MidCap Financial Investment Corporation (NASDAQ:MFIC) Q2 2023 Earnings Call Transcript

MidCap Financial Investment Corporation (NASDAQ:MFIC) Q2 2023 Earnings Call Transcript August 2, 2023

MidCap Financial Investment Corporation misses on earnings expectations. Reported EPS is $0.37 EPS, expectations were $0.43.

Operator: Good afternoon, and welcome to the earnings conference call for the period ended June 30, 2023 for MidCap Financial Investment Corporation. At this time, all participants have been placed in a listen-only mode. The call will be open for a question-and-answer session following the speakers’ prepared remarks. [Operator Instructions] I will now turn the call over to Elizabeth Besen, Investor Relations Manager for MidCap Financial Investment Corporation. Please go ahead, ma’am.

Elizabeth Besen: Thank you, operator, and thank you, everyone, for joining us today. Speaking on today’s call are Tanner Powell, Chief Executive Officer; Ted McNulty, President; and Greg Hunt, Chief Financial Officer. Howard Widra, Executive Chairman, as well as additional members of the management team are on the call and available for the Q&A portion of today’s call. I’d like to advise everyone that today’s call and webcast are being recorded. Please note that they are the property of MidCap Financial Investment Corporation, and that any unauthorized broadcast in any form is strictly prohibited. Information about the audio replay of this call is available in our press release. I’d like to also call your attention to the customary safe harbor disclosure in our press release regarding forward-looking information.

Today’s conference call and webcast may include forward-looking statements. You should refer to our most recent filings with the SEC for risks that apply to our business and that may adversely affect any forward-looking statements we make. We do not undertake to update our forward-looking statements or projections unless required by law. To obtain copies of our SEC filings, please visit our Web site at www.midcapfinancialic.com. I’d also like to remind everyone that we posted a supplemental financial information package on our Web site, which contains information about the portfolio as well as the company’s financial performance. Throughout today’s call, we will refer to MidCap Financial Investment Corporation as either MFIC or the BDC, and we will use MidCap Financial to refer to the lender headquartered in Bethesda, Maryland.

At this time, I’d like to turn the call over to our Chief Executive Officer, Tanner Powell.

Tanner Powell: Thank you, Elizabeth. Good afternoon, everyone, and thank you for joining us today. I will begin call by highlighting our results for the June quarter, and will then provide our thoughts on the current environment. Following my remarks, Ted will cover our investment activity and portfolio, and we’ll also provide an update on credit quality. Lastly, Greg will review our financial results in detail. We will then open the call to questions. Beginning with our results, we are very pleased with our performance for the June quarter given our strong net investment income, a slight increase in net asset value per share, and stable credit quality. Net investment income per share for the June quarter was $0.44, well above the current $0.38 dividend, as we continue to see the benefit of higher base rates on our floating rate assets.

We are particularly pleased with these results when considering the relatively muted transaction environment which resulted in below-normal prepayment income. At the end of June, NAV per share was $15.20, an increase of $0.02 from the end of March, which reflects earnings in excess of a dividend, stable credit quality, and includes approximately $0.01 per share accretion from stock buybacks. We are pleased to report that we continue to observe relatively stable credit quality in our portfolio. We are seeing that most of our portfolio companies are able to handle higher interest costs, [reconstruct] (ph) their portfolio to withstand challenging periods. As a reminder, our corporate lending and other portfolio, which makes up 92% of our portfolio, primarily consists of first lien top-of-the-capital-structure loans is well diversified by borrower and industry, is largely sponsor-backed, and has what we consider to be robust documentation and financial covenants.

At the end of June, 96% of our corporate lending debt portfolio on a cost basis or 97% on a fair value basis had one or more financial covenants. Next, let me give a brief update on Merx. As discussed previously, we are focused on reducing our investment in Merx. While we don’t expect pay-downs to occur evenly, we believe aircraft sales and servicing income should allow for the pay-down of third-party trade level debt and MFIC’s equity and debit investment in Merx. Although Merx did not sell any aircraft in its portfolio during the June quarter, Merx repaid $3.5 million to MFIC, which was applied to the revolver. At the end of June, our investment in Merx totaled $193 million, representing approximately 8% of our total portfolio fair value.

Turning now to the market environment, the heightened volatility that we saw in the first quarter stemming from the regional banking crisis subsided as the quarter progressed despite ongoing concerns about inflation, higher interest rates, and fears about recession. Against this backdrop, new issue volumes were slow driven primarily by slower M&A activity partially offset by add-on activity as sponsors pursued bolt-on acquisitions. We still see financial sponsors, particularly those focused on the middle market, seeking financing solutions in the private credit market. We continue to observe more lender-friendly pricing and terms on new commitments compared to prior vintages, although we are seeing the pace of increases plateau. Moving to the dividend, our Board of Directors declared a dividend of $0.38 per share to shareholders of record as of September 12, 2023, payable on September 28, 2023.

A $0.30 dividend represents an annualized dividend yield of 10% on NAV. At current base rates, we are well-positioned to generate net investment income of excess of this dividend level. We believe our portfolio will continue to earn above the current dividend in a normalized rate environment. Our Board and management team continue to evaluate potential dividend increases versus retaining earnings. With that, I will turn the call over to Ted.

Ted McNulty: Thank you, Tanner, and good afternoon, everyone. Beginning with investment activity, as a reminder, MFIC is focused on investing in loans sourced by MidCap Financial, an affiliate of Apollo Global, which provides MFIC with a large pipeline of investment opportunities. MidCap Financial is a leading middle market lender with one of the largest direct lending teams in the U.S., with close to 200 investment professionals. MidCap financial was active during the June quarter, closing approximately $4.4 billion in new commitments. Specific to MFIC, new corporate lending investment commitments during the quarter totaled $79 million, all first lien, across 15 different borrowers for an average new commitment of $5.2 million as we continue to emphasize diversification by borrower.

17% of new commitments were made to existing portfolio companies. We continue to observe favorable pricing at lower leverage levels for newly originated loans. The weighted average spread on new commitments was 681 basis points, with an average OID of approximately 266 basis points. This translates into a very attractive weighted average yield of approximately 12.5% based on current base rates. The weighted average net leverage of new commitments was 3.7 times. In terms of funded investment activity, gross funding excluding revolvers for the corporate lending portfolio totaled $73 million. Higher interest rates and a lack of new deal activity led to a slowdown in repayment activity. Sales and repayments totaled $58 million. Net revolver fundings totaled $11 million.

And we also received a $3.5 million pay-down for Merx as Tanner mentioned. In aggregate, net fundings for the quarter totaled $22 million. Turning to our investment portfolio, at the end of June, our investment portfolio had a fair value of $2.41 billion, and was invested in 150 companies across 25 different industries. Corporate lending and other represented 92% of the total portfolio, and Merx accounted for 8% of the total portfolio on a fair value basis. 95% of our corporate lending portfolio was first lien. We continue to have conservative weighted average attachment and net leverage on our corporate loans of 0.1 times and 5.45 times respectively. Both of these metrics were flat compared to the prior quarter, which we consider to be another indication of our portfolio’s stable credit quality.

At the end of June, the average funded corporate lending position was $15.4 million, or approximately 0.7% of the total corporate and other lending portfolio. MFIC is focused on lending to the core middle market where MidCap Financial has strong, long-standing relationships with sponsors and borrowers, and a proven track record across cycles. As of the end of the June, the median EBITDA of MFIC’s corporate lending portfolio companies was approximately $55 million. We believe the core middle market offers attractive investment opportunities across cycles, and does not compete directly with either the broadly syndicated loan market or the high-yield market. The weighted average yield at cost of our corporate lending portfolio was 11.7% on average for the June quarter, compared to 11.3% last quarter, driven by an increase in base rates.

These yield figures are an average of the beginning and the end of the quarter. At the end of June, the yield of the corporate lending portfolio at cost was 11.9%, up from 11.5% at the end of March. The weighted average spread across the corporate lending portfolio was 614 basis points, up one basis points compared to last quarter. Turning to credit quality, our portfolio of companies continue to have solid fundamental performance with positive revenue and EBITDA growth. We’re not seeing any signs of overall credit weakness, although we have observed a deceleration in top line growth and some margin pressure. We’ve not seen a meaningful increase in covenant breaches or a pickup in amendment activity. We believe our credit quality has benefited from MidCap Financial’s strong sourcing and underwriting capabilities.

Based on data since mid-2016, which is the approximate date upon which we began utilizing our co-investment order. MFIC’s annualized net realized and unrealized loss rate on loans sourced by MidCap Financial is extremely low at approximately one basis point. The weighted average net leverage of the companies in our corporate lending portfolio was 5.45 times, unchanged compared to the prior quarter. As mentioned, the net leverage on new commitments was 3.7 times, well below the portfolio average. Moving to interest coverage, the weighted average interest coverage ratio was 2.1, down from 2.3 times last quarter, with four companies below one times. If we utilize June 30 base rates, the interest coverage would be 1.6 times compared to 1.7 times last quarter in that stress-test scenario.

In the coming quarters, we are closely monitoring these situations which we believe are manageable as these companies either have strong current liquidity or the underlying businesses are performing well. We want to underscore that we have not increased PIK income to create interest coverage. Importantly, MFIC benefits from MidCap Financial’s large, dedicated portfolio management team of nearly 60 investment professionals, which helps identify and address issues early. It is also important to note that MidCap Financial leads and serves as administrative agent on the majority of our deals, which provides meaningful downside protection. As agent, we are in active dialogue with the borrowers and have enhanced information flow, which allows us to be proactive in resolving problem credits as issues arise.

We are also monitoring near-term maturities to identify any potential risk of repayment so that we can address any issues early, and proactively work with borrowers to help them meet their liquidity needs. As part of our investment process, we are mindful of the specifics on making an acquisition as we believe sponsors are more likely to support businesses and funds with greater remaining duration. We continue to have very low levels of non-accruals. No investments were placed on non-accrual status during the quarter. At the end of June, investments on non-accrual status totaled $7.5 million or 0.3% of the total portfolio at fair value. With that, I will now turn the call over to Greg to discuss our financial results in detail.

Greg Hunt: Thank you, Ted, and good afternoon, everyone. Beginning with our financial result, net investment income per share for the June quarter was $0.44, as we continue to benefit from higher base rates on our floating rate assets and improved net interest margin. Prepayment income declined quarter-over-quarter due to lower prepayment activity. Prepayment income was approximately $600,000, compared to $2.6 million last quarter. Fee income also declined compared to the prior quarter. Fee income was approximately $1 million for the June quarter, compared to $2.2 million last quarter. PIK income remained very low, representing approximately 1.2% of total investment income for the quarter. GAAP net income per share for the quarter was $0.39.

NAV per share at the end of June was $15.20, an increase of $0.02 since the end of June. The $0.02 increase reflects net investment income of $0.44, which is $0.06 above the $0.38 dividend, $0.05 per share net loss on the portfolio, and approximately $0.01 accretion from stock buybacks. Additional details on unrealized net gains and losses are shown on page 16 on the earnings supplement. Total expenses for the quarter were $39.8 million, up $1.5 million compared to the last quarter, primarily due to higher interest expense. Gross management fees totaled $4.3 million, essentially flat quarter-over-quarter. As a reminder, MFIC’s base management fee was reduced to 1.75 on equity, beginning January of 2023. Among listed BDCs, MFIC’s management fee is the lowest, and we are the only BDC to charge management fees on equity, which we believe provides a greater alignment and focus on net asset value.

Gross incentive fees totaled $6.1 million for the quarter. As a reminder, our incentive fee on income is 17.5%, and includes the total return hurdle with a rolling 12-quarter look-back. We believe our fee structure is best in class amongst listed BDCs, and provides a strong alignment of interest with our shareholders. For the quarter, we generated an annual ROE based on net investment income of 11.6%, and an annualized ROE based on net income of 10.2%. Moving on, from a balance sheet perspective, our net leverage stood at 1.4 times at the end of June. As highlighted last quarter, in April, we were pleased to extend the maturity of our senior secured revolving credit facility by over two years, to April, 2028. We also are pleased that Kroll affirmed our investment-grade rating in June.

During the quarter, we repurchased approximately $2.3 million of stock, which had a $0.01 accretive impact on NAV per share. This concludes our prepared remarks, operator. And please open up the call for questions.

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Q&A Session

Operator: Yes, sir. [Operator Instructions] Our first question comes from Arren Cyganovich with Citi.

Arren Cyganovich: Thanks. Maybe you just talk a little bit about how your conversations with equity sponsors are right now, are you seeing any kind of loosening up in terms of increasing activity? I know it’s August now, so I imagine a seasonal slowdown happening, but just in general, relative, since we have some better lender-friendly type of terms today?

Tanner Powell: Sure. Thanks for the question, Arren. So, in terms of — I’ll try to handle it in two aspects. As it relates to, I think which is primarily what your question is getting at, in terms of overall activity, notwithstanding the summer doldrums which we inevitably encounter in August; we are seeing a modest tick up from earlier in the year off of relatively low base. I think that there is a Bain Capital Report that came out that said LBO volume was down 50% in the second quarter. We’re seeing a modest uptick and a greater willingness to engage from LBO sponsors. The second aspect of our conversation of sponsors relates to companies where either they’re trying to do something strategic and/or things are moving sideways.

And we continue to see a very healthy level of support from the sponsors. And in particular, in this type of environment, one of the ways that sponsors are electing to try and counter the [indiscernible] spread, if you will, in terms of expectations of multiples is by completing add-on acquisitions. And that dialogue has been very, very healthy, and shows continued equity support for the underlying borrowers.

Arren Cyganovich: Thank you.

Operator: Our next question comes from Kyle Joseph with Jefferies.

Kyle Joseph: Hey, good afternoon. Thanks for taking my questions. Just on the portfolio yield, Ted, obviously you expect expanding. How much of that is base rate and how much of it is [spread within] (ph)? I know you mentioned it’s still kind of a more lender-friendly environment out there.

Tanner Powell: Yes, thanks, Kyle. In terms of the spread, let’s just talk spread to help you disaggregate it there. In the quarter, we deployed at 681, and a OID of just over 2.5 points, which reflects what we’ve seen for a number of quarters, which is a very attractive environment for private credit lenders, notwithstanding the downdraft in M&A, private credit is able to service a disproportionate share of M&A that’s getting done. And more broadly against that backdrop, it continues to be lender-friendly. To my response to Arren’s question, we’re seeing, if I were to look at the deals that are being screened today, there might be a slight tightening in terms of spread as M&A picks up and people feeling better prospects and/or there is some level of [stabilization] (ph), which is enabling new sponsors to make better decisions and/or risk appetite has improved as we get further from some of the stress that we saw earlier this year.

Not to say that all has been mitigated, but generally speaking banks and markets are feeling a little bit better relative to what was a relatively low base for much of the first-half of the year.

Kyle Joseph: Very helpful, thanks. And then one follow-up for me, you mentioned some of the banking volatility negatively impacted deal flow, but stepping from longer-term perspective with potentially higher capital requirements at banks, do you see that as a longer-term opportunity for MidCap, but also the BDC sector as a whole?

Tanner Powell: Yes, absolutely. I’m sorry; I should have drawn the distinction there. I think, Kyle, when we see periods of volatility, which in this case or this year happened to be related to banking stress, there was, more broadly, a greater reticence to transact. And it wasn’t necessarily a function of whether banks were able to provide that financing or not, but you just saw reduced volumes which were more connected to volatility, and had less to do on whether or not the banks were providing it. As we and our peers have stressed, and we are huge believers in, we continue to benefit very much from a secular trend that has private credit taking share from the banking system as we roll forward, and expect that to continue.