in 2013, the team has steadily grown its ROE from an initial 9.5%. Now, let me provide an update on FLLP. At year end, when measured at fair value, FLLP had approximately $117 million of first lien senior secured floating rate loans across 25 borrowers, with an average loan balance of $4.7 million. The portfolio at FLLP is 100% performing. During the fourth quarter, we funded an additional $9.7 million of our equity commitment into FLLP. For the fourth quarter, FLLP paid distributions to SUNS totaling $894,000. Due to SUNS’ funding of its equity late in the fourth quarter, our resulting annualized distribution yield was approximately 9.8%. We expect this yield in the first quarter to return to 11% plus as we complete FLLP’s ramp. To-date, we have deployed approximately $41 million of our $51 million equity commitment into FLLP. In the fourth quarter, we made investments of approximately $102 million across 13 portfolio companies and had sales and repayments of approximately $67 million. Now, let me turn to our new Solar Life Science JV. As Michael mentioned, this JV enables our life science team to include public, later stage and larger enterprise value companies in their target market. Our life science team frequently financed companies in this niche while employed at GE Capital. In our opinion, these larger companies present an attractive investment opportunity, because of their more advanced product pipeline as well as their demonstrated proven access to public equity capital. Importantly, we view Deerfield’s expertise in the public healthcare sector as a valuable addition to this initiative. We are confident in the JV’s ability to earn mid-to-high teens ROE once it’s fully ramped. As the frothiness in the credit markets returned, we maintained our investment discipline on all fronts: credit quality, structural protections and yield. Through our ability with our sister company, Solar Capital, to provide a full array of financing solutions, we maintained our strong competitive position, which allowed us to source several attractive first lien investments during the fourth quarter. Now, let me highlight a few of those. We funded a $10 million investment in the first lien term loan to NorthStar Anesthesia, a leading provider of outsourced anesthesia services to hospitals and ambulatory centers. The company is backed by TPG Growth Partners. The loan has a net leverage of 3.6 times, covenant protection and a yield of 6.3%. In addition, we originated an $8 million investment in the first lien term loan of Professional Physical Therapy, a market leading provider of outpatient physical therapy in the Tri-State area. The company is owned by Thomas H. Lee Partners. The loan has covenant protection and a yield to maturity of 7.3%. Collectively, the Solar platform invested $40 million in this transaction. We also invested $12 million in a first lien term loan to Alera Group, an employee benefits and PC insurance brokerage platform. The loan is levered through 4.5 times, has covenant protection and carries a yield to maturity of 6.8%. In the aggregate, the Solar platform committed $45 million to this investment. During the quarter, we also invested $8.2 million in the first lien term loan of Ministry Brands, a leading provider of software to faith-based organizations. The loan has a net leverage of 4.2 times, covenant protection and a yield to maturity of 6.3%. And finally, in a proprietary secondary trade, we acquired $15 million of the first lien term loan to AMPAC Specialty Chemicals. The company is the only North American producer of a certain rocket grade chemical used in the U.S. Department of Defense missile programs, as well as NASA and U.S. Air Force satellite launches. The yield to maturity on this investment is 7.9%. Now, I will highlight a few of our repayments. We repaid on our $10 million investment in LegalZoom at a premium to par, resulting in an IRR of just under 11%. The remaining $13 million of our investment in Athletico first lien loan was also repaid at par, resulting in an IRR of just over 7%. In addition, our remaining $10.9 million investment in Highgate Hotels was redeemed at par in conjunction with the refinancing. Due to the less favorable terms on the new loans, we decided not to reinvest in the issuer at this time. And finally, we sold our remaining $1.4 million investment in Asurion’s second lien loan at an average price north of par. Early in 2017, we sold the remainder of this position, resulting in a cumulative IRR of approximately 11.4%. Consistent with the exits that I just highlighted, we have a consistent history of realizing value that exceeds our prior quarter’s marks. We have always taken a conservative approach to our valuation. Looking forward, we feel extremely confident that through our diverse origination engines, we will be able to continue to grow the portfolio. Importantly, we are not solely focused on this sponsor-backed segment of the mid-market, which has been slow over the last few months. However, given the significant amount of debt maturing through 2020 that will need to be refinanced, together with the approximately $500 billion of private equity on invested capital we are expecting a pickup in demand for credit capital from sponsor-owned companies as well. Now, I will turn the call back over to Michael.

Thank you, Bruce. In the fourth quarter, Solar delivered another quarter of solid results. With a comprehensive investment portfolio that’s almost 100% senior secured and 97.2% floating rate, coupled with multiple strategic initiatives offering low to high teens return on equity profiles, we believe we are well-positioned for continued strong performance. In what are currently continued challenging credit market conditions, we feel confident that through our proprietary sourcing channels, we can continue to expand our comprehensive portfolio of floating rate senior secured loans. We are excited about the new Solar Life Science program joint venture’s potential to further boost our investment income, as well as the incremental investment opportunities we expect to arise from our advisor’s joint venture with PIMCO. We are confident that once we fully invest our available capital, our portfolio will generate quarterly net investment income that continues to exceed our current distributions. At last night’s close, SUNS trades at an 8.1% yield, which represents a significant discount to the 4.7% implied yield of S&P LSTA Leveraged Loan 100 Index and the 6% yield of a representative sample of 14 closed end loan funds. Given the credit quality of our diversified portfolio, our disciplined investment philosophy and relatively low fee structure, as well as the investor-friendly actions management has taken such as the fee waivers, we believe SUNS deserves a premium valuation. As the second largest shareholder, we, the management team, are closely aligned with our fellow shareholders. We believe our ongoing efforts to responsibly steward our shareholders’ capital will result both in NAV preservation and significant investment income growth. Thank you very much for your time this morning. We look forward to speaking to you next quarter. Operator, would you please open the line for questions?

Thank you. [Operator Instructions] And our first question comes from Robert Schweich of RMB Capital. Your line is now open.

Thank you. At what point will rising interest rates related to Fed actions benefit the company?

Yes. We do have some disclosure in our 10-Q. Right now, we are looking pretty good. We do have that floating rate portfolio with LIBOR – one month LIBOR moving up above 50 basis points and the 3-month over 1% now. On the 3-month side, we are above our floors. And so we should just see a net benefit given our floating rate assets exceeding our debt and that will ramp over time.

Do you expect a benefit in 2017 of any meaningful significance?

If rates were to increase, we would, but we don’t know obviously what the best plan is for timing.

Thank you.

Thank you.

Thank you. [Operator Instructions] And our next question comes from Allison Taylor Rudary from Oppenheimer. Your line is now open.

Hey, good morning everyone.

Good morning.

I know you guys covered a lot of the life science JV details in the prior call for the Solar vehicle, but I still think it’s worth asking, if you guys could go into some of the reasons why you think that this particular area of investing is beneficial, why it has an opportunity and maybe a little bit about what some of the dynamics are in that lending environment that help you believe that you can kind of get to that mid-to-high teens ROE in this new vehicle for investors and the SUNS’ vehicle specifically?

Sure. I think it’s important to step back and understand, Allison, as I know you do that our team in the life science area has been doing this for over 15 years. And while they were previously employed in General Electric, there was no differentiation in their strategy between public and private companies, because they didn’t have the non-qualified constraint that we as a BDC have. So, this is where they have been operating the majority of their career until they got to Solar 3 years ago. So, the opportunity set is such that we felt that by creating this joint venture, we would have a vehicle where the team could now invest in these companies. And sometimes it’s the same company, it goes from private to public and now you can refinance your own loan whereas historically, they had to let those opportunities go to competitors that outside of the BDC sector, because obviously, all BDCs have this non-qualified constraint for public companies above the $250 million market cap. So, it allows them to mine the universe that they have historically been operating in, as well as the universe of private companies that migrate into the public sector. So, it’s more of the same for our team. I think it’s important to note that as it relates to Solar Senior, where you know we are focused on dollar one first lien risk assets across our platform, whether it’s cash flow lending, Gemino or life sciences, we see these as the least risky part of late-stage venture lending and so therefore Solar Senior appropriate from a risk perspective. As it relates to returns, the team, since they have been on our platform, has generated realized returns of 18.6%, when you factor in success fees, exit fees and warrants. We don’t believe that the yields will approach that for this asset class on an un-levered basis. But when you put modest amount of leverage, call it up to 1:1, you can take the low-teens asset level returns to the high-teens ROE. And so that’s how we look at it mathematically.

Great. That’s really helpful. Thank you for that color. And I guess my next question will be, when we look at the M&A environment right now currently and we see that kind of going forward, it does really appear that activity or at least announced activity in the larger markets seems to have fallen off a bit. And there is a lot of uncertainty around the environment. Is the tax environment – whether or not interest will be deductible, whether or not we’ll have a border adjustment tax and I kind of – maybe it would be helpful a little bit if you guys discuss both what the kind of horizon looks like both in terms of your pipeline and how you see your – the company managers that you work with in investing kind of viewing the next 12 to 18 months as they think about how to position their own capital structures going forward?

Sure. I think we are blessed at Solar Senior by having these diverse asset classes within mid-market lending that are not that correlated with each other, be it Gemino which is more of a relationship local bank healthcare lender on an asset-based underwriting perspective, the life science joint venture that we are now going to be ramping with Deerfield and then our direct cash flow lending. So, I think the M&A environment most directly affects our direct cash flow lending business at Solar Senior. And again, we are blessed by having diverse engines, not just relying on these sponsor community for deal flow. But I think as you know Michael and I having done this for many, many years know that the M&A cycle is just that and it moves quarter-to-quarter and year-to-year. We have seen more activity in the first quarter. But just reflecting on last year, we had over 200 deals in the fourth quarter alone, many of which we passed on, but there is activity. We just weren’t comfortable with some of the risk adjusted returns that were being offered. So, the activity is there and what’s most important is that there is a tremendous amount of pent-up un-invested private equity, as well as existing levered businesses and their portfolio companies that need to be refinanced as we move forward. So from our perspective, it’s a matter of when, not if. This capital we have deployed and our capital will be needed to leverage the equity. But I think that it’s fair to say that many people in the private equity community are waiting for a little more clarity from the new administration in terms of tax policy. I heard the new Treasury Secretary talk about a summer timeframe. And I think obviously the specifics are very important, but equally important is getting some clarity on what the specifics will be, so that people can make decisions. But I think that’s this year, hopefully, sooner rather than later event. So to your point, as we look out over 12 to 24 months, there will be activity. We can’t pinpoint it quarter-to-quarter from an M&A perspective, but we continue to see the sponsor community doing a lot of add-on acquisitions and that’s where we are spending a lot of our capital. We find that’s a great risk adjusted way to stay with the existing portfolio companies, put more capital to them on a diversified basis, while they are growing and expanding their business, which generally de-risks our investment. So the activity is there, but I think any real acceleration maybe held off until people have a little more clarity on some of the administration’s new policies.

That’s great color and that’s it for me. Thanks very much for taking my questions.

Thank you.

Thank you. [Operator Instructions] And our next question comes from Jonathan Bock of Wells Fargo Securities. Your line is now open.

Good afternoon and thank you for taking my questions. Michael, as we look at the senior secured investment landscape today with spreads tighter etcetera, we see you growing through off balance sheet JVs, both at SLRC and herein, those have been very attractive. I am curious to your views on forward NOI growth beyond that of the dividend, because on one side, we have received the benefit of your fee waivers that have allowed NOI to stay right in line with the dividend, but it would also be hard to assume that you would give the benefit of the fee waiver to the extent that earnings surpasses the dividend as a result of, take your pick, good investment, LIBOR increasing, you name it. So, I mean, is the common point that you are going to get across now here with this waiver is the best you are going to be able to do is you get the dividend and that’s it and that could be a right answer. I am just curious, I am not sure investors know that.

I think thematically, that’s a great question, Jonathan. We should step back and look back at the genesis of the current fee waiver and that was the equity offering that we did last fall as you know, because the immediate use of proceeds is to pay down the credit facility and put some near-term pressure on NII. Until you deploy those proceeds, we at the management decided it’s appropriate to put that waiver in place while we re-ramp the portfolio and got NII back to that covering the distribution level. I think it’s important to note, as I am sure you will do, when you run the math on the new life science joint venture and SUNS’ $75 million commitment to it, it gives SUNS the ability to meaningfully exceed its current distribution.

Okay. Then the next question I would like to discuss would be just all-in spread compression as well as general risk across the investment landscape, where do you see yields kind of panning out over the next 12 months largely because to the extent that economic growth is improving, we will likely continue to see spread compression, as well as we have seen kind of leverage rates rise and the upper middle-market where you are focused here seems to be fairly competitive. And so just a long-term view on spreads as well as where we are in terms of just the current credit cycle namely because corporate credit is fairly extended now and your forward views would be very helpful? Thank you.

Yes, I am going to let Bruce hit that, but what I would like to emphasize before he does is, it’s very important to note that we have these diversified sourcing engines in place. So Gemino, which has roughly $100 million portfolio today, is not really influenced by the spread compression that you are discussing. They are still getting their very high returns and we haven’t seen any spread compression there. And ultimately, when we ramp our life science portfolio, we are going to have exposure to about 150 of loans on our balance sheet and those loans have not and will not experience spread compressions. So, a significant amount of our comprehensive portfolio is insulated from the dynamics that you are pointing out.

And I think Jonathan, as you know, first and foremost for us it begins with analysis of risk. And I think we have been incredibly disciplined when existing portfolio companies are refinancing or recapping out a dividend to the owner to re-underwrite that new risk level, that is really 99% of our work and then try to overlay that, assuming we are comfortable with the risk with what is the appropriate yield in this market environment that we can get. I would say that as you look back over the last couple of years where we have had periods of spread compression, it seems to be generally – and I will just focus on first lien mid-market loans for a moment – it seems to sort of floor out for the most part in L400, L425. And then in other times like late ‘15, early ‘16 when there was some dislocation, it would migrate out L550, L525. And we tend to sell into strength the lower yielding investments. You saw in SUNS in Q4, we had over $100 million of originations. Most of that was new deals rather than staying in existing deals and we had access of over $65 million, because we took that opportunity to both cycle out of some second liens, so we can redeploy proceeds into this JVs that we have and the flips at SUNS, but also to sell into strength as well as some of our lower yielding first lien investments that all seem to have a par bid that we had taken at issuance in ‘98 or ‘99. So if history is going to repeat itself today, we are feeling that floor again around 4, 4.25, because what happens is there are floor to spreads here, because the big buyers that step in very often are the CLO buyers and you get to a minimum spread where it just doesn’t work for their structure and they start to put a little bit of floor and discipline underneath that spread compression, but that’s how I would range it. That 4 to 4.25 on the low end and we’ve seen it migrate up to 5.25 to 5.50 as things widen out, that can change in a quarter’s time as you know, but that’s how I would range it out.

Great. Thank you.

Thanks, Jon.

Thank you. [Operator Instructions] And this does conclude our question-and-answer session. I would now like to turn the call back over to Michael Gross, Chairman and Chief Executive Officer for any further remarks.

Just thank you for all your time this morning. We look forward to talking to you when we report Q1 results in early May or anytime before that. Take care.