MidCap Financial Investment Corporation (NASDAQ:MFIC) Q4 2023 Earnings Call Transcript

MidCap Financial Investment Corporation (NASDAQ:MFIC) Q4 2023 Earnings Call Transcript February 27, 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 December 31, 2023 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. 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 our Chief Executive Officer, Tanner Powell, MFIC’s Chief Executive Officer.

Tanner Powell: Thank you, Elizabeth, and thank you everyone for joining today’s call. I’ll begin today’s call with a summary of our results and we’ll also provide our perspective on the current environment. Ted will then cover our investment activity and provide an update on the investment portfolio of credit quality. Lastly, Greg will review our financial results in greater detail and we’ll also discuss our recent financing transactions. We will then open the call to questions. Yesterday after market closed we reported strong results for the December quarter to cap off a strong year highlighted by an increase in net investment income, an increase in net asset value, stable credit performance, and continued de-risking over the portfolio.

Net investment income per share for the December quarter was $0.46, up from $0.43 last quarter, which corresponds to an annualized return on equity or ROE of 11.9%. Results for the quarter reflect an increase in recurring interest income from our predominantly floating rate portfolio as well as strong prepayment income. GAAP EPS for the December quarter was $0.51, up from $0.46 last quarter, which includes a net gain on the portfolio of $0.05 per share, reflecting the stable credit quality of our portfolio. Our GAAP earnings for the quarter correspond to an annualized ROE of 13.3%. We believe these results demonstrate the merits of our investment strategy and our fee structure which aligns incentives to our manager with the interests of our shareholders.

We also continue 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 December corporate lending and other represented 92% of the total portfolio of which 96% was firstly and on a fair value basis. We believe MFIC has one of the most senior corporate lending portfolios among DDCs as evidenced by our low attachment point of 0.1x. 98% of our corporate lending portfolio has one or more financial covenants and 88% of our corporate lending portfolio is backed by financial sponsors who we know well and with whom MidCap Financial has long-standing relationships. We believe we have constructed a corporate lending portfolio that will perform well even during a potential economic slowdown.

Overall we feel good about the health and quality of our corporate lending portfolio as our underlined borrowers have largely been able to handle higher borrowing costs. All key credit metrics have either improved or were unchanged during the quarter. No investments were placed on non-accrual status. We have not seen any significant signs of credit weakness. That said we are closely monitoring our portfolio and mindful of the potential impacts of higher for longer rate environment. As of December 31, 2023, MFIC’s net asset per share, NAV per share was $15.41, an increase of $0.13 cents or 0.9% compared to the prior quarter, which reflects operating earnings above the dividend and a net gain on the portfolio. We also continue to focus on enhancing the right side of our balance sheet.

During the quarter we closed on MFIC’s first CLO transaction and we also issued some unsecured debt which Greg will discuss in greater detail. These transactions improved MFIC’s debt maturity ladder. I would now like to provide a perspective on the current environment. The credit markets rally during the December quarter fueled by diminishing concerns about a recession, a slowdown in an inflation, and the Federal Reserve signaling rate-hiking cycling had come to an end. As the quarter progressed we saw an increase in sponsor activity which combined with a rebound in the syndicated loan market contributed to a sublime demand imbalance for private loans resulting in spread compression. We saw borrowers taking advantage of this dynamic to refinance or reprice existing liabilities.

That said we continue to see private lenders fill the void left by banks. Looking ahead we believe we will likely see a pickup in deal activity in 2024, given a more stable backdrop, better visibility into rates, significant private equity dry powder which needs to be deployed, and increasing pressure for sponsors to exit assets in order to make distribution and or return of capital to investors. Sponsors focused on the middle market are primarily seeking financing solutions in the private credit market. Buyers and sellers are becoming more aligned on valuation. At Apollo and MidCap we are seeing a noticeable pickup in pipeline activity in recent months As you know, MFIC is squarely focused on the core middle market. MidCap Financial has a long track record which spans 14 years of lending to middle market companies and includes closing on approximately 110 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. In short we believe the core middle market offers attractive investment opportunities across cycles and does not compete directly with either the broadly syndicated market or the high yield market. Next, let’s turn to the dividend, our 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 quarter dividend to shareholders of record as of March 12, 2024 payable on March 28, 2024.

A $0.38 dividend represents an annualized yield of approximately 9.9% based on NAV per share as of December 31. Our dividend continues to be well covered by net investment income. For the full year net investment income outpaced dividend by nearly 17% as we chose to retain earnings which contributed to the 2.1% increase in NAV per share per the year. At current base rates we are well positioned to generate net investment income in excess of this dividend. We will continue to evaluate our dividend policy giving the prevailing interest rate environment. In summary, we generated solid returns for our shareholders in 2023 and we believe we are well positioned to continue to deliver attractive returns looking ahead. As we enter 2024 we are excited about the strategic transaction that we announced last quarter.

As a reminder, in November, MFIC announced that it entered into merger agreements with Apollo Senior Floating Rate Fund Inc. or AFT and Apollo Tactical Income Fund Inc. or AIF pursuant to which AFT and AIF will merge into MFIC subject to shareholder approvals and other customary closing conditions. AFT and AIF are both listed, closed-in funds registered under the Investment Company Act of 1940 and managed by an affiliate of Apollo. We have filed a registration statement and preliminary joint proxy statement in connection with the transaction. During this registration period we are extremely limited in what we can discuss. Once declared effective we will commence a proxy solicitation process to seek the requisite shareholder approvals for the mergers and we will be happy to engage in a more detailed dialogue at that time.

In the meantime, please understand that we will not be able to answer any questions related to the proposed merger 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. 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 December quarter closing approximately $3.9 billion in new commitments or approximately $15 billion for the full year. Acquisition activity among existing borrowers was significant. During the quarter MFIC deployed capital into what we believe is an attractive environment characterized by notably lower leverage.

MFIC’s new investment commitments during the quarter totaled $175 million of new first-linked commitments across 20 different borrowers for an average new commitment of $8.8 million as we continue to focus on diversification by borrower. 45% 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 625 basis points with an average OID of approximately 234 basis points. This translates into a very attractive yield of over 12%. The weighted average net leverage of new commitments was 3.6x. We’re currently seeing some pricing compression on new commitments as a result of the market dynamics previously discussed.

We have a strong pipeline of investment opportunities. So far in the March quarter, MFIC has closed approximately $100 million of new commitments. In terms of funded investment activity, gross fundings, excluding revolvers for the corporate lending portfolio totaled $114 million. Sales and repayments totaled $152 million. Net corporate lending revolver paydowns were $1 million and we received the $7 million paydown from Merx. In aggregate, net repayments for the quarter totaled $47 million. Our portfolio turnover continues to drive a positive shift in the composition of the portfolio. Sales and repayments included the repayment of one of the few remaining second-lien positions in our portfolio, reducing our second-lien exposure to less than 2% of the total corporate lending portfolio.

This shift underscores the ongoing improvement in the risk profile of our portfolio. Turning to our investment portfolio, we have a well-diversified senior corporate lending book. At the end of December, our portfolio had a fair value of $2.33 billion and was invested in 152 companies across 23 different industries. Corporate lending and other represented approximately 92% of the portfolio and Merx accounted for 8% of the total portfolio on a fair value basis. The average funded corporate lending position was $14.7 million, or approximately 0.7% of the total corporate and other lending portfolio. 96% of our corporate lending portfolio was first-lien and 98% of our corporate lending debt portfolio on a cost basis had one or more financial covenants.

The weighted average yield at cost of our corporate lending portfolio was 12.2% on average for the December quarter, up from 12% in the September quarter. At the end of December, the weighted average spread on the corporate lending portfolio was 623 basis points, up 2 basis points compared to the prior quarter. 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. We believe MFIC has one of the most senior corporate lending portfolios in the industry. Not all debt categorized as first-lien has a similar risk profile. We know that some lenders categorize loans as first-lien even when there’s leveraged senior to their positions, which is why we think it’s important to look at both leverage and attachment points.

At the end of December, MFIC’s net leverage and attachment points on our corporate loans was 5.27x and 0.1x respectively. This extremely low attachment demonstrates that we are invested in the most senior part of the capital structure. Moving to interest coverage, the weighted average interest coverage ratio is 1.9x unchanged from last quarter with three companies below 1x, one less than last quarter. We’re closely monitoring these situations and believe they’re manageable as these companies have strong current liquidity, given underlying business performances, or have strong sponsor support. As of December 31, 2023, the median EBITDA, the MFIC’s corporate lending portfolio companies, was approximately $47 million. Our portfolio companies are generally maintaining solid fundamental performance with revenue and EBITDA continuing to grow.

We’ve not seen a meaningful increase in covenant breaches or a pickup and amendment activity. We believe our credit quality has benefited from MidCap Financial strong sourcing and underwriting capabilities. Our underwriting on MidCap source loans has proven to be sound. Based on data since mid-2016, which is the approximate data upon which we began utilizing our co-investment order, our annualized net realized and unrealized loss rate is around 1 basis point on loan sourced by MidCap Financial. We think this performance data shows how well the strategies performs. Our non-accrual rate remains very low. No investments were placed on non-accrual status during the quarter. At the end of December, investments on non-accrual status totaled $5.7 million or 0.2% of the total portfolio at fair value.

We believe these strong credit metrics reflect the way in which we’ve prudently constructed our 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. Importantly, MFIC benefits from MidCap Financial’s large dedicated portfolio management team with over 60 investment professionals which helps identify and address issues early. It’s also important to note that MidCap Financial leads and serves as administrative agent on the vast majority of our deals which provides meaningful downside protection. As agent, we are in active dialogue with the borrower and have enhanced information flow which allows us to be proactive in resolving credit problems.

Moving on to Merx, as discussed previously we are focused on reducing our investment in our aircraft leasing and servicing business. 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 debt and the MFIC’s investment in Merx over time. As a reminder, Merx started the year with 57 planes and at the end of December, Merx own 31 aircraft which reflects 8 aircraft that were sold during the December quarter. The 8 aircraft were sold for approximately our September 30 value and the cash proceeds were used to pay-down debt, thus providing additional de-risking to the remainder of our investment in Merx. As of December 31, 2023, our investment in Merx totaled $191 million, representing approximately 8% of the total portfolio of fair value, a decrease of over $70 million or 27% compared to the end of 2022.

For the December quarter, Merx paid approximately $9 million including $2 million of interest and a $7 million return of capital. For the full year, Merx paid MFIC approximately $84 million including $8 million of interest and $76 million return of capital. With that, I will now turn the call over to Greg to discuss our financial results in detail.

Gregory Hunt: Thank you, Ted, and good morning everyone. Beginning with our financial results, net investment income per share for the December quarter was $0.46, which reflects strong recurring interest income and strong prepayment income. For the quarter, prepayment income was $3.5 million and dividend and fee income was approximately $1 million combined. PIK income remains very low, representing approximately 1.3% of total investment income for the quarter. GAAP net income per share for the quarter was $0.51 which includes the net gain in our investment portfolio. Results for the quarter correspond to an annual return on equity based on net investment income of 11.9% and an annualized ROA based on net income of 13.3%. MFIC’s NAV per share at the end of December was $15.41, an increase of approximately $0.13 or 1% from the end of September.

The $0.13 increase reflects net investment income of $0.46, which is $0.08 above the $0.38 distribution and a $0.05 gain on the portfolio. Additional details on the net gain are shown on Slide 17 in the earnings supplement deck. Net expenses for the quarter were $42.2 million, up $1.9 million compared to the prior quarter, primarily due to an increase in interest expense. As discussed on last quarter’s call, in early November, MFIC closed its first CLO transaction, issuing $230 million of notes at a cost over SOFR of 240 basis points. The CLO has a reinvestment period of four years. And in December, we priced $80 million of 5-year non-core to unsecured notes in the $25 par market with a fixed coupon of 8%. This unsecured issuance effectively pre-funds a portion of our unsecured debt maturing in March of 2025.

Proceeds from both transactions were used to pay down borrowings under our revolving credit facility. At the end of December, unsecured debt represented 38% of total principal debt outstanding compared to 33% at the end of September. As a result of these two transactions, the weighted average interest rate on our debt for the quarter was 6.94% up from 6.76% from the prior quarter. We believe it was prudent to diversify and extend the maturity of our funding sources. We intend to continue to evaluate and monitor our capital raising transactions going forward. Management fees totaled $4.1 million for the December quarter, essentially flat to the prior quarter. As a reminder MFIC’s base management fee was reduced to 1.75% on equity beginning January 1, 2023.

And it’s one of the only listed BDCs to charge management fees on equity, which we believe provides strong shareholder alignment with a focus on net asset value. Gross incentive fees totaled $6.3 million for the December quarter. As a reminder, our incentive fee on income is 17.5% and includes a total return hurdle with a rolling 12 quarter lookback. In 2023, net investment income outpaced dividends as we chose to retain earnings in grown assets. As a result, we accrued approximately 1.1 million of excise tax during the December quarter, which is included in our general and administrative expenses on our statement of operations. Our current estimates of undistributable taxable income or spillover income at the end of 2023 was approximately $0.92 per share.

We will continue to monitor our undistributed earnings as part of our capital management consideration. Moving to our balance sheet, MFIC has net leveraged with 1.34x as of December 31, 2023, compared to 1.4x at the end of September, 2023, reflecting $47 million of net repayments during the quarter and the increase in net assets from retained earnings and the net gain on portfolio. This concludes our remarks. Operator, please open up the call to questions.

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Q&A Session

Operator: [Operator Instructions] Our first question comes from Mark Hughes with Truist. Please go ahead.

Mark Hughes: Yes, thank you. Good morning. You had suggested your position to generate NII ahead of the dividend, something the foreseeable future, with the forward curve as it is now, have you modeled out, kind of how durable that should be? Any time period you want to share in terms, of your thinking about that ability to pay the dividend?

Gregory Hunt: Yes, I mean I think we’ve been Mark, we’ve been very disciplined in keeping our dividend at the $0.38 as we look out – to the curve, the forward curve. And we’re confident at this point given where we are that in the near future, which is let’s say the next four to eight quarters, we have coverage on that $0.38 dividend.

Mark Hughes: Understood. And then from a credit perspective, you all seem to be in very good shape. Interest coverage was steady sequentially. Do you think there will be more of a buildup of pressure kind of across the sector, given the higher for longer perhaps, and still choppy economy. Do you think it’s going to get worse, for the sector, or do you think this is the – maybe a reasonably steady state?

Ted McNulty: Hi, Mark. Yes, I mean I think we’re seeing two things. On one side of the coin, we’re still seeing revenue and EBITDA growing in our underlying portfolio companies, which is helpful. And then, if we do have higher for longer that’s going to – put pressure on the company’s ability, to continue to invest in the business. Right now it still feels like, it still feels like a pretty good place. I think, if you – asked most investment folks a year ago, or two years ago, everyone was thinking that there would be a harder landing than what we’ve had. And so, we’ve all been pleasantly surprised by the rather benign credit environment. And I think, as we mentioned on the call, we don’t see anything that other than the pressure from high interest rates that would cause, any concern.

Mark Hughes: And then anything in healthcare, maybe some discussion of pressure on reimbursements, fee schedules, higher labor costs within your healthcare exposure, how are you positioned relative, to some of these risk factors?

Tanner Powell: Yes. I think we’ve, every quarter we take a look at the portfolio, in different sectors and what the themes are that, we need to be concerned about, either from a top down perspective, or that we see bubbling up from a bottoms up perspective. And when we were going through, the portfolio this past quarter, yes I think the answer is not zero, but it’s very, very small in terms of exposure, to in particular the labor issue. And then on reimbursement, I mean this is certainly an item that is at the forefront of mines. And not surprisingly, we, like other lenders, do our best, to not take outright stroke of pen reimbursement risk. And while, it certainly is there to some extent to-date, as we look to Ted’s point, when we look very critically at our exposures within healthcare seem, to be managing those challenges that are – you kind of well publicized across the space.

Mark Hughes: Appreciate it. Thank you.

Operator: Thank you. Our next question comes from Casey Alexander with Compass Point. Please go ahead.

Casey Alexander: Yes, good morning. If I was a better analyst, I’d probably know the answer to this question. But with Merx, is the remaining planes, are they plane specific? Some of the planes, if they’re sold, have to go to the securitization? Some of the planes, if they’re sold, would result in a paydown of the revolver, or is it a pool? And if it’s a pool, then when does it turn more to the revolver, as opposed to paying down the securitization?

Tanner Powell: Thanks, Casey, for the question. So, we have on – about 22 of the planes remaining sit within two securitizations, called [MAPS-18 and MAPS-19]. And the other claims, the other eight, or so are in a joint venture that we have, that we’re 15% of. So the proceeds from the joint venture, in selling those assets would go to pay down, the capital you know, pay down our capital that we have invested, in the portfolio right away. Within the securitizations that capital – the sale of those planes, will go to pay down debt. For example, during ’23, we paid down approximately $240 million worth of debt inside of those securitizations with the sale of over 11 planes.

Casey Alexander: Okay. All right. Secondly, Greg, with the 8% unsecured note, did you consider swapping that into a floater, given the fact that, the forward curve suggests that rates, could start to get easier, over the course of the next couple of years?

Gregory Hunt: We did consider it, but we have a two-year call provision. And kind of looking at the curve, we decided at this point, and we can always change our decision, we have not swapped the 8% note.

Casey Alexander: Okay. And then my last question is, and you guys is, if everything goes as you expect, or suspect then it will in relation to the merger. Do you have, you know, sort of a guideline for when you think, assuming that the vote goes the right way, that that deal could close? When should we be thinking about it, actually consummating?

Ted McNulty: Yes, I think, you know, as Tanner mentioned in the opening comments, we’re limited to what we can say. I can say that we continue to work on this standard review in the comments from the SEC, and we expect that to be completed in the near future. And then after that, once our N14 is effective, we can comment on the timing, more directly.