MidCap Financial Investment Corporation (NASDAQ:MFIC) Q1 2024 Earnings Call Transcript

MidCap Financial Investment Corporation (NASDAQ:MFIC) Q1 2024 Earnings Call Transcript May 8, 2024

MidCap Financial Investment Corporation isn’t one of the 30 most popular stocks among hedge funds at the end of the third quarter (see the details here).

Operator: Good morning, and welcome to the Earnings Conference Call for the period ended March 31st, 2024 for MidCap Financial Investment Corporation. At this time, all participants have been placed in 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.

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 also like to call your attention to the customary Safe Harbor disclosure in our press releases 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 the SEC’s website at www.sec.gov or 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. 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 Tanner Powell, MFIC’s Chief Executive Officer.

Tanner Powell: Thank you, Elizabeth, and thank you everyone for joining today’s call. I will begin today’s call with a summary of our results and will also provide our perspective on the current environment. I will then provide an update to our proposed merger with Apollo Senior Floating Rate Fund Inc. and Apollo Tactical Income Fund, Inc. Ted will then cover our investment in activity and provide an update on the investment portfolio and credit quality. Lastly, Greg will review our financial results in greater detail. Yesterday, after market closed, we reported solid results for the March quarter, which included a slight increase in net asset value per share, relatively stable credit performance, and continued derisking of the portfolio.

Net investment income per share for the March quarter was $0.44, which corresponds to an annualized return on equity or ROE of 11.4%. Results for the quarter reflect solid recurring interest income from our predominantly floating rate portfolio and strong fee and prepayment income. GAAP EPS for the March quarter was $0.39. Similar to last quarter, we continued to improve the risk profile of our portfolio by reducing our exposure in Merx, our aircraft leasing portfolio company as well as our second lien exposure. At the end of March, corporate lending and other represented 92% of the total portfolio, of which 97% was first lien on a fair value basis, up from 96% last quarter. With the repayment of one of our few remaining second lien positions, our second lien and other debt exposure is now only about 0.7% of the total corporate lending portfolio.

We believe MFIC has one of the most senior corporate lending portfolios among BDCs as evidenced by our weighted average attachment point of essentially zero. We believe we have constructed a corporate lending portfolio that will perform well even during a potential economic downturn. Overall, we feel good about the health and quality of our corporate lending portfolio as our underlying borrowers have largely been able to handle higher borrowing costs. We have not seen any significant signs of credit weakness across the portfolio. We are, of course, closely monitoring our portfolio and mindful of the potential impacts of a higher for longer rate environment. I would now like to provide our perspective on the current environment. Despite high interest rates, elevated inflation and geopolitical uncertainty, U.S. economy has proven to be resilient and continues to display strong growth.

At the beginning of 2024, investors expected the Federal Reserve to cut rates multiple times during the year. However, as the quarter progressed, sovereign inflation has pushed out the expectation for the start of rate cuts and the market generally believes that we are in a higher for longer scenario. Apollo’s Chief Economist believes that there’s a reasonable chance that the Fed may not cut at all in 2024, while the market is currently pricing in only 1 cut this year. Specific to the lending market, during the first quarter, there has been an increase in activity in the syndicated loan market. MFIC is focused on the middle market, which is less susceptible to competition from the syndicated loan market. Although, spreads in our market have decreased, the decline has been less than what we have observed in liquid loan markets.

Spreads in our market are still healthy by historical standards, and we continue to believe risk return in the middle market remains compelling. In our market today, a typical deal with price with a spread of around 500 basis points to 550 basis points. As you know, MFIC is squarely focused on the core middle market, Midcap Financial, which was founded in 2009 has a long track record, which includes closing on approximately $114 billion of lending commitments since 2013. This origination track record provides us with a very large data set of middle market company financial information across all industries, and we believe makes Midcap Financial, one of the most informed and experienced middle-market lenders in the market. Apollo’s affiliation with Midcap Financial is a significant competitive advantage for MFIC.

In short, we believe the core middle market offers attractive investment opportunities across cycles and did not compete directly with either the broadly syndicated loan market or the high-yield market. Next, let’s turn to the dividend. Approach to dividend seeks to provide shareholders with an attractive current yield while also retaining some earnings for NAV stability and growth. To that end, our Board of Directors declared a dividend of $0.38 per share, consistent with our prior year — prior quarter dividend to shareholders of record as of June 11, 2024, payable on June 27, 2024. A $0.38 dividend represents an annualized yield of approximately 9.9% based on NAV per share as of March 31. Our dividend continues to be well covered by net investment income.

Before handing the call over to Ted, I would like to provide a brief update on MFIC’s proposed mergers with AFT and AIF. We remain excited about these proposed mergers, and we believe that their consummation, which is subject to receipt of certain stockholder approvals and satisfactory of other customary closing conditions will create a stronger combined company. We look forward to realizing the potential benefits of a larger combined company, including enhanced returns for all stockholders greater scale and enhanced portfolio diversification after closing. As a reminder, if one or both of these mergers closed MFIC will pay a one-time cash dividend of $0.20 per share to all stockholders following the closing. The exact record date for this dividend will be determined by MFIC’s Board of Directors based on the timing of the closing.

We filed a definitive joint proxy statement/prospectus related to the mergers on April 4. And the special meeting for the stockholders of all three funds to vote on the merger proposals have been scheduled for May 28. We have officially commenced the proxy solicitation process related to these proposals, and we kindly request that any stockholders of MFIC, AFT or AIF, who have not yet cast their votes on these proposals do so in the coming days. Please note that we will not be able to answer any questions related to the current vote count on today’s call. With that, I will turn the call over to Ted.

Ted McNulty: Thank you, Tanner. Good morning, everyone. Beginning with investment activity, as a reminder, MFIC is focused on investing in loans sourced by MidCap Financial, which provides MFIC with a large pipeline of investment opportunities. Market Lender was one of the largest direct lending teams in the US with close to 200 investment professionals. On last quarter’s call, we mentioned we were seeing a noticeable pickup in pipeline activity. We’re pleased to report that this has led to a strong level of closings during the March quarter. MidCap Financial was active during the March quarter, closing approximately $5.1 billion in new commitments, an increase of approximately 31% from the December quarter. During the March quarter, MFIC’s new investment commitments totaled $149 million of new first lien commitments across 16 different borrowers for an average new commitment of 9.3 million as we continue to focus on diversification by borrower.

38% of new commitments were made to existing portfolio companies. Although, we are seeing some pricing compression in the market, the weighted average spread of our new commitments in the quarter was relatively unchanged at 624 basis points, one basis point lower than commitments made during the December quarter. The weighted average OID for new commitments was approximately 211 basis points. This spread in OID translates into a very attractive unlevered asset yield of around 12%, assuming a 5% base rate. The weighted average net leverage of new commitments was 3.9 times. We believe the risk return on these new commitments is very compelling. Our pipeline of investment opportunities remains strong. In terms of funded investment activity, gross fundings for the corporate lending portfolio, excluding revolvers, totaled $129 million.

Sales and repayments totaled $95 million. Net corporate lending revolver paydowns were $14 million, and we received a $4 million paydown from Merck’s. In aggregate, net fundings for the quarter totaled $16 million. Our portfolio turnover continues to drive a positive shift in the composition of our portfolio. Sales and repayments included the exit of a $15 million second lien position, which reduced our already low second lien and other debt exposure by half to just $13.8 million, or 0.7% of the total corporate lending portfolio at fair value. We believe this negligible amount of non-first lien exposure highlights the very senior nature of our corporate lending portfolio. Turning to our investment portfolio, we have built a well-diversified senior corporate lending board.

At the end of March, our portfolio had a fair value of $2.35 billion and was invested in 154 companies across 23 different industries. Corporate lending and other represented approximately 92% of the total portfolio, and Merck’s accounted for 8% of the total portfolio on a fair value basis. The average funded corporate lending position was $14.6 million, or approximately 0.7% of the total corporate and other lending portfolio. 97% of our corporate lending portfolio was first liens, up from 96% last quarter, and over 99% of our corporate lending debt portfolio on a cost basis had one or more financial provenance, and 88% of our corporate lending debt portfolio on a cost basis had one or more financial provenance, and 88% of our corporate lending portfolio is backed by financial sponsors who we know well and with whom MidCap Financial has longstanding relationships.

Despite the higher for longer interest rate environment, our portfolio companies continue to exhibit strong fundamental performance and meet our expectations. On a median basis for the quarter, portfolio company revenue and EBITDA both increased by mid-single digits year-over-year. The growth in revenue is attributable to organic expansion, while improvements in margins are due to borrowers optimizing their cost structures. We believe the sustained positive improvement is an encouraging indicator of the portfolio’s underlying strength. The weighted average yield at cost of our corporate lending portfolio was 12.1% on average for the March quarter, down slightly from 12.2% in the December quarter. At the end of March, the weighted average spread on the corporate lending portfolio was 621 basis points, down two basis points compared to the end of December.

Turning to credit quality. Our focus on true first lien top of the capital structure middle market loans has resulted in what we consider to be strong and resilient credit metrics. Given the second lien repayment I mentioned, the weighted average attachment point for our corporate lending portfolio was essentially zero, or to be more precise, 0.04x. This metric means that there is no senior debt to our positions, illustrating that our corporate lending portfolio is indeed first lien. We believe it is key to look at this metric as not all debt labeled first lien is actually top of the capital structure, as its name would suggest. At the end of March, the weighted average net leverage of our corporate lending portfolio was 5.36x, up from 5.27x last quarter.

Moving to interest coverage. The weighted average interest coverage ratio remained at 1.9x unchanged, with four companies below one times. We are closely monitoring these situations and believe they are manageable, that the companies have strong current liquidity, good underlying business performance, or have strong financial sponsor support. The median EBITDA of MFIC’s corporate lending portfolio was approximately $47 million. We have 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. Our underwriting on MidCap sourced loans has proved to be sound. Based on data from mid-2016, which is the approximate date upon which we began utilizing our co-investment order, our annualized net realized and unrealized loss rate is around two basis points on loans sourced by MidCap Financial.

We think this performance data shows how well the strategy has performed. Although we added our $12 million investment in Naviga [ph] to non-accrual status during the quarter, investments on non-accrual remain very low, totaling $14.4 million, or 0.6% of the total portfolio at fair value across three names. Naviga is currently in a sales process and initial bids are reflected in our mark. We believe these stable credit metrics reflect the way in which we have constructed our portfolio and it is the direct result of focus on sourcing assets from MidCap Financial, one of the leading middle market lenders. Importantly, MFIC benefits from MidCap Financial’s large dedicated portfolio management team of over 60 investment professionals, which helps identify and address issues early.

It is also important to note that MidCap Financial leads and serves as an administrative agent on the vast majority of our deals, which provides meaningful downside protection. As an agent, we are in active dialogue with the borrower and have enhanced information flow, which allows us to be proactive in resolving problem credits. Moving on to Merx, as discussed previously, we are focused on reducing our investment in our aircraft leasing and servicing businesses. While we do not expect paydowns to occur evenly, we believe aircraft sales and servicing income should allow for the paydown of third-party debt and MFIC’s investment in Merx over time. As of March 31, our investment in Merx totaled approximately $190 million, representing approximately 8% of the total portfolio at fair value.

During the March quarter, Merx paid MFIC approximately $5.9 million, which included $1.9 million of interest and a $4 million return of capital. 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 morning, everyone. Beginning with our financial results, net investment income per share for the March quarter was $0.44, which reflects solid recurring interest income, as well as strong fee and prepayment income. For the quarter, prepayment income was $2.2 million, and fee income was $1.7 million. PIK income remains very low, representing approximately 3% of the total investment income for the quarter. GAAP net income per share for the quarter was $0.39, which reflects a $0.05 loss on our investment portfolio. Results for the quarter correspond to an annualized return on equity based on net investment income of 11.4%, an annualized ROE based on net income of 10.1%. MFICs NAV per share at the end of March was $5.42, up $0.01 over the prior quarter, reflects net investment income of $0.44, which is $0.06 above the $0.38 distribution and a $0.05 per share loss on the portfolio.

As Ted mentioned, the vast majority of our corporate lending portfolio continues to have strong fundamental performance. Additional details on the change in unrealized gains and losses by strategy are shown on slide 17 in the earnings supplement deck. Net expenses for the quarter were $39.8 million, down $2.4 million compared to the prior quarter, primarily due to lower general and administrative expenses, as well as lower interest expense and lower incentive fees. We recruited de minimis amount of excise tax in March compared to approximately $1.1 million in the September quarter. The weighted average interest rate on our debt for the quarter was 7.09%, up from 6.94% last quarter, which reflects a full quarter impact of the CLO notes and the baby bonds, which both closed during the December quarter.

As stated on last quarter’s call, we intend to continue to evaluate and monitor capital raising transactions going forward. Management fees totaled $4.4 million for the March quarter, essentially flat compared to the prior quarter. As a reminder, MFIC’s base management fee was reduced to 1.75% on equity beginning January 1, 2023, and is one of the only listed BDCs to charge management fees on equity, which we believe provides greater alignment and focus on net asset value. Incentive fees totaled $6 million for the March quarter. As a reminder, our incentive fee on income is 17.5% and includes a total return hurdle with a 12-quarter look back. Our current estimate of undistributable taxable income or spillover income at the end of 2023 was $67.3 million or $1.03 per share.

Moving to our balance sheet, MFICs net leverage was 1.35 times at the end of March compared to 1.34 times at the end of December, reflecting $17 million of net fundings during the quarter. This concludes our prepared remarks. Operator, please open the call to questions.

See also 20 States with the Highest Fertility Rates in the US and 10 Best Cookies and Crackers Stocks to Buy.

Q&A Session

Operator: The floor is now open for questions. [Operator Instructions] Our first question will come from Mark Hughes with Truist. Please go ahead.

Mark Hughes: Yeah, thank you. Good morning. To perceive much in the way of competitive moves, say, given the broadly syndicated market, a little more activity there, you’ve seen some lenders get down more into the middle market, impacting spreads and maybe along with that, I think you talked about 500 to 550 basis point spread today. Has that been relatively stable lately? Or has that been moving through the quarter? How would you say it is kind of the trend?

Howard Widra: Tanner, let me — I’ll comment on that. This is Howard. The not so immediately, and that’s really because obviously, you may see large sponsors that are covered and doing larger deals occasionally get down in the middle market. But in order to cover the middle market, you need to have a comprehensive coverage effort which is — and continuity in the market with a lot of those sponsors. And so you just don’t see the capability of the people who are focused on the larger market competing directly probably syndicated with the capabilities to sort of just step into that market holistically. It doesn’t mean it doesn’t happen on occasional deals. I mean as a separate matter, there’s capital being created in the middle market all the time.

And then those teams may or may not have comprehensive coverage as well. So there is definitely competition that’s causing compression, but it’s not really the result of the broadly syndicated market. The middle market is one of the strengths of it as being sort of insulated from those — that variation.

Mark Hughes: And then any comment on the trajectory of spreads this year if you think about where they were in January to where we are today?

Tanner Powell: Happy to take that. So Mark, I would call your attention to, we alluded to the fact that deals are between $500 million and $550 million. And in the quarter, we actually executed at $624 million. And that has to do with what we talk about a lot, there’s a gestation period for deals getting done, and that reflects a lot of self potencies that have been commenced last year. And so that’s a pretty significant tightening that we see. What we are seeing is some modicum of stability as at this juncture post December where conditions improved and you saw some of the spread tightening and rally in markets more broadly, those sale processes are hitting — are now at a point where the — we’re able to create new credit assets and our pipelines are very full.

So I would say, certainly, my initial comment there reflects the tightening overall that we’ve seen in the middle market, but seeing some stability now that sales prices have had an opportunity to run their course and the opportunity for new credit asset creation.

Mark Hughes: Thank you for that. One more and you probably have addressed this, but I wonder if you could update us on the kind of the seniority profile. You tell emphasized the focus on first lien, — once you do the merger with the other Apollo funds, how will that look roughly speaking?

Tanner Powell: Yes. It will look similarly — those funds which is obviously publicly available, have some more broadly syndicated type loans, but predominantly first lien. And then, Mark, as we’ve talked about, both in our prepared remarks in the filings, as well as also our investor decks that the intention is obviously over time as those loans mature or we can sell out of them to obviously reposition them into our core strategy of mid-cap loans, first lien floating rate loans that we source – that are sourced by the mid-cap platform.

Mark Hughes: Thank you very much

Operator: Thank you. Our next question will come from Kyle Joseph with Jefferies. Please go ahead.

Kyle Joseph: Hey, thanks for taking my questions and sorry if I missed this. But did you give a sense or pro forma leverage or ballpark area post-merger?

Tanner Powell: We’ll be somewhere around between 1.15 and 1.2 times levered

Kyle Joseph: Okay. Got it. Helpful. And a good segue to my next. Over the last couple of years, you guys have been focused on reducing core and lowering all leverage and now especially with the merger where we can have at the point where you can think about more transitioning to kind of the offensive side if that’s fair to ask?

Tanner Powell: So Kyle, I mean certainly, we’re really excited by the prospect. Should we be successful of having an opportunity to deploy even more capital. Yes. I wouldn’t attach the offensive, defensive valence to it per se because our strategy since we got the ability to go up in leverage has been a 100% focused on sourcing — or sorry, participating in or investing in loans that are originated at MidCap and so our approach doesn’t change. I think this is just a very elegant opportunity to do even more of it and to kind of create an even bigger percentage of the portfolio with those MidCap sourced loans.

Kyle Joseph: Got it. Very helpful. And then one follow-up for me, probably, Greg, is where we are on rates. I’m not going to ask you to predict where rates are going to go. But just how you’re thinking about the right side of the balance sheet and the mix between floating rate and fixed rate liabilities. And that’s it for me. Thanks, guys.

Greg Hunt: Okay. I mean I think that from our point of view, we do have our $350 million 10-year note coming due in March of 2025, which is fixed rate. I do think we did our baby bond, which was fixed rate, and we didn’t swap it because we have a two-year call option on it. I do think that as we go out, we’ll match our liabilities with our assets.

Kyle Joseph: Great. Thanks for taking my questions.

Operator: [Operator Instructions] Our next question is – apologies. Our next question will come from Robert Dodd with Raymond James. Please go ahead.

Robert Dodd: Good morning. On credit quality, obviously looks right. I mean pickups going up and always getting paid down, et cetera. Have you seen any initial increased discussion from sponsors? I mean it was five months ago, it looks like there were going to be six cuts and sponsors could afford to sit on their hands, so to speak, and wait maybe interest coverage that’s still above one, but moving might resolve itself, if I put it in one way. But with the possibility of no cuts, but the cuts same one, the high interest costs are live longer in the portfolio. So, has there been any change in what sponsors are doing proactively? I said no one increasing amendment request yet? Are there any preliminary discussions there? Or any color you can give on what the outlook is given, it looks like rates are going to stay extremely high for quite a lot longer at this point?

Greg Hunt: Yes. Yes. Happy to take that. So, there’s a couple of things going on. One, over the kind of, I would say, economic environment over the last few years, the sponsors and the companies are focused on really becoming more efficient so that they could prepare for a longer term hold, if necessary. And then as you alluded to, when there was a view that there were going to be five rate cuts, people got excited about doing M&A. So, with the process of rate cuts going away, I think we can at least kind of fall back from a fundamental performance standpoint that the companies are doing well. And then secondly, if you think about the technicals of the private equity market, you still have a lot of dry powder that needs to be put to work.

You still have a number of sponsors that need to return capital in order to be able to raise their next fund. So, that’s going to drive transactions. And there’s going to be a period of time like any time that there is volatility in rate expectations or market valuations for the bid/ask to come together and so I think that’s happening. And that will take a little bit of time to play out. And then the third thing that we’re seeing is more and more continuation vehicles where sponsors have companies within their funds and they need to hold on to those longer to really realize the multiples that they’re looking for. And then I guess, finally, the last thing I would say is that in terms of discussions with sponsors about other alternatives, there are some early conversations around extensions and re-pricings, where they’re coming back and saying, we thought we were going to monetize this year, but we’re going to look to next year.

They’re not at the point in their fund where they need to do a continuation vehicle or they don’t feel the pressure to return capital. And so there are very constructive discussions around the lending groups extending the maturity and addressing the overall structure. So, I would say those are kind of the four dynamics at play.

Robert Dodd: Really helpful. Thank you. I mean a quick follow-up to that one. Does a continuation vehicle constitute a change in control in the mandatory refinancing, does that mean you finance that? Or is it automatic that you get ported across to the new vehicle with the existing loan

Ted McNulty : Yes. So it is typical that that would be a change of control, but it’s also typical in the direct lending space that you don’t just show up one day at your desk and get a notice that it’s going to happen, right? There’s an ongoing dialogue about what the strategy is, what the financing is going to be. And there’s some visibility around the sponsor will come and say, hey, do you want to support this going forward? And sometimes we say yes, and sometimes we say no, at which point they launch a financing process that aligns with their continuation vehicles.

Robert Dodd: Got it. Thank you. And then one more if I can, if hypothetically, the mergers close sometime in the not-too-distant future, how is the something change in the competitive environment out there, BSL et cetera has that changed your plan about churn sets within those acquired vehicles if they were to close?

Tanner Powell : Thanks, Robert. I think I would say, no. I think that you should rely on us or expect us to always be evaluating risk reward in the context of the market environment, what makes sense? And then furthermore, as faced with — as we think about investing, we’re always cognizant of vintage and wanting to do things with a measured approach. And that would be the same if hypothetically these were to close. And so if we are confronting an environment such as what we do today, we would be evaluating the market in a similar fashion and evaluating risk reward and our intention would has always been do not take outsized exposure to any one particular vintage and would expect to connect ourselves in a similar manner, should the merger be successful.

Robert Dodd: Got it. Thank you.

Operator: Thank you. We show no further questions at this time. I would like to turn the call back to management for closing remarks.

Tanner Powell: Thank you, operator. 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 with any other questions, and have a good day.

Operator: This does conclude today’s call. We thank you for your participation. You may disconnect your lines at this time, and have a wonderful day.