Q2 2023 New Mountain Finance Corp Earnings Call
Participants
John R. Kline; President, Director & CEO; New Mountain Finance Corporation
Laura C. Holson; COO, CFO & Treasurer; New Mountain Finance Corporation
Steven Bruce Klinsky; Chairman of the Board; New Mountain Finance Corporation
Bryce Rowe
Ryan Lynch; MD; Keefe, Bruyette, & Woods, Inc., Research Division
Presentation
Operator
Hello, and welcome to the New Mountain Finance Corporation Second Quarter 2023 Earnings Call. (Operator Instructions) Please note this event is being recorded.
I would like now to turn the conference over to John Kline, President and CEO. Please go ahead.
John R. Kline
Thank you, and good afternoon, everyone. Welcome to New Mountain Finance Corporation's Second Quarter 2023 Earnings Call. On the line with me here today are Steve Klinsky, Chairman of NMFC and CEO of New Mountain Capital; Robert Hamwee, Vice Chairman of NMFC; and Laura Holson, COO, interim CFO of NMFC. Steve is going to make some introductory remarks, but before he does, I'd like to ask Laura to make some important statements regarding today's call.
Laura C. Holson
Thanks, John. Good afternoon, everyone. Before we get into the presentation, I would like to advise 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 August 2 earnings press release.
I would also like to call your attention to the customary safe harbor disclosure in our press release and on Page 2 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 to by law. 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.
At this time, I would like to turn the call over to Steve Klinsky, NMFC's Chairman, who will give some highlights beginning on Page 4 of the slide presentation. Steve?
Steven Bruce Klinsky
Thanks, Laura. It's great to be able to address you all today, both as NMFC's Chairman and as a major fellow shareholder. Adjusted net investment income for the second quarter was $0.39 per share, more than covering our $0.32 per share regular dividend that was paid in cash on June 30. Our earnings improved by $0.08 compared to Q2 of last year and $0.01 sequentially over Q1 of 2023.
Our net asset value per share remained stable at $13.14 compared to last quarter, demonstrating continued strong credit performance across our portfolio. We believe our loans are well positioned overall in defensive growth industries that we think are right in all times and particularly attractive in less certain economic times.
New Mountain's private equity funds have never had a bankruptcy or missed an interest payment and the firm now manages over $40 billion of assets. Similarly, as shown on Page 13 of this presentation, since inception over 12 years ago, NMFC has experienced net gains across all of its realized credit investments with only $72 million of unrealized depreciation on our books as of the end of Q2.
The rising rate environment continues to be a substantial positive for our quarterly earnings since we cheaply land on floating rates. As Page 16 of the presentation shows, we expect to continue to significantly outearn our $0.32 per share regular dividend at current interest rates, if all other factors hold constant.
Given our earnings of $0.39 per share this quarter, we will make our second consecutive variable supplemental dividend in the amount of $0.04 per share, which is equal to approximately half of the Q2 quarterly earnings in excess of our regular dividend of $0.32. This additional $0.04 dividend will raise the total dividend to $0.36 per share all in for this quarter, which is at the high end of our previous guidance.
NMFC will pay these supplemental distributions on September 29 to holders of record as of September 15. The remainder of the excess earnings will remain on our balance sheet and may be paid out in the future.
Our dividend at $0.36 represents an annualized current dividend yield of just over 11%. Looking forward to Q3, in addition to our $0.32 regular dividend, we expect to generate a variable supplemental dividend of $0.03 to $0.04 per share payable in Q4. This incremental payout is supported by expected strong credit performance and continued elevated base rates.
We believe the strength of New Mountain and of NMFC is driven by the quality of our team. New Mountain overall now numbers 245 members, and the firm has developed specialties in attractive defensive growth sectors that is a cyclical growth sectors, such as life science supplies, health care information technology, software, infrastructure services and digital engineering.
When pursuing our credit investing efforts, we utilize our extensive group of industry experts to provide unique knowledge and expertise that allows us to make very informed high-conviction underwriting decisions. Over the last 6 months, we have continued to expand the quality of our overall team.
Finally, we, as management, continue as major shareholders of NMFC. Senior management and employee share ownership has been rising over time, and we now own approximately 13% of NMFC's total shares personally.
With that, let me turn the call to John.
John R. Kline
Thank you, Steve. Good afternoon, again, everyone. Thank you for joining us today. I would like to offer some more details on our overall investment strategy and performance metrics.
Starting on Page 7, we highlight our disciplined industry selection, which shows exposure to a diversified list of defensive noncyclical sectors. These sectors and industry niches are characterized by durable growth drivers, predictable revenue streams, margin stability and great free cash flow conversion.
We have successfully avoided cyclical, volatile and secularly challenged industries, which could be riskier areas to invest in today's high rate environment. Our strategy has been consistent over our 12-plus years as a public company, and it allows us to operate with confidence in any economic environment.
Page 8 provides a high-level snapshot of our business, where we show a long-term track record of delivering consistent enhanced yield to our shareholders by avoiding losses and distributing virtually all of our excess income to shareholders. Since our IPO in 2011, NMFC has returned over $1 billion to shareholders through our dividend program, generating an annualized return of 10%.
Our current portfolio is exposed to companies in good industries that are performing well and where our last dollar of risk is approximately 40% of the purchase price paid for the business. We lend primarily to businesses owned by financial sponsors who are sophisticated and supportive owners with significant capital that is junior to the loans that we make.
Notably, over 20% of our portfolio companies across our credit platform have attracted additional equity capital in the last 12 months. This capital has been deployed to support M&A, bolster liquidity and to pursue general business expansion. This is a great indication that our portfolio consists of companies that are performing well and are able to attract additional investment at healthy valuations even in more challenging times.
Turning to Page 9. The internal risk ratings of our portfolio were relatively stable quarter-over-quarter. We continue to have approximately 93% of our portfolio within our green risk rating. Our most challenged names within the orange and red categories represent only approximately 2% of NMFC's fair value. And we have derisked our book by marking our red names at $0.18 on average and our orange names at $0.46. At these valuation levels, our weaker names do not represent material future downside risk to our book value.
The updated heat map is shown in its entirety on Page 10. Given our portfolio's orientation towards defensive sectors like software, business services and health care, we believe our assets are well positioned to continue to perform no matter how the economic landscape develops. Our team continues to spend significant time and energy monitoring and assessing performance of our nongreen names.
While there are some performance headwinds present, we do believe the majority of these companies, particularly those rated yellow have the ability to migrate back to green over time.
Turning to Page 11. We provide a graphical analysis of NAV changes. Starting on the left, credit-specific movements represented a $0.10 decrease in book value, driven by markdowns in primarily orange and red names. Broad market movement was a $0.06 book value tailwind for the quarter as credit spreads tightened during Q2.
And as Steve mentioned earlier, we overearned the regular and supplemental dividends by $0.04 per share. It's important to note that we were to value all of our green rated loans at par and keep the balance of the portfolio at current fair value, our book value would be $13.70 compared to our actual NAV of $13.14 at 6/30.
Page 12 addresses NMFC's nonaccrual performance. On the left side of the page, we show the current state of the portfolio where we have $3.2 billion of investments at fair value, with $47 million or 1.5% of the portfolio currently on nonaccrual. Of these names, most are from much older vintages, have been written down materially and have a good chance of exiting the portfolio in the medium term.
It is worth noting that UniTek is on this list despite strong recent performance. Years ago, when UniTek was underperforming, we recapitalized the business, which caused NMFC to cease accrual on certain tranches of preferred stock. The new money had a warrant, which diluted the older preferred, but increased our ownership stake in the business. Today, that warrant is now held on NMFC's books at $47 million, which more than offsets the write-down on the older tranches of preferred.
On the right side of the page, we show our cumulative credit performance since inception, where NMFC has made $10 billion of investments and achieved net gains on all realized positions of $10 million. This is consistent with our value proposition of preserving principal value and distributing nearly all of our net investment income through predictable quarterly dividends.
On Page 13, we present NMFC's overall economic performance since IPO, showing that we have delivered consistent and compelling returns. Cumulatively, NMFC has paid $1.1 billion in total dividends to shareholders while generating $10 million of cumulative net realized gains and only $72 million of net unrealized depreciation netting to over $1 billion of value created for shareholders.
Page 14 shows a stock chart detailing NMFC's equity returns since its IPO. Over this period, NMFC has generated a compound annual return of 10%, which represents a very strong cash flow-oriented return in excess of both the high-yield index and an index of BDC peers who have been public at least as long as we have.
I will now turn the call over to our Chief Operating Officer and Interim Chief Financial Officer, Laura Holson, to discuss our current portfolio construction and financial results.
Laura C. Holson
Thanks, John. We believe the outlook for the rest of 2023 in the sponsor-backed direct lending market is positive. While deal flow continues to be down overall, the direct lending market remains the primary financing market available for sponsors, and there are pockets of activity where we have the opportunity to make loans at attractive yields while remaining very selective. We remain bullish on the medium-term outlook for M&A given the magnitude of dry powder for private equity and have started to see new deal activity pick up in recent weeks.
We also continue to see good opportunities to make incremental loans to existing well-performing portfolio companies seeking to pursue accretive M&A. The deal structures remain compelling, with leverage levels meaningfully below peak levels, and significant sponsor equity contributions representing the vast majority of the capital structures.
Page 16 presents an interest rate analysis that provides insight into the positive effect of increasing base rates on NMFC's earnings. As a reminder, the NMFC loan portfolio is 89% floating rate and 11% fixed rate, while our liabilities are 56% fixed rate and 44% floating rate.
Given this capital structure mix, we are long SOFR and thus have material positive exposure to increasing rates. In Q2, we saw average base rates close to current levels with an average base rate on our assets of 5% versus current SOFR of about 5.4% and about 10 basis points lower than the average rate on our liabilities.
If rates follow the projected SOFR curve and settle in the 3.5% area, we would still expect our net investment income to exceed our regular dividend as shown on the bottom chart, all else equal.
Moving on to origination activity on Page 17. In Q2, we originated about $30 million of new loans as we were fully invested during the quarter with limited repayment activities. Notably, during the quarter, we opportunistically sold about $120 million of assets at or above our marks in order to delever our balance sheet. For the past several quarters, we operated at the high end of our target leverage range of 1 to 1.25x and felt it was prudent to modestly delever. Given the high base rate environment, the impact of minor deleveraging has not impeded our ability to significantly outearn our regular dividend.
As I discussed in the market overview, we continue to see compelling opportunities and have line of sight into a few repayments that should provide some available capital for deployment into our highest conviction deals.
Turning to Page 18. We show that our asset mix is consistent with prior quarters where about 2/3 of our investments, inclusive of first lien SLPs and net lease are senior in nature. Approximately 8% of the portfolio is comprised of our equity positions, the largest of which are shown on the right side of the page.
Assuming solid operating performance and the supportive valuation environment, we believe these equity positions could continue to increase in value and drive book value appreciation. We hope to monetize certain of these equity positions in the medium term and rotate those dollars into cash-yielding assets.
Page 19 shows that the average yield of NMFC's portfolio has increased from 10.9% in Q1 to 11.6% for Q2, primarily due to the higher for longer shift in the base rate curve. Generally speaking, spreads remain attractive and support our net investment income target.
Page 20 highlights the scale and credit trends of our underlying borrowers. As you can see, the weighted average EBITDA of our borrowers has increased over the last several quarters to $144 million. While we first and foremost concentrate on how an opportunity maps against our defensive growth criteria and internal New Mountain knowledge, we believe that larger borrowers tend to be marginally safer, all else equal.
We also show that relevant leverage and interest coverage stats across the portfolio. Portfolio company leverage has been consistent over the last several quarters. Loan-to-values continue to be quite compelling, and the current portfolio has an average loan-to-value of just over 43%.
From an interest coverage perspective, we've seen modest compression as base rates rise. The weighted average interest coverage on the portfolio declined slightly to 1.6x from 1.8x last quarter. We do expect interest coverage to move modestly lower as SOFR contracts reset at today's rates, but note that we've seen sponsors continue to proactively support company liquidity and continued M&A activity, as John outlined earlier.
Finally, as illustrated on Page 21, we have a diversified portfolio across 114 portfolio companies. The top 15 investments inclusive of our SLP funds account for 39% of total fair value and represent our highest conviction names.
I will now cover our financial results. For more details, please refer to our quarterly report on Form 10-Q that was filed last evening with the SEC. As shown on Slide 22, the portfolio had about $3.2 billion in investments at fair value at June 30 and total assets of $3.3 billion, with total liabilities of $2 billion of which total statutory debt outstanding was $1.7 billion, excluding $300 million of drawn SBA-guaranteed debentures.
Net asset value of $1.3 billion or $13.14 per share was flat compared to prior quarter. At quarter end, our statutory debt-to-equity ratio was 1.22:1 and 1.19:1 net of available cash on the balance sheet, consistent with the balance sheet deleveraging I mentioned previously.
On Slide 23, we show our quarterly income statement results. For the current quarter, we earned total investment income of $95.2 million, a $3.5 million increase from the prior quarter. The increase was primarily driven by higher interest income from base rate resets.
Total net expenses were approximately $55.6 million, a $2 million increase quarter-over-quarter due primarily to higher base rates on our floating rate debt. As a reminder, the investment adviser has committed to a management fee of 1.25% for the 2023 calendar year. The investment adviser has also pledged to reduce its incentive fee, if and as needed during this period to fully support the $0.32 per share regular quarterly dividend. The adviser intends to extend each of these commitments by 1 year. Based on our forward view of the earnings power of the business, we do not expect the investment adviser to need this dividend protection program. And it is important to note that the investment adviser cannot recoup fees previously waived.
Our adjusted NII for the quarter was $0.39 per weighted average share, which meaningfully exceeded our Q2 regular dividend of $0.32 per share. As Slide 24 demonstrates, 100% of our total investment income is recurring this quarter, given the minimal fees early on Q2. You will see historically that over 90% of our quarterly income is recurring in nature and on average, over 80% of our income is regularly paid in cash. We believe this consistency shows the stability and predictability of our investment income. Importantly, over 96% of our quarterly PIK income is generated from our green rated names.
Turning to Slide 25. The red line shows the coverage of our regular dividend. This quarter, adjusted NII exceeded our Q2 regular dividend by $0.07 per share. From Q3 2023, our Board of Directors has again declared a regular dividend of $0.32 per share as well as a supplemental dividend of $0.04 per share, which will be paid on September 29 to shareholders of record on September 15.
As a reminder, our supplemental dividend program pays out at least 50% of any earnings in excess of our regular dividend. Since our Q2 earnings exceeded the regular dividend by $0.07, we are paying a supplemental dividend of $0.04 alongside the Q3 regular dividend.
On Slide 26, we highlight our various financing sources. Taking into account SBA-guaranteed debentures, we had $2.3 billion of total borrowing capacity at quarter end with $357 million available on our revolving lines, subject to borrowing base limitations. We have a valuable mix of fixed and floating rate debt and the 56% of fixed rate debt continues to be an earnings tailwind in this rising base rate environment.
As a reminder, covenants under both of our Wells Fargo and Deutsche Bank credit facilities are generally tied to the operating performance of the underlying businesses that we lend to rather than the marks of our investments at any given time.
Finally, on Slide 27, we show our leverage maturity schedule. As we've diversified our debt issuance, we've been successful at laddering our maturities to manage liquidity, and over 85% of our debt matures in or after 2025. For the 2018 convertible notes that mature later this month, we will utilize existing capacity on our revolving credit facilities to repay the notes.
As a reminder, earlier this year, we proactively upsized our 2022 convertible notes to help address the 2023 maturities.
Additionally, our multiple investment-grade credit ratings provide us access to various unsecured debt markets that we continue to explore to further ladder our maturities in the most cost-efficient manner.
With that, I would like to turn the call back over to John.
John R. Kline
Thank you, Laura. As we look out over the balance of 2023, we remain confident in the quality of our investment portfolio and believe we are on track to deliver great risk-adjusted returns to our shareholders. We once again thank you for your support and look forward to maintaining an open and transparent dialogue with all of our stakeholders.
I will now turn things back to the operator to begin Q&A. Operator?
Question and Answer Session
Operator
(Operator Instructions) Our first question comes from Bryce Rowe with the Hovde Group.
Bryce Rowe
Wanted to maybe start on the -- John, I wanted to start on the comments around the fair value marks on the orange and red-rated names kind of moving lower quarter-over-quarter. Just curious if there's something specifically going on within the portfolio companies or just kind of a measure of conservatism on your part to lower those [share value].
John R. Kline
Sure. I guess what I'd say is, when we think about this quarter, we think it was a really great quarter. When we look at the vast majority of our portfolio companies in NMFC, we're really pleased with the way they're performing in this higher interest rate environment. There are just a couple of names in the portfolio that have been weaker, and they continue to be a little weaker. And as a result, we've marked those down. And so I think it's really as simple as that. And I think the really good news is the earnings are really good. The portfolio is solid, and there are just a few names that are weaker, and we have to reflect that.
Bryce Rowe
Got it. Okay. That's helpful, John. And then just the comments around kind of pace of originations in the quarter and then opportunistically selling out of some investments to reduce balance sheet leverage. Are you trying to possibly operate with less balance sheet leverage, certainly, in the target range that you've set, but just kind of wanting to understand how you're thinking about balance sheet leverage and being able to invest in this market?
John R. Kline
Sure. I can take a shot at that. I'm sure Laura may have some additional comments. But I think we had a number of quarters where we were at the high end of our range. And we just felt like it was appropriate to not be at the high end of every quarter, and we're very comfortable being at the middle end of the range. And I think now we're a little bit more in the middle at 1.19.
We really did see a golden opportunity to sell, as Laura mentioned, some lower-yielding names at really good prices, so that we could just achieve that a little bit of extra financial flexibility. So going forward, I think we'll continue to be within our range. And certainly, we're very comfortable operating this business between 1.15 and 1.25. And I think that's what you should expect to see.
Operator
Our next question comes from Ryan Lynch with KBW.
Ryan Lynch
First question I had was, can you just maybe give us an update on your net lease portfolio? Obviously, there's been a lot of discussions broadly about commercial real estate and how that's going to fare. And there's obviously stronger sub positions and not office maybe being one of the weaker positions. But if you could just talk about your overall -- what are your sort of allocations you have in your net lease portfolio? And how has that been holding up?
John R. Kline
Sure. Yes, I very much like to talk about that. So when we think about the strategy for our net lease portfolio, we own property that is occupied by a lot of companies, many of which are owned by sponsors, and they're mission-critical assets that the businesses need to operate. And that's a big part of our underwriting thesis. And so when we think about the character of the assets, it's a lot of industrial assets. It's a lot of warehousing, but it really has no real office exposure or any exposure to the asset classes that you read negative things about in the Wall Street Journal.
So this is mission-critical assets that are owned by businesses that we know well and they're entering into long-term leases, and we feel very good about that strategy even in an environment where we do see problems in different areas of the real estate asset class, which is a massive asset class. So hopefully, that gives you just a sense.
And when we think about these properties where I mentioned their long-term leases, they have contractual escalators that make our lease payments more valuable every year, and so it's a good part of our portfolio.
Ryan Lynch
Okay. That's helpful. And then obviously, there's some -- the commercial real estate space is going through some changes. There's obviously some very strong sectors and then potentially some weaker sectors. Are you guys looking at more opportunities in this space given kind of the dynamics that are playing out? Or are you guys kind of set with what you have right now?
John R. Kline
We like the position that we have in the long-term triple net lease assets that we own on the balance sheet. And we think that as capital becomes available on our balance sheet, we see a great opportunity to invest that capital into sponsor-backed direct lending, unitranche loans, and that's what we plan to do. So that's the way I would answer that question.
Ryan Lynch
And then just one last one. Can you maybe just give us -- I know it's hard to do a broad overview, but kind of a broad overview of how your health care services portfolio is performing. That's obviously a sector that broadly speaking, potentially could be having some challenges with higher labor costs and then maybe some contractual fixed rates from insurance. So I'd love to just get an update on how that portfolio is performing. And then how are the fundamentals trending? Are they improving worsening versus maybe 3 to 6 months ago?
Laura C. Holson
Sure. I can start. Yes, I mean, clearly, health care has been a space that I think you can really differentiate yourself as an investor. And I think health care is probably one of our strongest verticals for New Mountain Capital overall. So Steve might have some comments you want to add in addition to that. But -- so when I think about our credit portfolio in health care services, we do have some physician practice management type businesses. But I think we've done a nice job of really delineating between the sectors within physician practice management that maybe are better than some others.
When I look at our portfolio overall, we do have some exposure to dental and dermatology and some -- in eye care, et cetera. But I would say the businesses that we lend to in these sectors have generally performed reasonably well. I mean these are operationally intensive businesses. And so it's a sector where execution really matters. So we've tried to be mindful of that as we think about backing the right sponsors in these sectors. And as I said, really relying on the in-house expertise that we have within New Mountain Capital to help us kind of pick the winners and losers within health care.
And performance-wise, I would say, in aggregate, performance has been probably a little bit stronger lately. We've seen some of the wage pressure that we had seen previously impacting the health care services sector. It's not gone, but it definitely seems like it's improving at the margin.
But Steve, do you want to add anything just about the...
Steven Bruce Klinsky
No. I guess one thing I would say is health care technology and life science has been one of the very, very best areas for our private equity firm for many years. We're very deep in the space as owner-operators. So I think, for example, if you look at our CLO portfolio, where we're ranked and how many markdowns where we're very high up on the top of safety because we can distinguish or we try to distinguish good for bad names. It's just -- we don't just say it's health care, let's do it. There's a lot of specificity in the health care models, and we try to use that for both private equity and credit.
Ryan Lynch
Understood. I understand there's a lot of nuance in each individual investment there in that portfolio. That's all for me. I appreciate the time today.
Operator
(Operator Instructions) With no further questions, this concludes the question-and-answer session. I would like now to turn the conference back over to Mr. John Kline for any closing remarks.
John R. Kline
Great. Well, thank you, and thanks to everyone who joined us on our second quarter conference call today, and we very much look forward to speaking to you on our third quarter call, which will take place in November. Have a great day. Thanks.
Operator
This concludes our conference. Thank you for attending today's presentation. You may now disconnect.
