Sunrise Realty Trust, Inc. (SUNS) Q3 2018 Earnings Report, Transcript and Summary

Good afternoon, ladies and gentlemen, and welcome to the Q3 2018 Solar Senior Capital Earnings Conference Call. At this time, all participants are in listen-only mode. Later we will conduct a question-and-answer session and instructions will follow at the time. [Operator Instructions] As a reminder, this conference is being recorded. I would now like to introduce your host, Mr. Michael Gross, Chairman and Chief Executive Officer. Please go ahead.

Thank you. Good morning and our apologies for starting slightly late. Welcome to Solar Senior Capital Ltd. Earnings Call for this fiscal quarter ended September 30, 2018. I'm joined here today by Bruce Spohler, our Chief Operating Officer; and Rich Peteka, our Chief Financial Officer. Rich, please start off by covering the webcast and forward-looking statements.

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'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 relates to future events or future performance of 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 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 third quarter 2018 marks another solid quarter of operating performance for Solar Senior Capital. Our diversified portfolio of senior secured cash flow and asset based loans is 100% performing. Net asset value was stable at $16.81 per share at September 30 and GAAP net investment income of 36% per share, fully covered our distributions. Middle market cash flow lending continues to be extremely competitive. Our company as a portfolio declined approximately $86 million or 12% from the prior quarter primarily due to elevated repayments in our cash flow loan portfolio and our decision to not participate in several of the refinancings. We believe it is paramount to maintain our strict discipline in cash flow lending in the safe aggressive structures tight pricing and elevated risk. Importantly, our investments through our asset-based lending businesses Gemino and North Mill have contributed loans of strong structural protections. At quarter end, over 97% of our comprehensive portfolio is invested in first lien senior secured loans. In addition, over 40% of our portfolio is now comprised of first lien asset based loans, the remainder primarily in first lien cash flow loans. Importantly, we believe the risk adjusted return profile in our asset based lending initiatives is currently more attractive than many of the cash flow opportunities given the frailty credit markets. The higher inquiry received for ABL investments allowed us to remain highly selective in underwriting middle market cash flow investments. Now I'll report in the progress with two important initiatives that we believe enhance the strategic positioning of SUNS that significantly improves our flexibility and resources to drive long term value for our shareholders. The first initiative is a new asset covered requirement. On October 11, our shareholders overwhelmingly approved the reduction in the asset covered requirements, thereby accelerated timing of the modification which had initially been approved by our Board of Directors in early August. As a result, on October 12, Solar Senior Capital's asset-covered requirements changed from 200% to 150%. Given our investment's focus on senior secured first lien loans which has been financed at much higher leverage levels in private funds and banks, we have increased our target leverage ratio to a range of 1.425x to 1.5x debt to equity. This new target range allows for meaningful and substantial cushion to the new asset rates requirement in credit facility covenants. At the end of Q2, we successfully refinanced our credit facility to accommodate the increase to a new regulatory leverage. Approximately 93% of those [indiscernible] of the proposal is a sign of showing confidence in our ability to strategically and prudently manage the increased leverage flexibility. We'd like to express our sincere appreciation to our shareholders to the support during the SUNS' property process. Importantly, we want to reiterate that the asset coverage modifications will not change our investment strategy. It will however enhance Solar Senior Capital's ability to further expand our specialty finance lending platform. The new asset coverage ratio simplifies SUNS' business model as well, specifically during Q3 as LLP became a wholly owned portfolio company of the SUNS resulting the consolidation of FLLP's assets and liabilities on its balance sheet. Previously, our investment in the FLLP were considered non-qualified assets. By consolidating the assets of FLLP, our portfolio of cash flow senior secured loans has approximately the same leverage on balance sheet as our previous look-through [ph] leverage of 0.7 times at September 30, the loans now counts as qualified assets. This has freed up significant 30% capacity. When combined with our new target leverage, SUNS' significant non-qualified investment capacity giving us the flexibility to make acquisitions and expand our specialty finance platform. Consolidation of FLLP assets has also resulted enhanced transparency, simplicity reporting and streamline decision-making. We intend to move closer to our new target leverage range by growing our portfolio over time when the market opportunity presents itself. Consistent with our long standing conservative investment approach, we'll be prudent with the use of leverage. We view the increased leverage flexibility simply in other investments and risk management tool. We believe the additional leverage flexibility provides Solar Senior Capital with a potential to generate incremental long-term returns to shareholders. Our niche ABL businesses across both SUNS and our sister company Solar have achieved double-digit asset level cumulative weighted average internal rates returns and continue to originate asset-based investments that are highly attractive on a relative value basis. We are pleased with the progress we have made in evolving SUNS to a more diversified niche-specialty finance company. Importantly, the asset coverage modification and increased scale will enable us to do more of what we've been doing, invest in first lien senior secured loans with the current emphasis on asset based loans. The second initiative involve a SUNS investment advisor Solar Capital Partners also favorably impact SUNS. Solar Capital Partners recently announced the closing on private credit funds with total equity commitments of over $750 million. Included in new funds expected leverage are existing SMAs and our two BDCs with their increased investment capacity, the FCP platform now has over $5.5 billion of investable capital. The increased scale of capital across our platforms strategically positions us to be a solutions provider with an ability to speak for as much as $200 million in a given transaction while still maintaining our strict conservative diversified portfolios. We expect this greater enhanced investment capacity across the platform to result in more investment opportunities for SUNS, with an enhanced ability to negotiate terms and meet our astringent underwriting criteria. The SUNS platform is in a strong liquidity position. At September 30 when considering the combined credit facilities of SUNS balance sheet and at North Mill and Gemino, that's approximately $250 million of unused borrowing capacity invested across the platform, subject to borrowing based limitations. We will continue to be highly disciplined in deploying available capital. At this time I would like to turn the call over to our Chief Financial Officer Rich Peteka.

Thank you, Michael. Solar Senior Capital Ltd net asset value at September 30 was $269.7 million or $16.81 per share. This compares to a net asset value of $269.9 million or $16.83 per share at June 30. Solar Senior's investment portfolio at September 30, 2018 had a fair market value of $465.2 million in 49 portfolio companies operating in 21 industries, compared to a fair market value of $470.2 million in 49 portfolio companies operating in 22 industries at June 30. During the quarter, SUNS and it's JV partner entered into a purchase and sell agreement whereby SUNS purchases JV partner's equity together with an agreement to sell them their near prorata share of the investments and flip. This agreement resulted in SUNS only 100% of the equity interests and now controlling as LLP. Accordingly, as LLP was consolidated on to SUNS' balance sheet at September 30, 2018. We also used the accordion [ph] feature on SUNS' credit facility during the quarter where we added another $25 million commitment. This brought SUNS' total credit capacity to $325 million which includes FLLP. That said, at September 30, 2018, SUNS' net leverage increased from 0.7 times -- increased upto 0.7 times from 0.65 times at June 30. The increase in leverage was primarily related to the consolidation of the company's investment in FLLP during the quarter. Solar Senior's new target leverage is 1.25 times to 1.50 times net debt-to-equity under the reduced asset coverage requirements. From a P&L perspective, gross investment income for the three months ended September 30, 2018 totaled $11 million versus $9.5 million for the three months ended June 30, 2018. Net expenses for the three months ended September 30, 2018 were $5.3 million, compared to $3.8 million for the three months ended June 30. Accordingly, net investment income for the quarter ended September 30, 2018 was $5.8 million or $0.36 per average share as compared to $5.7 million or $0.35 per average share for the three months ended June 30, 2018. Below the line, Solar Senior had a net realized and unrealized loss for the third fiscal quarter totaling $0.4 million, compared to net realized and unrealized loss of $0.1 million for the three months ended June 30, 2018. Accordingly, Solar Senior had a net increase to net assets resulting from operations of $5.4 million or $0.34 per average share for the three months ended September 30, 2018. This compares to 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, 2018. Lastly, our Board of Directors declared a monthly distribution for November 2018 of $11.75 per share, payable on December 4, 2018 to stockholders of record on November 21, 2018. At this time, I'd like to turn the floor over to our Chief Operating Officer, Bruce Spohler.

Thank you, Rich. As Michael mentioned, our intention with the increased flexibility afforded by the modified asset coverage requirement is to expand our portfolio through investments in our three core strategies. Firstly in senior secured cash flow loans to upper mid-market companies; first lien asset based loans secured predominantly by accounts receivable to mid-sized companies that operate exclusively in the healthcare industry through our company Gemino; and lastly, first lien asset-based loans and factoring facilities secured by accounts receivable to mid-sized companies that operate predominantly in manufacturing services and distribution industries. In addition, we will continue to evaluate opportunities to further expand our specialty financed platform. In the aggregate, at quarter end, our investments across these three segments totaled approximately $625 million encompassing 170 distinct issuers. The average investment per issuer was approximately $3.7 million or 0.6% of the comprehensive portfolio, highly diversified. When measured at their value, approximately 98% of our portfolio consisted of senior secured loans, of which over 57% are in first lien cash flow loans, 40% are in first lien asset-based loans, and only 2% are in second lien cash flow loans with a dominium's amount in equity, less than 1%. In addition, over 90% of our investments have floating rate coupons which should continue to benefit our performance in today's rising rate environment. SUNS' weighted average yield on a fair value basis for it's total portfolio was 9.6%, consistent with the prior quarter. Including investments and repayments across our three lines of business, originations totaled $40 million and repayments were approximately $125 million; this resulted in a reduction of $86 million in our overall portfolio. As Michael mentioned, we experienced elevated repayments in our cash flow portfolio and elected not to reinvest in the new structures on the basis of terms and capital structure that did not meet our current underwriting requirements. Now, let me provide an update on the credit quality and earnings power of the portfolio. At quarter end, 100% of our portfolio is performing. Our internal risk assessment on a weighted average of our loan portfolio remains at two at 930, and based on our one to four risk-rating scale with one representing the least amount of risk. Today, our watch list represents less than 5% of our overall portfolio. Now, let me touch on our three investment verticals. Cash flow; at quarter end, our portfolio totaled $370 million of cash flow loans representing 60% of the total portfolio. Our cash flow portfolios comprised of loans to 50 different borrowers with an average investment size of $7.5 million. The fair value weighted average asset level yield at this portfolio was just under 8%, up slightly from the prior quarter. Our second lien cash flow exposure represents only 2% of the entire $600 million portfolio and we expect this to continue to climb over the coming quarters. At September 30, the weighted average EBITDA of our first lien cash flow investments was $98 million, clearly upper end of mid-market. On a fair value weighted average basis, leverage through our investment was 4.4 times, and interest coverage ratio was 2.6 times, representing a lower risk profile than the liquid loan market. In addition, the weighted average latest 12 months revenue growth was over 8% and EBITDA growth was approximately 7%, reflecting continued positive trends in our portfolio company fundamentals. During the third quarter, we originated cash flow investments of $30 million and had repayments of approximately $95 million. With the addition of the newly raised private capital, SUNS is already benefiting from SCPs increased scale and ability to be a full-solutions provider. For example, recently we were able to support every [ph] partner's refinancing of AEGIS [ph] toxicology sciences, previously a portfolio company of our sister BDC-SORC. As a platform, we doubled our investment dollars to over $65 million across our platform with SUNS taking an $11 million investment in the first lien term loan. Let me turn to North Mill. At quarter end, our North Mill portfolio was approximately $146 million, representing over 23% of our total portfolio. This portfolio includes loans to 87 distinct bars with an average funded investment size of $1.7 million. The weighted average asset yield at North Mill was 12.7%. During the quarter, we have an increase of $1 million of funding's and repayments of $18 million. For the quarter, North Mill paid SUNS a cash dividend of $0.4 million equating to a 10.2% average annual yield on cross. Now turning to Gemino. At quarter end, Gemino's portfolio was $108 million, representing 17% of our comprehensive portfolio. Gemino's portfolio was comprised of loans of 33 borrowers with an average funded loan size of $3.3 million. The weighted average asset level yield for Gemino's portfolio was 11.4%. During the quarter, we funded $10 million of new asset-based investments and had repayments of approximately $13 million. For the quarter, Gemino paid SUNS a dividend of just under $1 million, equating to an 11% annualized yielded cost. In summary, as Michael mentioned, the middle market cash flow lending environment remains extremely frothy. At SUNS, we benefit from our diversified origination engines across both cash flow and asset-based lending verticals, which allows us to allocate capital to those investments that meet our strict underwriting criteria. In addition, we believe the enhancement to the investment budget platform scale will result in more investment opportunities across both, our cash flow and specialty finance asset classes at SUNS. However, we will continue to be prudent and highly disciplined in deploying our substantial available capital. Now, let me turn the call back to Michael.

Thank you, Bruce. Since the 2011 inception of SUNS, our investment and management decisions have consistently been focused on building long-term value, protecting capitals, and maintaining alignment with our shareholders. In 2018, we have put additional strategic building blocks in place in the form of reduced asset coverage requirements and enhanced platform scale to provide greater flexibility to drive long-term shareholder value. Importantly, we've been prudent in the phase to sustain frothy credit markets and remained disciplined, not compromising credit quality for yield. The result is a solid portfolio foundation from which we can grow. We've always maintained an investment philosophy assuming that we're late in the credit cycle and we believe that in the current environment it pays to be cautious. Remains to be seen whether the recent volatility in the equity markets and rate increases will lead to more traffic and investment opportunities but we believe our differentiated origination platform and diversified portfolio position us well to navigate in any environment. At approximately 0.7 times net debt-to-equity, we are under levered relative to our target range of 1.25 times to 1.5 times net debt-to-equity and we continue to have substantial drive [indiscernible] via differentiated investment verticals. If the credit cycle does shift, we believe our history of conservatism will enable us to outperform on a relative and absolute basis, and we will be well-positioned to take advantage of market dislocations. I would like to again express our appreciation to our shareholders and banks for their overwhelming support to approve the adoption of the modified asset coverage ratio. The greater flexibility does not change our investment strategy, rather meaningfully, enhance our ability to grow, to build and potentially acquire niche-specialty finance businesses as we continue to broaden our diversified commercial finance platform. In addition, 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. As last slide close of $16.06 per share; SUNS trades at approximately 4.5% discount to net asset value and carries the yield of 8.8% which represents a significant discount of 5.5% implying yield of the S&P/LSTA leveraged loan 100 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 for your time this morning. And at this point, we'd like to take your questions. Operator, please open the line.

[Operator Instructions] The first question comes from the line of Alison [ph] from Oppenheimer.

I noticed that interest income was kind of tracking substantially higher linked quarter despite portfolio pay-offs and maybe another -- a couple of other variables. And I was wondering if you could walk through some of the attributes of that -- kind of, visible spike in interest income?

I think it's a combination of -- some of the assets were paid off late in the quarter, as well as we had some reversal on some assets that we were able to recapture prior interesting group [ph].

So is it fair to say that the late pay-off potentially accelerated fees would -- is this -- I guess, is it fair to say that this is -- that was tracking higher than what we might straight line kind of out from here as we think about how the portfolio is going to look going forward?

Yes.

And then, I guess, likewise the same question will be -- when you collapse the FFLP program on balance sheet, all of those loans now will be on balance sheet and we since then think about those as being added to interest income and the dividends from these equity going away. Is that correct?

Yes.

Our next question comes from the line of Mickey Schleien from Ladenburg.

I wanted to ask about the leverage target; I think in your prepared remarks you said you would continue the existing business plan and let the market come back to you. But does that also contemplate perhaps putting lower risk assets onto the balance sheet given that the math might work better with the higher lot large [ph]?

Sure. As you know, we think we put pretty low risk assets as it is on SUNS balance sheet, so I wish there was a new asset class but it's really doing more of the same. And I think it's important to note on the cash flow side, Mickey, as you appreciate the constraint has really not been fundamentals, the market as well as our portfolio is rather benign and performing well in terms of the operating fundamentals but it's been the structures and having done this for 30 years, we're one dislocation away from seeing covenants come back in, that's at least what's happened in prior cycles. And I think there -- then you would see us be much more aggressive in deploying capital and using that additional leverage flexibility. And I think on the other side of the assets, it's selectively -- not only organically growing both [indiscernible] but we now have the flexibility by bringing flip-on, by expanding our 30% basket, by having the leverage requirement increase, to look for new platforms to add, as well as portfolios on to SUNS. So I think those are going to be the drivers rather than anything new or different or lower risk asset class. As you know, the average leverage as we mentioned is in the low fours, these are traditional firstly in the mid-market cash flow loans but it's -- again, on the risk spectrum, the constraint and headwind for us has been more structured than it has been leverage levels.

I noticed that you recaptured some incentive fees during the quarter, I know the math is somewhat complex but given where the portfolio is and the outlook for the pipeline etcetera, do you expect a similar amount of incentive fees to be recaptured quarterly?

No, the main source of recapture there was -- Bruce's earlier comment about despite an interesting comeback we were able to recapture some interest income from investment that had been non-accrual, that went back on accrual. So that's not recurring, that was like a onetime hop [ph].

And that impacted the incentive fee recapture, that's where I'm referring to.

Yes, exactly. As well as the net investment income for the shareholders as well, obviously.

And lastly, I think I noticed a spike in fixed income this quarter; was there anything -- was that idiosyncratic or was there some sort of trend in the market that…

No, it was just -- as part of an amendment in a company we might give them a little bit of fixed income for three to six months while they rebuild their cash flows and go back to cash pay. So you should see it as a temporary development and it's very episodic as we look at doing some of the restructurings at individual companies.

[Operator Instructions] Your next question comes from the line of Bashir [ph] from Wells Fargo.

Just kind of thinking high level for both of your vehicles which collapsed and are committed to our growing specialty finance at this juncture. Does this make you more active in perhaps onboarding a new specialty finance vehicle?

Absolutely. I think we're very excited about it and frankly, the team has booked and this is very sad [ph]. The direct impact after both Solar and Solar Senior with the modified asset coverage and collapsing the off-balance sheet vehicle to split as that dramatically increases our 30% capacity which allows us to go back to the market and look for those [indiscernible] that we did make sense to add to our adjusted platforms.

On the solar call, and correct me if I'm wrong here; you mentioned that NEF was solar dedicated but I think Crystal [ph] allocates when -- if other committees approve. Is that right? And what are the assignments for the SUNS vehicle Gemino?

So Gemino and North Mill are similar to nation's equipment for solar in that they are pulling out subsidiaries [ph] and the loans are step aside that all those loans is a 100% go into Solar Senior and other shareholder vehicles.

[Operator Instructions] I'm showing no further questions at this time. I would now like to turn the conference back to Mr. Michael Gross, Chairman and Chief Executive Officer. Sir, please go ahead.

We thank you for your time this morning. And if you have any follow-up questions, please feel free to call us directly. Bye, bye.