MidCap Financial Investment Corporation (NASDAQ:MFIC) Q3 2022 Earnings Conference Call November 3, 2022 5:00 PM ET
Company Participants
Elizabeth Besen – Investor Relations Manager
Tanner Powell – Chief Executive Officer
Ted McNulty – President
Greg Hunt – Chief Financial Officer
Howard Widra – Executive Chairman
Conference Call Participants
Kenneth Lee – RBC Capital Markets
Finian O’Shea – Wells Fargo Securities
Kyle Joseph – Jefferies
Melissa Wedel – JPMorgan
Paul Johnson – KBW
Operator
Good afternoon, and welcome to the earnings conference call for the period ended September 30, 2022 for MidCap Financial Investment Corporation. [Operator Instructions] I will now turn the call over to Elizabeth Besen, Investor Relations Manager for MidCap Financial Investment Corporation.
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 the 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 also like to 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 website at www.midcapfinancialic.com.
I’d also like to remind everyone that we posted a supplemental financial information package on our website, which contains information about the portfolio as well as the company’s financial performance.
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 today’s call with some comments about the market environment and why we believe our corporate lending portfolio is well positioned and well constructed for a challenging market environment. Next, I will highlight our results for the quarter and provide an update on Merx, and then I will discuss the increase to our quarterly dividend.
Following my remarks, Ted will discuss our investment activity, including the meaningful cash paydowns we received from several investments we are seeking to reduce. Ted will also cover the portfolio’s credit quality, including how our portfolio companies are performing in the current environment. Lastly, Greg will review our financial results in detail. We will then open the call to questions.
Throughout today’s call, we will refer to the company as MFIC or the BDC; and we refer to the Bethesda-based lender, which sources senior secured middle-market investment opportunities for Apollo managed capital, including the BDC, as MidCap Financial.
Beginning with the current environment, the public credit markets remain volatile as the Fed reiterated its commitment to tighter financial conditions in order to combat inflation. The secondary price rally in the leveraged loan and high-yield markets in the first half of the quarter were all but erased in the second half as investor sentiment was dampened by the elevated interest rate environment and recessionary concerns.
During the quarter, credit spreads continue to widen and U.S. leverage loan issuance plummeted to the lowest level since the fourth quarter of 2009, driven by a pullback from CLO investors. Banks continue to struggle to offload financing commitments made prior to the current more volatile environment. Although deal activity has slowed, borrowers continue to turn to the private credit market which offers certainty of execution.
In general, periods of economic stress and broader market volatility create better opportunities for direct lending. Amid this broader market volatility, we have seen improved lender terms and spreads for private direct – for the private direct lending market, which continues to experience strong demand from financial sponsors and companies. We would expect terms to continue to tighten and spreads to widen – continue to widen should economic stress continue or worsen.
For scaled capital providers like MidCap Financial, we believe that there are opportunities to lend to high-quality companies with attractive pricing and terms. MidCap Financial was relatively active during the September quarter with $3.3 billion of new originations. In the first nine months of 2022, MidCap Financial’s new originations totaled $12.5 billion. Additionally, we expect a tougher environment – the tougher economic environment should lead to an increase in ABL opportunities, an area where MidCap Financial has a large and successful franchise.
In the face of significant market volatility, our corporate lending portfolio continues to perform well, which we believe demonstrates the value of our senior secured investment strategy and the quality of our portfolio companies. Our underwriting process contemplates the potential for macroeconomic headwinds. As the macro environment continues to become more challenging, we believe the strength of our underwriting and the quality of our portfolio will become more apparent.
We have constructed what we believe to be a well-diversified portfolio of true first-lien floating rate corporate loans invested in less cyclical industries with granular position sizes. At the end of September, our corporate lending loans were 94% first lien with a weighted average attachment point of 0.2x, the metric which demonstrates that we are invested in the most senior part of the capital structure.
Moving to our financial results. Net investment income was $0.35 per share for the quarter, which reflects an increase in interest income due to higher base rates as well as strong fee and prepayment income, partially offset by a slight decline in income from Merx as we continue to reduce the size of this investment. Amid the challenging market conditions, we are able to generate considerable – we were able to generate considerable cash paydowns from several investments which we are seeking to exit, which Ted will discuss later during the call.
Overall, given the volatile market environment, we recorded a net loss of $6.6 million on our portfolio. Given the total return feature in our incentive fee structure, incentive fees accrued during the quarter were below the full rate. We ended the period with net asset value per share of $15.45.
Moving on. As discussed previously, we are focusing on reducing our investment in Merx, our aircraft leasing portfolio company by selling aircraft and deemphasizing its servicing business. During the September quarter, Merx continued to make progress by selling two aircraft, reducing the number of planes in its own fleet from 62 to 60, which allowed Merx to prepay $14 million to MFIC.
In conjunction with the paydown to MFIC and the aircraft sales, we converted $111 million of Merx’s revolver into equity. Accordingly, at the end of September, our investment in Merx totaled $266 million, representing 11% of the total portfolio, consisting of a $150 million revolver with a 10% interest rate and $116 million of equity.
The paydown and conversion of debt to equity will reduce the amount of interest that Merx pays to MFIC from approximately $6 million in the September quarter to approximately $3.8 million per quarter going forward. Despite the broader uncertain macroeconomic environment, there are no signs of slowdown in daily global flight activity, and we continue to focus on reducing our exposure.
Now let me switch to our dividend policy. Given the impact of higher rates on our net interest income, the strong performance of our corporate lending portfolio and considering the upcoming reduction in our fee structure, we are pleased to announce that we are raising our regular quarterly base dividend by 15.6% from $0.32 per share to $0.37 per share, payable to shareholders of record as of December 19, 2022.
As a reminder, on our last conference call, we made several important announcements, including the establishment of what we consider to be the industry-leading fee structure among listed BDCs. Recall that BDC’s base management fee was permanently reduced to 1.75% on equity. Among listed BDCs, MFIC’s management fee is the lowest and is the only one to charge management fees on equity.
The incentive fee on income was permanently reduced from 20% to 17.5%. The changes to the fee structure will be effective for the period beginning January 1, 2023. We are raising the dividend to a level which we believe reflects the current earnings power of our portfolio, including some of the permanent benefit of our reduced fee structure, which is not yet reflected in our financial results. When the new fee structure becomes effective, we expect to significantly out-earn this $0.37 base dividend, and we will reevaluate our dividend at that time.
With that, I will turn the call over to Ted to discuss our investment activity.
Ted McNulty
Thank you, Tanner. Beginning with investment activity. Given our focus on reducing the fund’s net leverage, MFIC’s new investment activity was limited during the quarter. MFIC’s new corporate lending commitments totaled $21 million across three companies for an average new commitment of $7 million. The new commitments were first-lien floating rate loans with a weighted average spread of 639 basis points and a weighted average net leverage of 4.5x.
Excluding revolvers, gross fundings for the quarter totaled $67 million, and sales and repayments totaled $154 million. Net revolver fundings were approximately $5 million. In aggregate, net repayments for the quarter totaled $83 million. Repayments for the quarter included $101 million from corporate lending positions, $14 million from Merx and $39 million from other investments, including some shipping and oil and gas positions.
Post quarter end, we exchanged 50% of our non-income-generating investment in Carbonfree at our September 30 mark for $7.5 million cash and $12.5 million interest-bearing note. Net leverage at the end of September was 1.4x. Given our visibility into additional repayments in the coming months, we are well positioned to make new commitments during what we believe will be an attractive vintage characterized by relatively wider spreads, lower leverage levels and tighter documentation.
Turning to the overall portfolio. Our investment portfolio had a fair value of $2.46 billion at the end of September across 136 companies in 26 different industries. Corporate loans and other represented 89% of the total portfolio and Merx represented 11% of the portfolio at fair value. 94% of our corporate loans were first lien. The weighted average spread on our corporate loans was 613 basis points at the end of September.
In general, despite an environment of heightened uncertainty, we see minimal negative impact in the fundamental performance of our corporate lending portfolio companies. While we’re cognizant that borrowers will likely face increased challenges over the coming months due to inflationary pressures, higher interest rates and potential headwinds from an economic slowdown, we believe we have designed our corporate lending portfolio to be defensive and perform well during periods of increased stress. We believe MFIC has one of the most senior secured portfolios among BDCs, as evidenced by our low attachment point of 0.2x.
Our corporate lending portfolio consists of granular position sizes with our average position of $16.9 million. Our credit metrics remained relatively stable during the quarter. At the end of September, the weighted average net leverage of the corporate lending portfolio was 5.52x compared to 5.45x last quarter. The weighted average interest coverage ratio was 2.7x compared to 2.8x last quarter. These weighted average interest coverage ratios are based on company data from the last 12 months.
Looking at the most recent quarter, we have observed some pressure on this metric, as expected. The weighted average interest coverage ratio was 2.2x based on company data from the June quarter.
Our second-lien term loan in K&N, which had a fair value of $14.2 million at the end of September and which was originated in 2016, was placed on nonaccrual status during the quarter. At the end of September, investments on the nonaccrual status totaled $23.6 million or 1% 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 statement of operations, total investment income was $58.9 million for the quarter, up 10.3% quarter-over-quarter. Recurring interest income rose due to the impact of higher base rates. Fee and prepayment income was strong. Prepayment income was $2.9 million, up from $1.9 million last quarter; and fee income was approximately $1.5 million, up from $500,000 last quarter. Dividend income was essentially flat quarter-over-quarter.
The weighted average yield at cost on our lending portfolio was 8.9% at the end of September, up from 8% at the end of June. The increase in yield was primarily due to higher base rates. Net expenses for the quarter totaled $36.2 million, up $6.3 million quarter-over-quarter due to higher interest expense related to our credit facility, which bears a floating rate interest rate and higher incentive fees.
As a reminder, MFIC’s incentive fee on income includes a total return hurdle with a rolling 12-quarter look-back. Given the net loss of $6.6 million for the quarter, incentive fees during the quarter totaled approximately $4 million, up from $1.4 million last quarter. Net investment income per share for the quarter was $0.35.
During the quarter, we recorded a net loss on the portfolio of $6.6 million or $0.10 per share. When you look at our corporate loan book and you exclude the impact of Chyron and K&N, our spreads began – and considering our spreads began to widen during the quarter, our corporate loan book was slightly down.
On Page 16, in the earnings supplement, we disclosed a net gain or loss by strategy over the past five quarters. NAV per share at the end of September was $15.45, a $0.07 or $0.05 decrease quarter-over-quarter. The decrease is primarily attributable to the $0.10 loss on the portfolio, partially offset by $0.03 from net investment income relative to our dividend.
Moving on. Our liquidity position remains strong with undrawn revolver capacity well in excess of unfunded commitments to borrowers. We are well positioned to benefit from higher rates. To put some color around the potential for near-term earnings impact, based on quarter-end rates, we estimate that a 100 basis point and a 200 basis point increase in reference rates would result in annual incremental earnings of approximately $0.13 and $0.26, respectively. No stock was repurchased during the quarter.
Lastly, I wanted to mention that MFIC will be changing its fiscal year-end from March 31 to December 31, effective December 31, 2022. Accordingly, MFIC will file its annual report on Form 10-K for the fiscal year ended December 31, 2022, in late February 2023.
This concludes our prepared remarks. Operator, please open the call to questions.
Question-and-Answer Session
Operator
[Operator Instructions] We will take our first question from Kenneth Lee with RBC Capital Markets. Please go ahead.
Kenneth Lee
Hi. Good afternoon and thanks for taking my question. Wondering if you could just talk a little bit about key drivers for the unrealized losses that you saw in the Merx business in the quarter? Thanks.
Tanner Powell
Yes, sure. Thanks, Kenneth. So when we look at Merx, we are evaluating each plane and its prospects with impending lease maturities. And more specifically, the slight write-down that we saw in this particular quarter pertain to our view on the resolution of a number of planes as we are working through at lease maturities. But nothing other than – no broader point there other than marking to reflect our current view on those particular situations.
Kenneth Lee
Got you. And one follow-up, if I may. In terms of the cash paydown you received from some of the investments, is there any visibility in the near-term of any additional cash paydowns from other investments? And realizing it might be a little idiosyncratic, but what could be some key drivers there to see some additional cash paydowns in the future? Thanks.
Tanner Powell
Yes, sure. And when we look across our granular portfolio of 130 obligors and with the obvious caveat, Kenneth, that things are somewhat volatile out there is our near-term visibility suggests more paydowns in the future against a backdrop of broadly declining M&A volumes. But if anything, our current forecast as we sit here today would suggest some modest further paydowns from here.
Kenneth Lee
Got you. Very helpful. Thanks, again.
Operator
And we will take our next question from Finian O’Shea with Wells Fargo Securities. Please go ahead.
Finian O’Shea
Hi, everyone. Good afternoon. Back to Merx, Tanner, can you go back to the essence or driver of why so much was converted to equity? And then sort of to follow on Ken’s question on the write-down, can you reconcile that to the proportionately steeper decline in the quarterly interest payment that we’ll see from Merx, the $6 million in unrealized marks today versus the, I think, a couple of million a quarter, and correct me if I’m wrong there, on interest income?
Howard Widra
Okay. Yes, Fin, this is Howard. I think what we said, we should look at Merx. We’re liquidating Merx, and we have a combined mark of in the $250 million range. We got to pay down. When we got that paydown, we felt like as we’re liquidating and we expect to see additional cash coming in over the next quarters, it was better to just have less income coming off of the combined position, and so we recasted. It really wasn’t – there was nothing behind sort of the underlying value that changed. We just felt like the less capital that comes out of it, the more capital goes to return to basis.
And because of our earnings power, as sort of we show in our dividend raise in our expected earnings, we felt like we were well positioned to be in that position. So the first thing is we do expect to get additional paydowns, although it can be lumpy. But we’re focused on it and are in the throes of making that happen. And the recast is just really towards the intent of having as much capital go to basis as possible.
Finian O’Shea
Okay. Thank you. And just a small follow-on there. How much of an issue is sort of net investment income? Leases are maybe flat or stagnant and LIBOR base rates are going up. Is that an item? Are you hedged there?
Howard Widra
Well, we have leases set. So they’re not based off rates. They’re sort of basically fixed, and the debt is fixed. Yes, we have a fixed rate debt in our securitization. So we’re not really impacted by that.
Finian O’Shea
Okay. That’s helpful. Thanks so much.
Operator
And we’ll take our next question from Kyle Joseph with Jefferies. Please go ahead.
Kyle Joseph
Good afternoon. Thanks for taking my questions and apologies, a couple of calls today, hopped on a little late, sorry if you covered this. But obviously – so originations were light. I think you guys talked about that was on purpose to delever the balance sheet. But can you give us a sense for your pipeline and then also kind of the spreads you’re seeing on new deals and how that compares to the portfolio?
Tanner Powell
Yes, sure. I’m happy to take that, Kyle. So the – like you said, there was some deleveraging in the particular quarter. When we look at the current market environment, clearly, M&A has slowed. We are very fortunate and benefit from the wide funnel that MidCap Financial, the Bethesda-based lender, affords us. And interestingly, as we look forward and as we alluded to in our prepared remarks, across the various product areas, in particular, ABL is one area where we see increasing opportunity.
So our outlook is broadly lower M&A, but still a nice level of opportunity. And what I would say to add to that is while certainly as things are moving so quickly and valuation expectations have been recalibrated, that’s certainly one of the drivers for limited M&A opportunity on the sponsor side. We are still seeing a good pipeline of add-on acquisitions, and that’s both in the form of funding our existing delayed draws as well as also new commitments to existing borrowers as those small – those relatively smaller add-ons are more palatable in this market environment, and that’s another nice opportunity for us in the environment.
Kyle Joseph
Yes. And then…
Tanner Powell
Sorry, Kyle, I didn’t hit the spread. Sorry. So if we look at spreads and even ignore, obviously, the effect of the base rate, and right now versus, call it, at the beginning of the year, we’re seeing spreads at 100 to 200 basis points wider, and that’s not just in spread, we’re seeing – if you think the average deal that we were doing about a year ago was 575, we’re seeing 650 to 675 and importantly, also seeing more convexity come from a greater OID, kind of going from 98 to at least 97 and even below in certain cases. So 100 to 150 basis points of the spread widening, exclusive of the effect of the base rate or LIBOR/SOFR going up.
Kyle Joseph
Got it. And then, yes, in terms of – shifting to credit, we saw your leverage statistics and added one investment to nonaccrual. But has there been – have you seen a greater demand or pickup in amendment activity? And how would you gauge kind of the health of your portfolio as companies deal with higher interest expenses, ongoing inflation, et cetera?
Tanner Powell
Yes, absolutely. So not yet. And I think the good point of – the point of emphasis, and hopefully, this comes through in how we presented our approach for many years now, is our borrowers within our corporate book, kind of 95% plus have financial covenants. And so the good news is we do have a seat at the table. There is a normal level of activity that happens anyway, whether opening up a document to do an add-on acquisition or a myriad other reasons.
In terms of what you’re obviously getting that in terms of credit weakening type amendments, we have not seen that tick up. Keep in mind that these metrics are tested on a backward-looking basis. And so for instance, the numbers that are filtering to those tests at this moment in time, Kyle, are 6/30 numbers. And so we would imagine it’s only natural in this type of environment for that to pick up. But as of now, we’ve seen very limited excessive or above-normal amendment activity.
Kyle Joseph
Got it. Very helpful. Thanks for answering my questions.
Operator
We’ll take our next question from Melissa Wedel with JPMorgan. Please go ahead.
Melissa Wedel
Good afternoon. Most of my questions have been asked already. But I thought it would be helpful just to quickly review how you’re thinking about portfolio leverage right now and where you’d ideally like to operate given how things are evolving from a macro perspective? Thanks.
Tanner Powell
Yes. Thanks, Melissa. As you saw and as we mentioned in our prepared remarks, we are at 1.42x, our previous – which is the lower end of our previous stated range. And also drawing on my answer to Kenneth’s question, we would expect to operate at or below that level in the near term, in part due to some visibility in some of the payments.
As we have said, historically, from a risk standpoint, we do believe our first-lien strategy, granular position size – our true first-lien strategy, granular position size does allow us to operate at that higher leverage level. But that’s where we sit today and that’s what we see, again, based on some visibility on near-term payments.
Operator
[Operator Instructions] And we’ll go next to Paul Johnson with KBW. Please go ahead.
Paul Johnson
Yes. Good evening, guys. Thanks for taking the questions. Real quick on just the interest coverage ratio that you mentioned, the decline in this most recent quarter, I guess, with most sort of updated financials that you have dropping from 2.9x to 2.2x. It sounds like a big drop, obviously, also a fairly significant increase in rates over that time period as well. But I was wondering if you could just kind of comment on that and, I guess, if you had any sort of commentary around EBITDA performance of your portfolio companies if that at all is reflected into that number as well.
Tanner Powell
Yes, sure. Yes, go ahead, Greg.
Greg Hunt
Yes. Yes, sure. Yes, no, thanks for the question. Just to clarify the LTM interest coverage ratio went from 2.8x to 2.7x, so only a modest downward revision on an LTM basis as of June. We did quote a 2.2x number, which was a sensitivity looking at the company data only for the June quarter, and that kind of make sense as rates were starting to rise. And as we look forward, we certainly do expect there to be more pressure as rates continue to rise.
I think one of the ways we think about it is we’re starting from a good point. We’ve got a significant amount of sponsor equity behind the majority of the loans that we make. We’re starting in the high 2s, as we mentioned, 2.7x on an LTM basis. So we have an equity cushion. We’ve got true first-lien positions, and we’ve got covenants to get us to the table if we do see EBITDA start to deteriorate.
So I think from an EBITDA standpoint, to get to the next part of your question, we saw EBITDA growth. EBITDA, still being in a growth mode at 6/30, in the low to mid-single digits, which has tapered off from what we saw in prior quarters, but still in positive territory. And so we’ll continue to watch this closely, obviously, and as will everyone in the credit markets.
Paul Johnson
Got it. Thanks for that. And I appreciate the correction there. It makes sense. And then just on the dividend increase, I imagine this was obviously with kind of your house view on forward rates and the new fee structure coming on. I’m just curious if that’s the case or if there’s any, I guess, room for potential increase from that level.
Ted McNulty
Yes. So we believe, like our view is that we have significant ability to sort of out-earn that stated dividend. And so our expectation is as we – our fees don’t kick in to the first quarter of next year, calendar quarter of next year. So as we get there and we start out-earning the dividend, the choices we have with regard to either raising our dividend or making special dividends sort of will be on the table. We would expect at a minimum to be making special dividends.
So – and some of it depends on the extent of the – of how much interest rates go from here. But even at today’s rates, we think we have good cushion for the $0.37. So we wanted to sort of put a mark on the ground of where we’re very comfortable, but we expect to be able to out-earn that solidly.
Paul Johnson
Got it. Appreciate it. That makes sense. Thanks that’s all for me.
Operator
And there are no questions at this time. I will now turn the call back over to the management team for closing remarks.
Tanner Powell
Thank you, operator, and thank you, everyone, for listening to today’s call. On behalf of the entire team, we thank you for your time today. Please feel free to reach out to us if you have any questions. And everyone have a good weekend and evening.
Operator
Thank you. And this does conclude today’s program. Thank you for your participation. You may disconnect.
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