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Edited Transcript of SUNS earnings conference call or presentation 22-Feb-19 4:00pm GMT

Q4 2018 Solar Senior Capital Ltd Earnings Call

NEW YORK Feb 26, 2019 (Thomson StreetEvents) -- Edited Transcript of Solar Senior Capital Ltd earnings conference call or presentation Friday, February 22, 2019 at 4:00:00pm GMT

TEXT version of Transcript

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Corporate Participants

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* Bruce John Spohler

Solar Senior Capital Ltd. - COO

* Michael S. Gross

Solar Senior Capital Ltd. - Chairman, President & CEO

* Richard L. Peteka

Solar Senior Capital Ltd. - Treasurer, Secretary & CFO

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Conference Call Participants

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* Finian Patrick O'Shea

Wells Fargo Securities, LLC, Research Division - Associate Analyst

* Mickey Max Schleien

Ladenburg Thalmann & Co. Inc., Research Division - MD of Equity Research & Supervisory Analyst

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Presentation

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Operator [1]

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Good day, ladies and gentlemen, and welcome to the Solar Senior Capital Fourth Quarter 2018 Earnings Conference Call. (Operator Instructions) As a reminder, this conference call is being recorded.

I would now like to introduce your host for today's conference, Michael Gross, Chairman and Chief Financial Officer (sic) [Chief Executive Officer]. You may proceed.

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Michael S. Gross, Solar Senior Capital Ltd. - Chairman, President & CEO [2]

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Thank you and good morning. Welcome to Solar Senior Capital Ltd.'s earnings call for the fiscal year ended December 31, 2018.

I'm joined here today by Bruce Spohler, our Chief Operating Officer; and Rich Peteka, our Chief Financial Officer.

Rich, would you please start off by covering the webcast and forward-looking statements?

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Richard L. Peteka, Solar Senior Capital Ltd. - Treasurer, Secretary & CFO [3]

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Of course. Thanks, Michael. I'd like to remind everyone that today's call and webcast are being recorded. Please note that they are the property of Solar Senior Capital Ltd. and that any unauthorized broadcast in any form are strictly prohibited.

This conference call is being webcast on our website at www.solarseniorcap.com. Audio replay of this call will be made available later today as disclosed in our press release.

I'd also like to call your attention to the customary disclosures in our press release regarding forward-looking information. Statements made in today's conference call and webcast may constitute forward-looking statements, which relate to future events or our future performance or financial condition. These statements are not guarantees of our future performance, financial condition or results and involve a number of risks and uncertainties.

Actual results may differ materially as a result of a number of factors, including those described from time to time in our filings with the SEC. Solar Senior Capital Ltd. undertakes no duty to update any forward-looking statements unless required to do so by law.

To obtain copies of our latest SEC filings, please visit our website or call us at (212) 993-1670.

At this time, I'd like to turn the call back to our Chairman and Chief Executive Officer, Michael Gross.

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Michael S. Gross, Solar Senior Capital Ltd. - Chairman, President & CEO [4]

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Thank you, Rich. During a volatile fourth quarter in the capital markets, Solar Senior Capital delivered a strong operating performance. Given the sell-off in the liquid leveraged loan market, which impacted the valuation for many of our private loans at year-end, SUNS' net asset value was down 3% to $16.30 per share. Year-to-date, the leveraged loan index has already recovered the majority of the fourth quarter sell-off.

During the fourth quarter, SUNS delivered another consistent net investment income performance with GAAP NII of $0.35 per share for the fourth quarter covering our distributions. Also, for the fiscal year, SUNS' earnings of $1.41 per share fully covered its distribution.

At December 31, the fundamentals of our portfolio companies remain strong. At quarter end, over 98% of our comprehensive portfolio is invested in first lien senior secured loans comprised of approximately 40% asset-based loans and 58% cash flow loans.

The general market consensus is that we are late in the credit cycle. Our defensive positioning in first lien loans and our niche specialty ABL verticals should enable us to perform well either during a downturn or continued strong economic environment.

Following the end of the year turmoil, we are seeing some positive signs in our pipeline of an improved upper middle market cash flow lending environment. As a reminder, Solar Capital Partners now has the ability to underwrite and hold across its platform first lien loan tranches of up to $200 million.

This scale was achieved through 2 important strategic initiatives in 2018. The first initiative was a new asset coverage requirement. On October 11, the shareholders of SUNS and our sister BDC, SLRC, overwhelmingly approved the reduction in the asset coverage requirements, thereby accelerating the timing of the modification which had initially been approved by the company's Board of Directors in early August. As a result, on October 12, Solar Senior Capital's and our sister company, Solar Capital's, asset coverage requirements changed from 200% to 150%.

Given our investment focus on senior secured first lien loans, which have been financed at much higher leverage levels in private funds and banks, we have increased our target leverage ratio to a range of 1.25x to 1.5x debt to equity. This new target range allows for a meaningful and substantial cushion to both the net asset ratio requirement and leverage covenant on our credit facility, which we refinanced to accommodate the increase to the new regulatory leverage.

Importantly, we want to reiterate that the asset coverage modification will not change our investment strategy. It does, however, enhance Solar Senior Capital's ability to further expand our specialty finance lending platform.

The consolidation of FLLP in the third quarter made possible by the new asset coverage ratio freed up significant 30% capacity, giving us the flexibility to make acquisitions and expand our specialty finance platform.

Our team has been actively targeting new verticals, though during 2018 we were cautious as specialty finance company valuations became overheated. It appears the volatility in the fourth quarter has tempered some of these high valuations, and we're carefully rebuilding our commercial finance acquisition pipeline.

We intend to move closer to our new target leverage range by growing our portfolio over time when the market opportunity presents itself. Consistent with our long-standing conservative investment approach, we will be prudent with the use of leverage. We view the increased leverage flexibility as simply another investment and risk management tool.

The second initiative in 2018 involved increasing the scale of SUNS' investment adviser, Solar Capital Partners, to enhance its role as a solutions provider with the ability to provide for up to $200 million in a given transaction while maintaining conservatively diversified portfolios.

Scale is particularly important given our focus in cash flow lending to upper middle market sponsor-owned companies who we believe are better resourced to withstand an economic decline than their smaller peers.

During 2018, SCP closed on $2.3 billion of incremental investable capital, including leverage, across 2 private credit funds and separately managed accounts that are now co-investing alongside Solar Senior Capital and Solar Capital. This brings total investable capital across the platform to approximately $5.4 billion.

Most importantly, SUNS is already benefiting from SCP's enhanced scale and have formed new investments that were only possible by having larger hold sizes and additional 30% capacity. Bruce will provide details on this important development shortly.

With leverage of only 0.63x net debt to equity at the end of the fourth quarter, SUNS is in a strong liquidity position. At December 31, 2018, when considering the combined credit facilities of SUNS' balance sheet and at North Mill and Gemino, there's approximately $250 million of unused capacity across the platform, subject to borrowing base limitations. We will continue to be highly disciplined in deploying our available capital.

At this time, I'd like to turn the call over to our Chief Financial Officer, Rich Peteka.

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Richard L. Peteka, Solar Senior Capital Ltd. - Treasurer, Secretary & CFO [5]

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Thank you, Michael. Solar Senior Capital Ltd.'s net asset value at December 31 was $261.4 million or $16.30 per share. This compares to a net asset value of $269.7 million or $16.81 per share at September 30, 2018.

Solar Senior's investment portfolio at December 31, 2018, had a fair market value of $450.1 million in 47 portfolio companies, operating in 20 industries compared to a fair market value of $465.2 million in 49 portfolio companies operating in 21 industries at September 30.

At December 31, 2018, SUNS' net leverage decreased to 0.63x from 0.7x at September 30. Solar Senior's new target leverage is 1.25x to 1.5x debt to equity under the reduced asset coverage requirement.

From a P&L perspective, gross investment income for the 3 months ended December 31, 2018 totaled $10 million versus $11 million for the 3 months ended September 30. Net expenses for the 3 months ended December 31 were $4.4 million compared to $5.3 million for the 3 months ended September 30.

Net investment income for the quarter ended December 31, 2018 was $5.6 million or $0.35 per average share as compared to $5.8 million or $0.36 per average share for the 3 months ended September 30.

Below the line, Solar Senior had net realized and unrealized loss for the fourth quarter totaling $8.2 million compared to net realized and unrealized loss of $0.4 million for the 3 months ended September 30.

Accordingly, Solar Senior had a net decrease in net assets resulting from operations of $2.6 million or $0.16 per average share for the 3 months ended December 31. This compares to a net increase in net assets resulting from operations of $5.4 million or $0.34 per average share for the 3 months ended September 30.

Lastly, our Board of Directors declared a monthly distribution for March 2019 of $0.1175 per share payable on April 3, 2019 to stockholders of record on March 21, 2019.

At this time, I'd like to turn the call over to our Chief Operating Officer, Bruce Spohler.

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Bruce John Spohler, Solar Senior Capital Ltd. - COO [6]

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Thank you, Rich. Before I provide an update on our fourth quarter activity, let me take a minute to discuss our approach to valuation in light of the sell-off in the liquid leveraged loan market in the fourth quarter.

As Michael mentioned, this resulted in a technical markdown of our portfolio's fair market value. It is important to remember that Solar Senior is not simply a portfolio of leveraged middle market loans. Relative to most of our BDC peers, we're a unique combination of commercial finance businesses as well as a portfolio of senior secured upper mid-market cash flow loans.

Our valuation process is a combination of bottom-up, fundamental credit analysis with a top-down overlay where we look to the market technicals and various market metrics from the leveraged loan market for our cash flow loans as well as valuations of our peer specialty finance comparable companies for our commercial finance businesses.

We have applied a consistent approach to valuations throughout our history, and we believe that this bottoms-up, fundamental analysis, coupled with a top-down market technical yield analysis, is the right approach to providing fair market value.

As of today, already approximately 2/3 of the fourth quarter market decline in leveraged loans has already recovered.

Now turning to the portfolio. In the aggregate, at year-end, our investments across our 3 business lines totaled just over $580 million. This highly diversified portfolio consists of 161 borrowers with an average investment of approximately $3.6 million or 0.6% of our comprehensive portfolio. As Michael mentioned, the sell-off in the liquid leveraged loan market resulted in a technical markdown for our loans.

The majority of our NAV decline quarter-over-quarter resulted from this technical factor as well as softness in our commercial finance comparable company set that we use for valuations as well.

Measured at fair value, close to 100% of SUNS' portfolio consisted of senior secured loans, of which over 58% are in first lien cash flow loans, roughly 40% are in first lien asset-based loans and only 1.5% are in second lien secured loans and less than 0.1% is in equity.

Additionally, roughly 92% of loans had floating rate coupons, which should continue to benefit portfolio performance.

Our fixed rate exposure comes from North Mill's factoring portfolio, which contains loans with much shorter duration and higher yields.

SUNS' weighted average yield on a fair value basis for its portfolio at year-end was 10.5%.

During the fourth quarter, SUNS originated $83 million of loans and had repayments of approximately $83 million as well.

In the face of the year-end volatility with questions concerning the Fed's direction on monetary policy, we balanced caution by taking advantage of improved select investment opportunities. Originations for all of '18 totaled just over $260 million and repayments totaled just over $290 million.

Now let me provide an update on our credit quality and earnings power of the portfolio. At year-end, 100% of SUNS' portfolio was performing.

Now let me turn to the investment verticals, cash flow. At year-end, our cash flow portfolio totaled $340 million, representing 58% of our comprehensive portfolio. The cash flow portfolio is comprised of loans to 47 borrowers with an average investment of $7 million. The fair value weighted average asset-level yield was 8.1%, up slightly from the prior quarter.

Our second lien cash flow exposure approximates 1.7% or $10 million of the $580 million portfolio. We expect this to continue to decline over the coming quarters. Given our focus on maintaining a lower risk first lien portfolio, we have not made a new second lien investment in over 4 years.

At year-end, the weighted average EBITDA of our first lien cash flow portfolio was approximately $100 million. Leverage to our investment security was 4.5x on average, and our interest coverage was 2.3x on average. In addition, the weighted average revenue growth of our portfolio companies was 9% increase and EBITDA was up 4.2% at year-end, reflecting continued positive trends in our portfolio company fundamentals.

In the fourth quarter, we originated cash flow investments of $72.5 million and had repayments of $59 million. For the full year, we originated cash flow investments of $208 million and had repayments or amortization of approximately $218 million.

With the addition of the new private capital that we raised last year, which Michael referenced, SUNS is already benefiting from the platform's increased scale and ability to be a solutions provider.

During the fourth quarter, SUNS was able to participate across the Solar platform in refinancing KORE Wireless, an ABRY Partners portfolio company, in the form of an investment in their first lien refinance loan. The platform broadly committed to $100 million hold for this first lien loan and SUNS was able to invest $12 million in this loan. The loan carries an all-in yield of just under 9%.

Now let me update you on North Mill. At year-end, North Mill had a portfolio of approximately $122 million, which represented 21% of SUNS' total portfolio. It consisted of loans to 80 different borrowers with an average funded loan of $1.5 million. The weighted average asset-level yield of North Mill's portfolio was 17%, which is elevated from prior quarters due to some onetime prepayment fees that we received in the fourth quarter.

During the fourth quarter, North Mill funded new loans of $9 million and had repayments of $23.5 million. For the full year, North Mill funded $33 million of new loans and had repayments of $53.5 million.

During the fourth quarter, North Mill exited, including through liquidation, certain investments, which they do in the ordinary course of their business activities. North Mill has selectively taken reserves against the portfolio for these loans and is working to maximize the recovery.

During the fourth quarter, North Mill paid the company a cash dividend of $1.4 million, which equates to a 9% annualized yield.

Now let me turn to Gemino. Gemino at year-end had a portfolio of $108 million, representing 18% of SUNS' total portfolio. It was comprised of 34 different loans with an average loan size of just over $3 million. The weighted average asset-level yield for Gemino was 10.5%.

During the fourth quarter, we funded roughly $2 million of new loans and had repayments of roughly $1 million. For the full year of 2018, Gemino funded $22 million of new loans and had repayments of $21 million.

For the fourth quarter, Gemino paid SUNS a cash dividend of just under $1 million, equating to an 11% yield.

In summary, as Michael mentioned, in cash flow lending, we have begun to see an improved investment opportunity set for upper middle market loans as well as our niche ABL markets. We believe Solar Capital Partners, with their increased investment capacity across the platform will result in more investment opportunities for SUNS in cash flow lending and specialty finance. We will not, however, stretch for yield by taking on more risk through either second lien loans or investments in more volatile cyclical industries.

Now let me turn the call back to Michael.

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Michael S. Gross, Solar Senior Capital Ltd. - Chairman, President & CEO [7]

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Thank you, Bruce. Since the 2011 inception of SUNS, our investment and management decisions have consistently been focused on building long-term value, protecting capital and maintaining alignment with our shareholders.

In 2018, we put additional strategic building blocks in place in the form of reduced asset coverage requirements and enhanced platform scale that provides greater flexibility to drive long-term shareholder value.

Importantly, we've been prudent in the face of sustained, frothy credit markets and remain disciplined, not compromising credit quality for yield. The result is a solid portfolio foundation from which to grow.

We've maintained investment philosophy of assuming that we are late in the credit cycle, and we believe that in the current environment, it pays to be cautious. It remains to be seen whether the recent improvement in upper middle market lending opportunities will be a lasting trend, but we believe through our differentiated origination platform and diversified portfolio that we are well positioned to navigate through economic cycles.

At approximately 0.63x net debt to equity, we are underlevered relative to our target range of 1.25x to 1.5x, and we have substantial dry powder to deploy via our differentiated investment verticals. If the credit cycle does shift, we believe our history of conservatism will enable us to outperform on a relative and absolute basis, and we'll be well positioned to take advantage of market dislocations.

I would like to again express our appreciation to our shareholders and banks for their overwhelming support to approve the adoption of the modified asset coverage ratio. The greater flexibility does not change our investment strategy. Rather, it meaningfully enhances our ability to grow, build and potentially acquire niche specialty finance businesses as we continue to broaden our diversified commercial finance platform.

In addition, the reduced asset coverage requirement allows us to operate with an increased cushion to the regulatory leverage threshold, which should be a significant benefit in more volatile markets.

At last night's close of $16.96 per share, SUNS carries a yield of 8.3%, which represents a significant discount to the 6.1% implied yield of the S&P/LSTA Leveraged Loan 100 Index. Given the overall credit quality of SUNS' diversified portfolio, our differentiated origination engine and our disciplined investment philosophy, we believe SUNS represents an attractive investment on both a relative and absolute value basis.

We thank you for your time this morning and look forward to speaking to you next quarter. Operator, would you please open up the line for questions.

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Questions and Answers

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Operator [1]

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(Operator Instructions) And our first question comes from the line of Mickey Schleien with Ladenburg.

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Mickey Max Schleien, Ladenburg Thalmann & Co. Inc., Research Division - MD of Equity Research & Supervisory Analyst [2]

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I just have one question this morning. If I'm not mistaken, there was more deterioration in SUNS' NAV on a relative basis than at Solar Capital, but I'm assuming the valuation methodologies are pretty similar. What factors can you attribute that difference to?

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Bruce John Spohler, Solar Senior Capital Ltd. - COO [3]

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Sure. I think it's hard to -- I don't want to spend too much time on this call talking about Solar. But I just think from a high level your portfolio mix, as you know, is different at SUNS versus Solar in terms of Solar having life sciences, having equipment finance, having Crystal, whereas SUNS has Gemino and North Mill. So the comp sets that we look to are different and are weighted differently given their contribution to the overall portfolio. Obviously, cash flow loans are a bigger percentage also, Mickey, of SUNS' portfolio than Solar's. And so they're going to look more directly to the loan index. So it's a combination of mix factors.

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Operator [4]

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(Operator Instructions) And our next question comes from the line of Finian O'Shea with Wells Fargo Securities.

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Finian Patrick O'Shea, Wells Fargo Securities, LLC, Research Division - Associate Analyst [5]

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Just a higher level market question in regards to your additional emphasis on first lien. Just at large, this is something that frankly I can't remember the time I've heard anyone not say this and most data points or anecdotes point to all of the middle market private credit capital formation revolving around senior debt. And it also seems that second lien has gapped out a little bit or perhaps directly because of this or perhaps because they tend to be larger credits and are more liquid. So if you understand what I'm saying I'm sure by now, how do you look at this? How much more do the senior and junior markets have to diverge before you really give this a harder look?

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Bruce John Spohler, Solar Senior Capital Ltd. - COO [6]

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Sure. As you know, because we have our commercial finance businesses, and this is true at both platforms, SUNS and SLRC, as a meaningful part of the portfolios, they tend to be higher yielding and most importantly for us, they have real covenants and borrowing bases. That's true at North Mill and Gemino and as well as the Crystal and NEF platforms and life science over at Solar. So for us, it's much less, Finian, about where yields are. Obviously, we want to make as much money as possible on each investment but it really starts with, what are the structural protections? What are the covenants? What are the leverage levels? And what are the sacred rights in these documents? And that's what's troubled us over the last couple of years is the degradation of terms rather so much than price compression. And so what we're really looking for is terms to come back into the documents in the cash flow market. It's been a very long time since we've seen them in the second lien sector, which is why we haven't made a second lien investment in 4 years. The first lien loans, they do come back quickly during periods of volatility, and we saw a couple of those. We highlighted KORE. We're able to actually have covenants in Q4 in a few others. So that's really what will drive our behavior is if we can get terms. We'll blend out a nice, attractive portfolio yield between cash flow and commercial finance assets, but we want to see real teeth regardless of whether it's a cash flow loan or a commercial finance loan.

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Operator [7]

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(Operator Instructions) And I'm not showing any further questions at this time. I would now like to hand the call back over to Michael Gross, Chairman and Chief Executive Officer, for any closing remarks.

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Michael S. Gross, Solar Senior Capital Ltd. - Chairman, President & CEO [8]

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We have no additional comments, but we thank you for your time and your support. Have a good day.

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Operator [9]

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Ladies and gentlemen, this concludes today's conference. Thank you for participating and have a wonderful day.