Sunrise Realty Trust, Inc. (SUNS) Q2 2018 Earnings Report, Transcript and Summary

Good day, ladies and gentlemen, and welcome to the Q2 2018 Solar Senior Capital Ltd. Earnings Conference Call. [Operator Instructions]. As a reminder, this conference is being recorded. I would now like to introduce your host for today's conference, Michael Gross, Chairman and Chief Executive Officer. You may begin.

Thank you very much, and good morning. Welcome to Solar Senior Capital Ltd. earnings call for the fiscal year ended June 30, 2018. I'm joined here today by Bruce Spohler, our Chief Operating Officer; and Rich Peteka, our Chief Financial Officer. Rich, would 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 Senior Capital Ltd. and that any unauthorized broadcast in any form are strictly prohibited. This conference call is being webcast on our website, www.solarseniorcap.com. Audio replays of this call will be made available later today as disclosed in our press release. I'd 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 of financial condition. These statements are not guarantees of our future performance, financial condition or results and they 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 Senior 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. The second quarter of 2018 marked another solid quarter of operating performance for Solar Senior Capital. Our comprehensive portfolio grew approximately 4.5% than the prior quarter with net positive portfolio activity across all business units. Overall, our diversified portfolio of senior secured cash flow and asset-based loans continues to perform well. Net asset value was $16.83 per share at June 30, and GAAP net investment income of $0.35 per share fully covered our distributions. At June 30, 98.1% of our comprehensive portfolio was in first lien senior secured cash flow and asset-based loans. Nearly 40% of our comprehensive portfolio is now comprised of first lien senior secured asset-based loans with the remainder primarily in first lien senior secured cash flow loans. Importantly, we believe, the risk-adjusted return profile and our asset-based lending initiatives is currently more attractive than many of the cash flow opportunities we are seeing. As evidence, year-to-date, 80% of new issuance in the liquid leveraged loan market has been covenant-lite. During these frothy market conditions, our asset-based lending businesses, Gemino and North Mill have been facilitating our continued portfolio expansion via loans with strong structural protection. Not only do our asset-based senior secured first lien loans carry credit protections and yields superior to those available in liquid leveraged loan markets, but the higher income received from them enables us to remain extremely selective in the cash flow middle market. Expanding our ability to invest in these senior secured first lien asset-based loans was a significant consideration in our board decision to approve the reduction of the asset coverage requirement set forth in Section 61(a)(2) of Investment Company Act of 1940 as amended by the Small Business Credit Availability Act. As a result, on August 2, 2019, the SUNS asset coverage requirements will change from 200% to 150%. Additionally, in order to potentially accelerate the adoption, the Board authorized the submission of a proposal for shareholders to improve the application of modified asset coverage requirements. If passed, the change will go into effect today after the shareholder meeting. As mentioned on our prior earnings call, we took a very long, thoughtful analytical approach before making this decision, including extensive dialogue with independent directors, lenders and rating agencies. All of our niche ABL businesses across both SUNS and our sister company Solar have achieved double-digit asset level, cumulative weighted average internal rate of returns and continue to originate asset-based loans that are highly attractive on a relative value basis. We are pleased with the results of our efforts to develop SUNS into diversified niche specialty finance company. Accordingly, the asset coverage modification will enable us to do more what we've been doing, investing in first lien senior secured loans with a current emphasis on asset-based loans. Specifically, our first tactical step will be bringing the first lien loan program onto the balance sheet. In the program's current form although the underlying loans are qualified assets, the FLLP equity is included in our nonqualifying asset allocation. By moving FLLP, our portfolio of cash flow, first lien senior secured loans will have approximately the same leverage on balance sheet as our current look through leverage, but won't count as qualifying assets. This change not only increases efficiencies and simplicity, but also creates additional capacity in a nonqualifying asset bucket to grow our existing specialty finance businesses and build and to acquire other niche platforms. During the second quarter, we modified our revolving credit facility, which also extended its maturity to June 2023 and increased its investment flexibility. Subsequent to quarter end, we increased the committed amount by $25 million to $225 million. The new facility allows for leverage of up to 2:1 debt to equity, in line with the approval by our board. Given our investment focus on senior secured first lien loans, which have traditionally been financed at much higher leverage levels and private funded banks, we will increase our target leverage to a range of 1.25x to 1.5x debt-to-equity once the reduced asset coverage takes effect. This new target range allows for meaningful and substantial cushion to the new assets ratio requirement and new credit facility covenants. We intend to move closer to our target leverage range by growing our portfolio organically over time, only when the market opportunity permits. Consistent with our long-standing conservative investment approach, we'll be prudent with the use of leverage, given the trade-off between the incremental risk that comes with financial leverage and the reward of incremental earnings power. We view the increased leverage flexibility as simply another tool, and as you've seen from our conservative historical approach to leverage, if the market opportunity set does not merit increased leverage, we will not incur it. At June 30, 2018, when considering the unused debt capacity of our balance sheet, the $25 million of our credit facility upside, FLLP and strategic initiatives, SUNS had approximately $160 million of unused borrowing capacity to invest subject to borrowing base limitations. Lastly, our Board of Directors declared a monthly distribution for August 2018 of $11.75 per share payable on August 31 to shareholders of record of August 23. At this time, I'd like to turn over the call to our Chief Financial Officer, Rich Peteka.

Thank you, Michael. Solar Senior Capital Ltd.'s net asset value at June 30 was $269.9 million or $16.83 per share. This compares to a net asset value of $270.0 million or $16.84 per share at March 31, 2018. Solar Senior's investment portfolio at June 30 had a fair market value of $470.2 million in 49 portfolio companies, operating in 22 industries compared to a fair market value of $424.2 million in 46 portfolio companies operating in 21 industries at March 31. At June 30, the weighted average yields on our income producing portfolio was 8.9% measured across and over 98% of Solar Senior portfolio investments are performing. At June 30, 2018, net leverage increased to 0.65x from 0.51x at March 31. Once the modified asset coverage change goes into effect, Solar Senior's new target leverage will be 1.25x to 1.50x debt-to-equity. From a P&L perspective, gross investment income for the three months ended June 30, 2018 totaled $9.5 million versus $9.3 million for the three months ended March 31. Net expenses for the three months ended June 30 were $3.8 million compared to $3.7 million for the three months ended March 31. In Q2 2018, the investment adviser waived $0.4 million of performance-based incentive fees. On a cumulative basis, since SUNS IPO in 2011, the investment adviser has waived the management and performance-based investment fees and covered equity offering costs totaling $10.6 million. Ultimately, net investment income for the quarter ended June 30, 2018 was $5.7 million or $0.35 per average share consistent with the prior quarter. Below the line, Solar Senior had net realized and unrealized losses for a second fiscal quarter totaling $0.1 million consistent with the first quarter. Accordingly, Solar Senior had a net increase in net assets resulting from operations of $5.5 million or $0.34 per average share for the three months ended June 30. This compares to a net increase in net assets resulting from operation of $5.5 million or $0.34 per average share for the three months ended March 31. At this time, I'd like to turn the call over to our Chief Operating Officer, Bruce Spohler.

Thank you, Rich. Before diving into the details of our portfolio, I'd like to take a moment and provide an overview of our 3 principal lines of business. Our cash flow business invest in senior secured, predominantly first lien loans to sponsor-backed companies in the upper mid-market. Our health care asset-based business provides first lien senior secured loans to midsize companies, operating exclusively in the healthcare industry. We do this through our Gemino platform. These loans are typically secured by our borrower's accounts receivable. Our third platform, North Mill provides asset-based loans and factoring facilities, which are secured by a borrower's accounts receivable and are extended to mid-sized companies operating predominantly in the manufacturing, services and distribution industries. As Michael mentioned, our intention with the greater flexibility afforded by the modified asset coverage requirement is to expand our portfolio via loans in these three segments, but only when market conditions make it conducive to do so. Additionally, we will evaluate opportunities to further expand our specialty finance lines of business. In the aggregate, at quarter end, our investments across all three verticals totaled approximately $700 million, encompassing 171 distinct borrowers. The average investment per issuer was approximately $4 million or 0.6% of our total portfolio. Measured at fair value, just under 100% of SUNS portfolio consisted of senior secured loans of which 59% are in first lien senior secured cash flow loans, 39% in first lien senior secured asset-based loans and just under 2% are in second lien senior secured cash flow loans with a de minimis amount of equity at 0.1% of the portfolio. In addition, approximately 94% of loans have floating rate coupons, which should continue to benefit our portfolio's performance in a rising rate environment. SUNS weighted average yields with its comprehensive portfolio was 9.6%. Looking at investments and repayments across our three business lines, second quarter originations totaled $78 million and repayments were $45 million, resulting in net portfolio growth of $33 million. Now let me end with an update on the credit quality and earnings power of our portfolio. At June 30, 98% of SUNS portfolio is performing. We had 1 investment on nonaccrual, which we expect to put back on accrual status soon. Our internal risk assessment on a weighted average of our loan portfolio remains at approximately two, measured at fair market value and based on our 1 to 4 risk rating scale with one representing the least amount of risk. Importantly, during the second quarter, our watchlist shrunk from just over 5% of our portfolio in the first quarter to 3.7% at quarter end, reflecting the fundamental performance across our portfolio. Let me now provide an update on our investment verticals. For the cash flow segment, which includes loans held in our FLLP, it totaled $430 million, representing 61% of our total portfolio. The cash flow portfolio is comprised of loans to 51 borrowers with an average investment size of just over $9 million. The fair value weighted average asset level yield on this portfolio was 7.8%. We've steadily migrated out of our second lien exposure, which now represents only 1.9% of the comprehensive portfolio. At June 30, the weighted average EBITDA was over $90 million. On a fair value weighted average basis, leverage through our investment was 4.2x and interest coverage was 2.6x, representing a lower risk profile than today's liquid leveraged loan market. In addition, the weighted average LTM revenue growth was close to 7% and LTM EBITDA growth was over 9%, reflecting continued positive trends in our portfolio company fundamentals. During the second quarter, we originated senior secured cash flow investments of over $66 million, had repayments of approximately $38 million. Now let me turn to North Mill, our ABL platform. At June 30, North Mill's portfolio was approximately $163 million, representing 23% of our total portfolio. This included loans to over 90 different borrowers with an average funded investment size of just under $2 million. The weighted average asset yield at North Mill's portfolio was 13.3%. During the second quarter, we funded roughly $6 million of new asset-based investments and had repayments of approximately the same. During the second quarter, North Mill paid SUNS a cash dividend of $1.4 million, equating to an 11.2% annualized yield on cost. Now let me conclude with Gemino. At June 30, Gemino's portfolio was just over $110 million, representing 16% of SUNS's total portfolio. The portfolio is comprised of loans to 29 distinct borrowers with an average funded investment of just under $4 million. The weighted average yield at Gemino's assets was 10.7% at quarter end. And for the second quarter, we funded $6 million of new and existing asset-based investments and had repayments of just $2 million. During this quarter, Gemino paid the company a cash dividend of -- of $900,000, equating to an annualized yield of 11% on cost. In summary, while we continue to believe that the long-term investment thesis for private middle market lending remains intact, we cannot predict how long the current challenging environment in the cash flow segment will persist. We've maintained an investment philosophy of always assuming we are late in the credit cycle, and this discipline seems even more prudent today. No one knows if this stage of the cycle will end soon or persist for a number of years to come. We do, however, believe that our investment discipline, our differentiated origination platforms and our diversified portfolio position SUNS extremely well for either outcome. Now I'll turn the call back to Michael.

Thanks, Bruce. Since the inception of SUNS, our investment and management decisions have consistently been focused on building long-term value, protecting capital and maintaining alignment with our shareholders. We've been conservative in the phase of sustained frothy credit markets and remain patient and disciplined in not compromising credit quality for yield. And, as you know, we have never allowed leverage to drive our investment decisions. Since inception, SUNS has averaged 0.36x debt-to-equity despite a historical target of 0.75 to 0.85. For SUNS, our board decision to approve the modified asset coverage requirements focused on balance sheet optimization, portfolio financing flexibility and risk management and not on maximizing leverage. The greater flexibility does not change our investment strategy. It's enhanced our ability to execute on our existing strategy, including acquiring, building and growing specialty finance businesses. At last night's close of $16.90 per share, SUNS trades at an approximate 8.3% yield, which represents a significant discount to the 5.4% implied yield of the S&P/LSTA leveraged loan index. Given the overall credit quality of SUNS diversified portfolio, our differentiated origination engines and our disciplined investment philosophy, we believe, SUNS represents an attractive investment on both a relative and absolute value basis. We thank you very much for your time this morning. We look forward to speaking to you next quarter. Operator, at this time, could you please open it up to the questions, if there are any?

We thank you for taking the time this morning. And if you have any follow-up questions that we didn't cover in our script today, please feel free to give us a call. Thank you.