New Mountain Finance Corporation
Q2 2013 Earnings Call Transcript

Published: 8 Aug 2013

[Operator:]

Good morning, and welcome to the New Mountain Finance Corporation Q2 2013 Earnings Conference Call and Webcast. All participants will be in listen-only mode. (Operator Instructions) After today's presentation there will be an opportunity to ask questions. (Operator Instructions) Please also note this event is being recorded. I would now like to turn the conference over to Rob Hamwee, CEO. Please go ahead Sir.

[Rob Hamwee:]

Thank you and good morning everyone. With me here today is Steve Klinsky, Chairman of NMFC and CEO of New Mountain Capital; and Dave Cordova, CFO of NMFC. Steve Klinsky is going to make some introductory remarks. Before he does, I would like to ask Dave to make some important statements regarding today's call.

[Dave Cordova:]

Thank you, Rob. I would like to advice everyone that today's call and webcast are being recorded. Please note that they are the property of New Mountain Finance Corporation and that any unauthorized broadcast in any form is strictly prohibited. Information about the audio replay of this call is available in our earnings press release. I would also like to call your attention to the customary Safe Harbor disclosure in our August 7, 2013, press release and on page two of the slide presentation regarding forward-looking statements. Today's conference call and webcast may include forward-looking statements and projections, and we ask that you refer to our most recent filings with the SEC for important factors that could cause actual results to differ materially from those statements and projections. We do not undertake to update our forward-looking statements or projections unless required by law. Any references to New Mountain Capital or New Mountain are referring to New Mountain Capital, LLC or its affiliates and may be referring to our investment advisor, New Mountain Finance Advisers BDC, L.L.C. where appropriate. To obtain copies of our latest SEC filings and to access the slide presentation that we will be referencing throughout this call, please visit our website at www.newmountainfinance.com or call us at 212-720-0300. At this time, I would like to turn the call over to Steve Klinsky, the Chairman of New Mountain Finance Corporation, who will give some highlights beginning on page four of the slide presentation. Steve?

[Steve Klinsky:]

Thanks everybody. Before turning the call back over to Rob and Dave, I wanted to welcome you all to New Mountain Finance Corporation's second quarter earnings call for 2013. Rob and Dave will go through the details, but I'm once again pleased to present the highlights of another strong quarter for new Mountain Finance. New Mountain Finance's adjusted net investment income for the quarter ended June 30, 2013, was $0.50 per share. After deducting the one-time YP distribution of $0.12 per share our pro forma adjusted net investment income was $0.38 per share, which exceeds our previously announced range of $0.33 to $0.35 per share, and more than covers our previously announced Q2 dividend of $0.34 per share. The company's book value on June 30th was $14.32 per share, an increase of 1% from Q1 and an all time high for the company. We're also able to announce our regular dividend for the quarter ending September 30, 2013. The regular dividend will again be $0.34 per share, consistent with our previously communicated view that we have reached a fully ramped steady state dividend level. Additionally, we will be paying a $0.12 per share special dividend this quarter from the proceeds of a distribution we received from one of our equity holdings YP LLC. The credit quality of the company's loan portfolio continues to be strong with once again no new loans placed on non-accrual this quarter. We have had only one issuer default since October 2008 when the debt effort began, and it represented just 0.6% of the cost basis of our existing portfolio, and under 0.3% of cumulative investments made to-date. New Mountain Finance continue to expand its asset base in Q2. The company invested $150 million in gross originations in Q2, largely deploying the proceeds from June's $29 million equity capital raise and related credit facility upsizing. Targeted yields on new investments continue to be consistent with our previously communicated expectations. Our portfolio continues to emphasize positions in recession resistant, acyclical industries pursuant to New Mountain's overall strengths and strategy. We continue to be very pleased with the progress of New Mountain Finance to-date and we are pleased to address you as fellow shareholders as well as management. With that, let me turn the call over to Rob Hamwee, New Mountain Finance Corporation's Chief Executive Officer.

[Rob Hamwee:]

Thank you, Steve. As always I would like to start with a brief review of NMFC and our strategy. As outlined on Page 5 of our presentation, NMFC is externally managed by New Mountain Capital, a leading private equity firm, with more than $9 billion of assets under management, and approximately 100 staff members, including nearly 60 investment professionals. NMFC takes New Mountains approach to private equity and applies it to corporate credit with a consistent focus on defensive growth, business models, and extensive fundamental research. Some of the key hallmarks of the defensive growth business models include acyclicality, sustainable sector growth drivers, high barriers of competitive entry, niche market dominant, repetitive revenue, variable cost structures, and strong free cash flow. With a historically successful business model focused approach in mind, our mandate since the inception of New Mountains debt investment program in 2008 has been to primarily target what we believe to be high quality business that demonstrate most or all of the defensive growth attributes that are important to us, and to do so with an industry's that are already well researched by New Mountain. Or more simply put, we invest in recession in each different businesses that we really know and that we really like it. We believe this approach results in a differentiated and sustainable model that will allow us to generate attractive risk adjusted rate of return across changing market cycle and market condition. To achieve our mandate, we utilize the existing New Mountain investment team as our primary underwriting resource. Turning to Page 6, you can see our total return performance from our IPO in May 2011 to August 2nd, 2013. We continue to be very pleased with both our absolute and relative return performance. As outlined on Page 7, credit market saw a significant volatility in late May and June, as long-term treasury rates spike by over 100 basis points. This served as a catalyst for meaningful outflows in high yield market, which in turn grow credit spreads higher. The market has stabilized so far in Q3 and credit spreads have recovered somewhat. Recent history has shown that market conditions can change quickly. We would like to reemphasize that New Mountain Capital and accordingly NMFC have always been proactively focused on defensive acylical business models and that our financing has turned out until late 2016 and not subject to traditional mark-to-market margin cost. Given the recent rise in long-term interest rates, and the renewed focus in the market on the possibility of future short-term and long-term rate increases, we wanted to highlight NMFC's defensive positing relative to this potential issue. If you can see on Page 8, 88% our portfolio is invested in floating rate debt. Therefore, even in the phase of the material rise in interest rates, assuming a consistently shaped yield curve, we would not expect to see a significant change on our book value. Furthermore, as the table at the bottom of the page demonstrates, a meaningful rise in short-term rates will generally increase our NII per share with the only exception being a modest drive having a negative impact as the cost of our borrowing rise, while our interest income does not initially go up given the presence of LIBOR floor is on our assets. Our singly highest priority continues to be our focus on risk control and credit performance, which we believe overtime, is the single biggest differentiator of total return in the BDC space. If you refer to Page 9, we once again layout the cost basis of our investments, with the current 6/30/13 portfolio and our accumulated investments since the inception of our credit business in 2008. And then, show what if anything has migrated down the performance flatter. In Q2, no assets had negative credit migration. We continue to have one SLF asset with a cost of $13.5 million and the fair market value of $8.9 million that previously migrated from internal rating of 2 to an internal rating of 3, indicating operating performance materially below our expectations but no near or medium term expectation for non-accrual. We continue to have only one Portfolio Company on non-accrual representing a cost 0.6% of our total portfolio and under 0.1% of fair market value. Since the inception of our credit efforts in 2008, we've made investments in 116 portfolio companies of which only one has migrated to non-accrual. Over 99% of our portfolio at fair market value has currently rated 1 or 2 on our internal scale. Pages 10 and 11 show the operating company and SLF, respectively leverage multiple for all of our holdings above $7.5 million when we entered into an investment and leverage level for the same investment as of the end of the current quarter. Well, not a perfect metric, the asset by asset trend and leverage multiple is a good snapshot of credit performance and helps provide some degree of empirical, fundamental support for our internal ratings and marks. As you can see by looking at the two table, leverage multiples are in almost all cases trending in the right direction, and even more importantly, no single company in either page has had a material increase in leverage multiple with the exception of one loan in the SLF. Page 12, provides a little more detail on the $0.12 special dividend for our investment in YP. As you can see, we made a relatively modest investment of $10 million into this business a little over a year ago, primarily in the form of second lien debt. The business has outperformed our expectations in terms of both operating performance and cash flow generation, resulting in a significantly recapitalization transaction. We've now been fully repaid this 15% interest on our debt position, and have cumulatively received $6.9 million of dividend on our $500,000 equity investment. We continue to own approximately 1% of the equity in the company. And as part of the recapitalization, we invested $31 million into a new first lien term loan. On Page 13, we show a table depicting how NMFC's have publicly traded flow have increased by 350% based on the five equity offerings we have completed since our IPO. We now have $38.1 million shares in our flow, representing 85% of the total shares outstanding and liquidity and daily trading volume have increased commensurably. The chart on Page 14; helps to track the company's overall economic performance since its IPO. At the top of the page, we show how the regularly quarterly dividend is being covered at of net investment income. As you can see, we continue to cover 100% of our cumulative regular dividend out of NII. And on bottom of the page, we focused on below the line items. First, we look at realized gains and realized credit and other losses. While you can see the individual, annual, and quarterly data, I draw your attention to the number highlighted in blue, which shows cumulative net realized gains of $19.1 million into our IPO. Next, we look at unrealized depreciation. As you can see highlighted in grey we accumulated net unrealized depreciation of $13 million. For clarity, our mark-to-market loss on our one defaulted investment, ATI, of $5.50 million is reflected in this number along with various other mark-to-market gains and losses reflected on our schedule of investments. Finally, we combined net realized with unrealized appreciation to derive the final line in the table, which in the yellow box shows a current cumulative net realized and unrealized depreciation of $32.1 million. The point here is to show that on both the realized and combined realized unrealized basis, we have offset any credit losses or impairments below the line gains also in the portfolio. In fact, by this methodology we have built a $32 million cushion to offer any future credit losses some of which we have paid out of special dividend. Our market driven volatility around unrealized appreciation and depreciation may cause the bottom-line number to vary over time through economic gains and losses will accumulate in the realized bucket where we will start to retain a positive balance. Moving on to portfolio activity, as seen on Page 15, in Q2, we made significant investments in six portfolio companies and have total growth originations of $150 million. As you can see, the bulk of the investment activity came later in the quarter when we were able to take advantage of the market volatility I described earlier. The payments totaled $115 million and opportunistic sales were $1 million for total net origination less sales of $34 million. All the investments in keeping with our strategy are in industries and businesses that are well known to us through our historical private equity activities. For example, Deltek is an enterprise software business we owned in our private equity fund for over seven years. The in-depth knowledge of the company derived from our private ownership gives us great confidence in the accuracy over underwriting of the prospects of the business going forward. Pages 16 and 17 show the impact of Q2 investment and disposition activity on asset types and yields respectively. Asset net origination type was modestly skewed towards first lien investments. Yields on originations and disposals were broadly consistent. The modest increase in the portfolio yield for maturity from 10.4% to 10.7% was entirely a function of an increase in the forward LIBOR curve. Moving on to Page18, we continue to selectively find attractive opportunity to deploy capital. We continue to operate with our credit facilities, fully deployed, allowing for an optimized level of earnings, just like in recent quarters where we raised only as much capital as we have visibility to deploy in the near term, any balance sheet expansion from here will be a function of both how the pipeline of attractively priced and structured opportunities develops going forward and the magnitude of repayments received. In terms of the portfolio review on Page 19, the key statistics as of 6/30 look very similar to 3/31. As always we maintain a portfolio comprised of companies in the defensive growth industries like software, healthcare, business services and education that we believe will outperform in an uncertain economic environment. Finally, as illustrated on Page 20, we have a broadly diversified portfolio with our largest investment at 4.2% of fair value and the top 15 investments accounting for 46% of fair value consistent with past quarters. With that, I will now turn it over to our CFO, Dave Cordova, to discuss the financial statements and key financial metrics. David?

[Dave Cordova:]

Thank you, Rob. For more details on the financial results in today's commentary please refer to the Form 10-Q that was filed last evening with the SEC. Before we turn to Slide 21, I want to mention that we have included a structured chart as Appendix A in the presentation. Similar to prior calls, I will spend a moment reviewing the company's structure as a brief refresher. The structure was set up similar to an UPREIT structure whereby the public company Pubco has no direct operations of its own and its sole asset is its units of our operating business OpCo. Today the other units of OpCo are held by a private BDC owned by New Mountain’s private equity fund, AIV Holdings. This structure is a master feeder whereby the financial statements for OpCo flow to Pubco and AIV Holdings pro rata based on the respective ownership. All discussion throughout this call and presentation is focused on OpCo and its operations. Additionally, OpCo owns the equity of a non-recourse vehicle, the SLF. This vehicle originates lower yielding first lien loans, but with greater leverage at 2

[Rob Hamwee:]

Thanks, Dave. Well, once again we do not plan to give explicit forward guidance. It continues to remain our intention to consistently pay $0.34 per share on a quarterly basis for future quarters, so long as the adjusted NII covers the dividend in line with our current expectations. In closing, I would just like to say that we continue to be extremely pleased with our performance to-date. Most importantly, from a credit perspective our portfolio continues to be very healthy. Once again, we like to thank you for your support and interest and at this point turn things back to the operator to begin Q&A. Operator?

[Operator:]

Thank you, sir. We will now begin the question-and-answer session. (Operator Instructions) Our first question comes from Greg Mason of KBW. Please go ahead.

[Greg Mason:]

First, could you talk about the, I believe kind of $9 million of net depreciation in the quarter, obviously no new non-accruals so that was positive. What would you ascribe as the breakout of mark-to-market versus credit related in the [marks] [ph] this quarter?

[Rob Hamwee:]

Yeah, I mean it was almost all mark to - first of all, remember over half of it, $5 million, was just re-classing the YP that was in unrealized gain into the income statement, right. So the real number is $4 million. And of that $4 million I would say that the significant majority of that was just the market that moved down from March 31st to June 30th and impacted some marks. And I really would say there was really no material idiosyncratic credit driven net impact there.

[Greg Mason:]

And then, could you talk about one bigger picture and then kind of a smaller picture. Your ability to maintain the yields in the portfolio on the pro forma adjusted you had 10.7% yield last quarter, 10.7% yield this quarter. Can you just talk about what you are seeing in terms of yield compression? And then, also just kind of define that a little more, the 2Q originations were 10.1% yield in the sales and repayments were 10.8%. So also struggling little bit with how to connect the 10.7% last quarter to staying at 10.7% this quarter, so big picture and then smaller picture question?

[Rob Hamwee:]

Yeah, I’ll start with smaller picture, I mean, that's just the modest delta between the 10.1% and the 10.8% and the modest ins and outs. So if you rounded it to two decimals you would obviously see some slight decline. But at one decimal it's just -- it's not enough 70 bps differential on 10% portfolio churn it's just not enough to move it at one decimal place. On the macro, looks that's obviously an important strategy and challenge for us I think we were getting more worried right until things moved our way in the back half of the second quarter, we could have seen this moving three or four times now over the last couple of years where spreads seem to compress and then something happens in the world. So we're currently and you can see it initially in our early originations for this quarter. We're just looking at our pipeline we think we have reasonable comfort at this point that without changing our risk profile we can maintain those yields and that is obviously our -- after making sure we have no issues on the credit side that's our second biggest challenge.

[Operator:]

Our next question comes from J.T. Rogers of Janney Capital Markets. Please go ahead.

[J.T. Rogers:]

First one, just wondering what you guys are seeing in terms of private equity sponsor activity on the new M&A front. I had some commentary from some of your competitors that that is increasing. And then, may be also sort of willingness of business owners to sell given the current environment in the middle market?

[Rob Hamwee:]

Yeah. And I would say we obviously have a very good insight into that through both our own activities but also through the activity of our PE business. We are seeing significantly increased activity and would expect a pretty busy post Labor Day period through the end of the year. I don't know Steve if you want to add anything to that.

[Steve Klinsky:]

Well, for New Mountain itself on private equity, our new acquisition flow was actually very, very good. But I think it's important - I think it’s true of New Mountain finance as well. The important thing for an organization is to build its own team up enough that it can deliver whatever the market conditions are. And so, I think New Mountain's deal flow is better on private equities, our team has gotten bigger and stronger as the years have gone on and we're trying to do the exact thing in New Mountain Finance to outweigh any kind of market currents which is the stronger team. So I think we feel good on both fronts.

[Rob Hamwee:]

Yeah. And so, to your other point in terms of seller’s willingness to transact, look I think that has increased and there are a number of reasons for that. But I think that the net effect that you're seeing, and most part, is evaluations are not low. So sellers are not giving their businesses away by any means. But I do think you're -- people have -- except some period of time for people to accustom themselves to this new post '07 environment that we're in, but I think five years later, I think the enough time had passed that people's valuation expectations are more consistent with reality and so, I do think that's part of the driver of the increased flow.

[J.T. Rogers:]

Steve you mentioned building the team, I'm just wondering how many folks have you guys added at the NMFC level and are you looking to expand further?

[Steve Klinsky:]

Yeah, we've added at all parts of the firm and all parts of the firm support NMFC. As Rob explained we used the core team as the underwriting. So we've gone actually from around 28 investment professionals back in 2007 when we launched the private equity fund three we now have over 50, including about 20 people who were former Corporate CEOs or COOs or management consultants. We built up the specialist on the New Mountain Finance team kind of in parallel to that. And so, we just keep trying to continuously improve ourselves as an organization and it works we think for all parts of the organization, including NMFC.

[J.T. Rogers:]

And just one last question. I was just wondering is there any place in the capital structure that you find is offering the best risk return right now that unit tranche Mezzanine first lien loan, second lien loans?

[Rob Hamwee:]

Yeah, I wouldn't say there is any specific outliers. Sometimes in the past, we said that we're seeing particularly compelling value in first lien, other times in more junior portions. I think it's roughly in balance, so it's more about finding the right business. And then, it is there or is there not an opportunity somewhere in the capital structure to attractively deploy capital. But no, there is no obvious dislocation at this point in time in our judgment in any particular layer of the capital structure.

[Operator:]

(Operator Instructions) Our next question comes from Jonathan Bock of Wells Fargo Securities. Please go ahead.

[Jonathan Bock:]

Rob, one question for you. As it relates to the prices one willing to pay for a certain leverage level, can you give us a sense of your comfort level in terms of all in leverage for deal whether it is 5 or 6.1 or 6.5 times? And what you believe to be kind of the appropriate rate as leverage continually creeps up for very strong and acyclical and very healthy companies that you target?

[Rob Hamwee:]

Yeah, and that's a good question. I mean, Jon we're -- well, we obviously are looking at absolute leverage multiples. I think we start by looking at enterprise value relative to leverage multiples, right. So I'll say, I'd rather be 6 times levered on a 11 times business, and 4.5 times levered on a 5 times business. And that obviously, means you have to have high degree of confidence in your judgments around that denominator so that's a critical component, right if you think its 11 but it really what 7, you're going to find yourself in a bad place. And so, that's where I think the private equity D&A and team is so critical in helping us make those judgments, in really making those judgments. So that being said obviously, as absolute leverage creeps up you do have to look at coverage ratios and make sure that companies are properly hedging themselves from an interest rate perspective. And you obviously, will want to charge more for any given level of leverage for the same company. I can’t sit here and give you a sort of hard and fast rule though that five times leverage equals X percent and six times leverage equals Y percent. It really is going to be situation specific. And we also look not just that obviously the last dollar of leverage, but the average dollar of leverage, right. The different between being a thin five to six slug slice of mass under is being a two to six thick second lien or something like that. So, we have to take that into account as well. All I can say is we are quite conformable. And I think certainly the margin we could be getting more yield if we wanted to, but we are focused first and foremost on what we call zero loss underwriting, where we are not taking a portfolio approach assuming some percent are going to go bad. We are really each and every one of investments we make we believe has in our lines in obvious path to full repayment. Obviously, at some point we are going to make a mistake or two, but we are focused on kind of keeping our yield consistent with the minimal amount of risk. And I still think we are able to pull that off despite the modest creeping we have seen in leverage multiples like, you say in the highest quality businesses.

[Jonathan Bock:]

I appreciate that. And let’s say the current environment remains the same and perhaps gets tighter assuming the Fed, there is lot of big assumptions in that, but let us just assume that’s the case. What would you say portfolio velocity or more importantly, repayment activity looks like in the event the status quo at the current market is remains the same?

[Rob Hamwee:]

Yeah, I think we have always guided towards roughly a third of the portfolio churning in environment like you described. I think that still our expectation may be if we get even tighter from here, you will see that move up to 35% or 40%. So, that kind of how we are running the business again. And I think that the data validates that as well as just our insight into looking ahead from what we know about prophecies towards for the next two or three months, when we do have visibility and that’s really how we manage the business. And we always first and foremost make sure that we have enough quality originations to replace our churn, which is significant and then, and only then do we think about raising incremental capital to fund incremental deal flow.

[Jonathan Bock:]

I appreciate that. And then lastly, as we look at maybe a few newer transactions that were perhaps done at relatively attractive yield, just perhaps interested in the 17% rate that once getting on preferred shares in Black Oak, which we find very attractive in this environment. Maybe what are some of the unique items that are part of that investment that allows you to earn such a substantial risk adjusted return relative to perhaps the markets today, which are closer to 10% to 12%?

[Rob Hamwee:]

Yeah. I think one of the items is to know there is a bit of a short-term security. So, it’s not we expect it to get taken out in the first half of next year. So, we were able I think to, so that type of callability for this type of junior security we are able to charge a near-term rate. It was not quite as attractive sale as it appears it like to be getting 17% for the next three or four years, but that is not the case. And then secondly, there was a timing element, there was a reason why the issuer needed to move quickly and we were able to do that given some relationships and knowledge that we had and get paid for that. And thirdly, I think the fact that it isn’t that preferred as opposed to debt, I think you always get paid extra for that because there is just lots of other natural buyers, who don’t have a bucket for preferred.

[Jonathan Bock:]

And last question I understand why YP congrats that was an excellent investment. So, as one, participated in the refinance, which is also part of a very large dividend recap. What percentage of new investments today were recap, dividend recapitalization?

[Rob Hamwee:]

Just for the quarter?

[Jonathan Bock:]

Yeah, for about the 150 and originations that you made, may be ballpark, how many of those transactions were involved in dividend recapitalization?

[Rob Hamwee:]

I would tell you the exact number is going to be about 30%.

[Operator:]

And this concludes our question-and-answer session. I would like to turn the conference back over to our leaders for any final remarks.

[Steve Klinsky:]

Yeah. Well, thanks everyone for your time and your interest and your support. We appreciate it and look forward to speaking next quarter and of course in the interim. Always happy to take calls at any point in time. So, thanks again and enjoy the day. Bye, bye.

[Operator:]

The conference is now concluded and we thank you all for attending today’s presentation. You may now disconnect and have a wonderful day.