Monroe Capital Corporation (NASDAQ:MRCC) Q4 2022 Earnings Conference Call March 2, 2023 11:00 AM ET

Company Participants

Theodore Koenig - Chairman, President and CEO
Mick Solimene - CIO and CFO

Conference Call Participants

Kevin Fultz - JMP Securities
Christopher Nolan - Ladenburg Thalmann
Robert Dodd - Raymond James
Bryce Rowe - B Riley FBR

Operator

Welcome to Monroe Capital Corporation's Fourth Quarter and Full Year 2022 Earnings Conference Call.

Before we begin, I'd like to take a moment to remind our listeners that remarks made during this call today may contain forward-looking statements, including statements regarding our goals, strategies, beliefs, future potential, operating results, and cash flows.

Although we believe these statements are reasonable based on management's estimates, assumptions, and projections as of today, March 2nd, 2023, these statements are not guarantees of future performance.

Further, time-sensitive information may no longer be accurate as of the time of any replay or listening. Actual results may differ materially as a result of risks, uncertainty, or other factors, including, but not limited to, the risk factors described from time-to-time in the company's filings with the SEC. Monroe Capital takes no obligation to update or revise these forward-looking statements.

I will now turn the call over to Ted Koenig, Chief Executive Officer of Monroe Capital Corporation. Please go ahead, sir.

Theodore Koenig

Good morning and thank you to everyone who has joined us on our call today. Welcome to our fourth quarter and full year 2022 earnings conference call. I am joined by Mick Solimene, our CFO and Chief Investment Officer; and Alex Parmacek, our Deputy Portfolio Manager.

Last evening, we issued our fourth quarter and full year 2022 earnings press release and filed our 10-K with the SEC.

I'd like to open up with some thoughts and observations on the market and the general economic environment. In the fourth quarter of 2022 and in the early 2023 period, compelling opportunities for MRCC have begun to emerge in response to the market volatility and the wary tone of the M&A and financing markets.

As M&A and financing markets work through today's macroeconomic trends and what we consider to be a year of transition, middle market financing volume totaled almost $280 billion in 2022 according to Refinitiv. This mark was approximately 12% behind the record-setting volume in 2021, but still well above historical averages. As a firm, Monroe made approximately $6 billion of new investments in 2022.

In response to the current market volatility, we are executing on transactions that not only have enhanced economics, but that also come with reduced leverage as well as more favorable pricing terms and documentation, a trend that began in the third quarter of last year.

With current market conditions showing us lower leverage levels, coupled with higher equity cushions, we will selectively pursue assets in attractive markets as older vintage assets we pay.

Our view is that 2023 will present itself as one of the most attractive vintages for deploying private capital -- private credit capital and that MRCC is very well-positioned, especially as market share continues to move toward direct lenders away from traditional regulated lenders.

While we are excited about the opportunities ahead, we are also mindful that the higher interest rate environment and anticipated broader macroeconomic headwinds could potentially present stress within private credit loan portfolios.

We've intentionally built a portfolio at MRCC that is focused on investments at the top of the capital structure with meaningful equity value cushions across resilience, sectors -- recession-resilient sectors. We are confident that our defensive portfolio has been constructed to withstand those challenges and we are already seeing signs of resilience.

Many of our borrowers have begun to experience relief as input costs and the supply chain have altered course towards normalization from what we've seen last year. As such, our portfolio has been able to demonstrate credit quality stability despite the substantial interest rate increases from last year.

To supplement the defensive portfolio makeup, we maintain a deep and experienced portfolio management team. This team works in conjunction with our core investment teams to execute a key component of our portfolio management strategy, which is early intervention. This allows us to get ahead of potential challenges and we will continue to take a proactive approach to navigating through this uncertain environment. Ultimately, we believe that we are positioned to actively maximize outcomes, while remaining a trusted financial partner to our clients.

I will now transition to a snapshot of our fourth quarter results. Adjusted net investment income was $5.6 million or $0.26 per share, down from adjusted net income of $7.1 million or $0.33 per share for the third quarter, which included one-time benefits of the receipts of previously unrecorded interest income on the successful repayment of our investment in Curion Holdings.

Excluding the impact of this one-time benefit from the receipt of previously unaccrued interest income associated with Curion during the third quarter, adjusted net investment income in the fourth quarter grew by 1.8%.

We also reported NAV of $225 million or $10.39 per share as of December 31st, 2022, a decrease of $0.04 per share from NAV of $226 million or $10.43 per share as of September 30th, 2022. This decline in NAV was substantially the result of mark-to-market losses on the investments in MRCC Senior Loan Fund loan, which we refer to as our SLF.

The decrease in value at the SLF was driven by these mark-to-market unrealized losses on SLF investments, which are loans to traditional upper-middle market borrowers and have continued to experience higher volatility and valuations as a result of more recent interest rate increases. On a net basis, the valuations on the remainder of the portfolio remained relatively flat to September 30th, 2022.

During the quarter, MRCC's debt-to-equity leverage increased from 1.33 times debt to equity to 1.49 times debt to equity, slightly above our long-term target range of 1.3 to 1.4 times. The increase in leverage was primarily driven by strong investment activity during the fourth quarter, coupled with lighter-than-expected portfolio payoff activity. We continue to focus on managing our investment portfolio and selectively redeploying capital resulting from repayments.

The significant majority of our 105 portfolio companies are performing in line with expectations. Based on current and forecasted market interest rates, interest coverage is generally solid across our existing portfolio.

In addition, we believe that the modest weighted average loan-to-value in the portfolio provides us with strong downside protection and cushion to these investments and our portfolio will continue to benefit from the meaningful amount of equity invested in our companies.

New deals continue to undergo a comprehensive underwriting process that includes downside stress scenarios to assess performance volatility and cushion from rising interest rates, margin pressures, and an overall economic slowdown.

MRCC enjoys a strong strategic advantage in being affiliated with a best-in-class award-winning middle-market private credit asset management firm with approximately $16 billion in assets under management and approximately 200 employees as of December 31st, 2022.

Our dividend coverage continues to trend positively. We will continue to focus on generating adjusted net investment income that meets or exceeds our dividend and positive long-term NAV performance despite anticipated macro market headwinds and mark-to-market unrealized adjustments.

At this point, I will turn the call over to Mick, who is going to walk you through the financial results in greater detail.

Mick Solimene

Thank you, Ted. As of December 31st, 2022, our investment portfolio totaled $541 million, up $33 million from $508 million as of September 30th, 2022. Our portfolio consisted of debt and equity investments in 105 portfolio companies as of December 31st, 2022 as compared to debt and equity investments in 98 portfolio companies as of September 30th, 2022.

During the quarter, we made investments in eight new portfolio companies with fundings totaling $21.7 million at a weighted average interest rate of 11.2%. We also made nominal equity investments in two of these portfolio companies.

Further, we had revolver or delayed draw fundings and add-ons to various existing portfolio companies totaling $18.3 million.

During the quarter, we received one full payoff, which is for a nominal immaterial amount. We also incurred partial and normal course paydowns of $9 million and had no sales this quarter.

We are well-positioned to deploy capital from future repayments carefully and to attractive assets that will benefit from increases in interest rates and more favorable structures through participating in the substantial pipeline of opportunities generated at Monroe.

As of December 31st, we had total borrowings of $334.6 million, including $204.6 million outstanding under our floating rate revolving credit facility and $130 million of our 4.75% fixed rate 2026 notes.

Total borrowings outstanding increased by $33.4 million during the quarter. The revolving credit facility had $50.4 million of availability as of December 31st, subject to borrowing base capacity.

Now, turning to our financial results for the quarter ended December 31st, 2022. Adjusted net investment income, a non-GAAP measure, was $5.6 million or $0.26 per share compared to $7.1 million or $0.33 per share in the prior quarter.

While the average portfolio yield increased during the quarter ended December 31st, 2022, adjusted net investment income declined primarily as a result of a one-time benefit of the receipt of previously unaccrued interest income associated with the repayment of Curion Holdings that had previously been on non-accrual status, which occurred in the quarter ending September 30th, 2022.

Excluding the one-time benefit of Curion from the third quarter results, adjusted net investment income increased by 1.8% or $100,000 during the fourth quarter. When considering our targeted leverage, the rising interest rate environment, the favorable percentage of our fund leverage at a fixed rate, and the current credit performance at MRCC, we believe that on a run rate basis, our adjusted net investment income will comfortably cover the current quarterly dividend, all things being equal.

As of December 31st, our total -- our net asset value was $225 million, which decreased from the $226 million in net asset value as of September 30th. Our NAV per share decreased from $10.43 per share at September 30th to $10.39 per share as of December 31st. The $0.04 per share NAV decrease was substantially the result of mark-to-market losses on the investment in MRCC Senior Loan Fund I.

The decrease in value at the SLF was driven by these mark-to-market losses on the SLF investments, which are loans to traditional upper-middle market borrowers and have continued to experience higher volatility in valuations. Valuations on the remainder of the portfolio remained relatively flat on a net basis compared to the prior quarter.

Looking to our statement of operations. Total investment income was $15.2 million during the fourth quarter, down from $15.9 million in the third quarter. Excluding the one-time third quarter benefit of $2 million in interest income on Curion, investment income actually increased by $1.3 million or 9.4%, primarily as a result of increase in portfolio yield and average portfolio size.

In addition, during the quarter, we continued to see the impact of increases in interest rates on our investment income as all the portfolio borrowers exceeded their benchmark interest rate floors during the quarter, and we were fully benefiting from base rate increases across the portfolio during the fourth quarter.

At December 31st, the effective yield on our debt and preferred equity portfolio was 11%, up from 9.9% at September 30th. SOFR rates, which have continued to increase in the latter half of the year, rose during the quarter with one month SOFR at approximately 406 basis points as of December 31st versus approximately 314 basis points as of September 30th. All things being equal, a rising interest rate environment will continue to improve the yields on our investment portfolio and increase net investment income.

At December 31st, we had four investments on non-accrual status, representing 0.5% of the portfolio at fair market value compared to four investments on non-accrual status which represented 0.7% of the portfolio at fair market value at September 30th.

Our performance has steadily improved in this area as we have been working out the underperforming companies in our portfolio as we said we would on previous calls. This is the direct result of the turnaround and workout capabilities of our external manager, Monroe Capital, and the resources they have provided to us.

During the fourth quarter, we placed no additional borrowers on non-accrual status. Further, the investment performance risk rating distribution has remained relatively stable.

Moving over to the expense side. Total expenses slightly decreased from $9.7 million in the third quarter to $9.6 million in the fourth quarter, primarily driven by lower income taxes, primarily associated with blocker entities that hold certain of the company's equity investments and lower incentive fees.

These decreases were mostly offset by an increase in interest and other debt financing expenses due to the rising interest rate environment and higher average debt outstanding.

Net loss for the quarter totaled $1 million compared to a net loss of $7 million in the third quarter. Net realized and unrealized losses in investments were $300,000 for the fourth quarter.

Other net losses totaling approximately $700,000 during the fourth quarter were related to foreign currency forward contracts used to hedge currency exposure on certain investments.

As of December 31st, the SLF had investments in 60 different borrowers, aggregating $183.2 million at fair value with a weighted average interest rate of 9.7%. The SLF's underlying investments are loans to middle-market borrowers that are generally larger and more sensitive to market spread movements within the rest of MRCC's portfolio, which is focused on lower middle market companies.

The SLF portfolio decreased nominally in value by 10 basis points during the quarter from 93.6% of amortized costs as of September 30th to 93.5% of amortized cost as of December 31st.

Additionally, SLF realized on its previously recorded unrealized loss on Port Townsend Holding Company during the quarter. During the fourth quarter, MRCC received income distributions from SLF of $900,000 consistent with the prior quarter.

As of December 31st, 2022, the SLF had borrowings under its non-recourse credit facility of $122.2 million and $52.8 million of available capacity under its credit facility subject to borrowing base availability.

At this point, I will turn the call back to Ted for some closing remarks before we open the line for questions.

Theodore Koenig

Thanks Mick. In closing, we believe that we are well-positioned to emerge from a transitional 2022 to capitalize on compelling opportunities for private credit and navigate the market uncertainty that may lie ahead. Our average portfolio asset yield is in excess of 11% on current deals, which portends well for the rest of 2023.

The depth and experience of our originations and underwriting teams will allow us to continue to selectively deploy capital in sectors that we have demonstrated resiliency to economic cycles.

As we remain active in the market, we expect to realize the benefits of heightened demand for private capital from lower and overall middle-market companies, including, but not limited to, receiving more favorable economics and deal structures.

This strategy is consistent with our historical focus on providing well-protected, well-structured senior secured first lien loans to companies with insulated market positions and reliable business models, led by strong management teams and reliable sponsors.

We will continue to lean on our team and core underwriting principles to generate attractive and differentiated risk-adjusted returns while navigating the uncertainties of 2023 and beyond.

MRCC is well-positioned to deliver stable and consistent dividends for our shareholders, especially where our earnings and dividends stand to benefit from an increase in market interest rates.

We are excited about our investment portfolio and our prospects to continue and continue to believe that Monroe Capital Corporation, which is affiliated with an award-winning best-in-class external manager, Monroe Capital, provides a very attractive investment opportunity to our shareholders and other investors.

Thank you all for your time today. And this concludes our prepared remarks. I am going to ask the operator to open up the call now for questions.

Question-and-Answer Session

Operator

Thank you. [Operator Instructions]

We'll hear first today from Kevin Fultz with JMP Securities.

Kevin Fultz

Hi, good morning and thank you for taking my questions. I noticed that PIK income represented about 14.7% of interest income in the fourth quarter, which was up meaningfully from 7.8% in the prior quarter. I'm curious if the increase is driven by new deals that were maybe structured with the PIK component or that was possibly amendment related any insight would be helpful?

Theodore Koenig

Sure. Good morning Kevin. Thank you for the question. So, we did see an increase in PIK income during the course of the quarter. The primary reason for the increase in income was the election by one of our borrowers at its option to exercise that PIK plateau [ph] during the quarter.

If I look at our kind of PIK income trends quarter-over-quarter, year-over-year, we've kind of been in that 12% to 15% range. So, we feel comfortable with kind of where our PIK income is as a component of our total investment income. But that was the main cause for the increase during the quarter.

Kevin Fultz

Okay. Thanks. And I guess just to continue kind of on that line of questioning, I'm curious if you've seen an increase in amendment requests, I guess, in the December quarter and how that's trended recently?

Theodore Koenig

Yes. Really good question, Kevin. During the fourth quarter, we didn't really see any meaningful notable increase in amendment activity in our portfolio. Most of the amendment activity was related to transaction activity related to add-on transactions and technical amendments related to SOFR and LIBOR transition, but no meaningful amendment activity across our portfolio.

Kevin Fultz

Okay, that's great to hear. And then one more if I can. I noticed that other G&A expenses were up slightly in the fourth quarter. I guess, can you just discuss what drove the increase? I'm just trying to get a sense if we should be scaling G&A expense in our model?

Theodore Koenig

Yes. So, nothing meaningful in terms of that slight G&A bump. I would guide you towards kind of a historical pattern on the G&A front as you think about your model.

Kevin Fultz

Okay, great. I appreciate your time this morning. I'll leave it there.

Theodore Koenig

Thanks Kevin.

Operator

We'll hear next from Christopher Nolan with Ladenburg Thalmann.

Christopher Nolan

Hey guys. The SLF, any of the borrowings by the SLS secured by any MRCC investments in the main portfolio?

Theodore Koenig

They are not.

Christopher Nolan

Okay. And then I guess in terms of asset liability management, what you're thinking right now? I mean, if the view was -- if the Fed would start easing for whatever reason, would MRCC look ahead of time to get more fixed rate loans or put on hedges? What's the thinking around that?

Mick Solimene

Yes. So, we're mindful of kind of capital structure. We're -- we've got a very, very favorable capital structure in terms of that note we did that matures in 2026, the $4.375 fixed rate note.

But we are -- we have an internally dedicated capital markets being that we work with quite closely to think about kind of the liability side of our balance sheet and are keeping an eye on the markets to see if and when we might fine-tune our approach to the right-hand side of our balance sheet, but nothing imminent.

Christopher Nolan

Final question--

Theodore Koenig

Yes, Christopher, this is -- from my perspective, I think we're going to see some -- continue to see some slight increases here and overall Fed funds increases. Inflation is still not where they want it and they've signaled that we're likely to see more upside in interest rates than downside right now in the near-term.

Christopher Nolan

And then I guess final question is strategy related. Monroe Capital announced recently acquiring the management of another BDC. What strategy overall there? And how will the BDC and MRCC work together, if at all together?

Theodore Koenig

Good question. We've gotten a fair amount of discussions with media on this. About two weeks ago, we announced that Monroe, the private asset management company will acquire the investment adviser of another BDC Horizon Technology Finance NASDAQ, HRZN, that's a venture debt business.

The management team there is comprised of about 38 people. They've been in business for about 20 years, best-in-class track record history. They manage about $1 billion today in a combination of their BDC and institutional capital.

And I've been looking at the space for quite a while on behalf of Monroe. I think that the venture debt space in general is attractive in private credit, particularly in times when the IPO markets are closed, exits are difficult, fundraising is difficult for venture firms.

Instead of doing large down round equity financings, many of these high-growth companies will look to credit instead. Pricing is good. Leverage is good on enterprise value, low enterprise value risk. So, it's a -- it was an acquisition and opportunistic acquisition opportunity for us as a firm to continue to develop asset class categories that we can offer our institutional investors.

I don't think this will be an MRCC investment. I think it's a different type of asset class. But for our other funds and our institutional investors at our adviser level at Monroe, this represents a very attractive opportunity for us to take advantage of a tactical place in the market where we can earn excess alpha.

Christopher Nolan

Great. Thanks Ted. That???s it from me.

Theodore Koenig

Thanks Chris.

Operator

[Operator Instructions]

We'll hear now from Robert Dodd with Raymond James.

Robert Dodd

Hi guys. Question on the SLF, the earnings, obviously -- I mean, its portfolio is very sensitive as well. So, the earnings within that SLF have increased about north of 20% from Q1 to Q4, but the dividend has improved. Obviously, there's been markdowns within the SLF.

But should we think of the dividend opportunity from the SLF to MRCC is kind of having a high watermark or something like that where as in book equity has to get back above $80 million before you get 50% of the earnings because obviously, in the fourth quarter, the payout ratio was the dividend to you is like 37% of the earnings that you own 50% of it. So, can you give us any color on how we should think about that given that the earnings at the SLF are quite rate sensitive as the MRCC?

Theodore Koenig

They are quite rate sensitive. You are right, I would guide you towards our kind of $900,000 per quarter level as a run rate for the SLF. That's the guidance I would offer you on that front.

Robert Dodd

But could you give us any color about why -- is it the markdowns and those need to be recovered? Or what's the decision? I realize it's not solely your decision or the MRCC decision. But there is -- obviously, there has been an increasing mismatch between the earnings power within that and the dividend paid out? Is this a scenario where that changes?

Theodore Koenig

Yes, I think we're mindful of, obviously, future performance potential of the portfolio. We did have a realized loss in the portfolio last quarter in the form of Port Townsend and when we consider our dividend distribution from the SLF to both partners, both us and National Life. We consider portfolio performance in the context of that distribution yield and it's something that we assess as we always do when we make that dividend determination.

Robert Dodd

Got it. Okay. I appreciate that. And then just back to the horizon, Chris already asked the question, but I mean is there -- I mean you have some recurring revenue software business within MRCC. You obviously have an entirely different fund that focuses on that.

So, MRCC has sometimes taken opportunity to take advantage of other areas of expertise within Monroe. I mean that is the place. So, is there room -- is MRCC grew a small sleeve of venture debt? Or is that just something you don't consider appropriate for this vehicle at all?

Theodore Koenig

That's a great question, Robert. We manage $16 billion across our platform. MRCC gets the benefit of the entire platform. And what we try to do is in our allocation policies, provide allocations of each deal we do across the platform when it's appropriate for the specific fund for the investment vehicle.

I anticipate that from time-to-time, there's going to be highly attractive and accretive deals that we originate across the platform, whether it's from Horizon, whether it's in our software lending vertical, health care, sports, media, entertainment, and when the appropriate investment fits within the MRCC mandate as managed by our portfolio managers, Mick and Alex, you may see these assets.

But we've been pretty good historically it's sticking to our knitting and MRCC and developing a high-quality senior secured portfolio that's got low leverage and good interest coverage.

As you know, venture debt businesses don't necessarily have those two qualities. We may have good growth prospects. We may have good loan to value, good loan against enterprise value, but interest coverage and leverage are not usually the cornerstones of a venture debt portfolio. So, we're going to tread slowly, I think, with MRCC in the venture debt area.

Robert Dodd

Got it. Thank you for that.

Operator

And from B. Riley, we'll hear next from Bryce Rowe.

Bryce Rowe

Hi, good morning. I wanted to ask about balance sheet leverage and maybe just future visibility into repayment activity to help fund newer investments. So, obviously, you have a balance sheet leverage tick up above the high end of your range, certainly understand that can happen from time-to-time, but just curious if we should expect balance sheet leverage to stay at current levels or if you have some visibility into repayment activity that made you comfortable kind of going above the high end of the target?

Theodore Koenig

So, good morning Bryce and great question. So, as we manage the portfolio, we're looking into the future in terms of repayments we expect from our borrowers were in close contact with our over 100 borrowers. We're also looking into our originations pipeline, and we're trying to the kind of cadence those two things, if you will.

We had really, really strong origination activity during the fourth quarter, and our payoffs -- projected payoffs came lighter than expected as we looked at our payout pipeline. So, we came in at the end of the year above our leverage targets.

But the way we think about this going forward is we still maintain our long-term leverage target of 1.3 to 1.4 and would guide you in the short term to kind of the top end of that range, which is where we are targeting to manage the portfolio.

Bryce Rowe

Okay, that's helpful. And then maybe one more for you, Mick, just around credit quality. I mean obviously, you had a pretty steady non-accrual number, and I think 1 investment kind of makes up the bulk of what's left there in that non-accrual bucket. But beyond that, can you talk about maybe any kind of positive or negative migration you saw within the quarter and how it might relate to kind of internal risk ratings.

Mick Solimene

Yes. So, we did make further -- a little bit more further progress on non-accruals during the quarter. We received about a $600,000 of pay down on Bluestem Brands, which is one of our four non-performers. So, pleased with that.

In terms of portfolio migration during the course of the quarter, if you look at our rating distribution, we were up about $7 million or $8 million in our three rated category during the course of the quarter.

So, we had a couple of a few credits that migrated into our three rating during the quarter. You recall that we rate deals on a one through five basis, but had a few names migrate into the three category during the quarter.

But overall, I feel really comfortable with the quality of the portfolio, the coverage ratio on an interest basis at our portfolio companies are reporting and believe that the portfolio is generally sound.

Bryce Rowe

Okay, that's helpful. And then just maybe a follow-up to that, Mick. What -- the ones that did migrate into the three, what -- is there -- I assume that's idiosyncratic. What's going on there that--

Mick Solimene

Yes. So, good question. So, the oil companies are still experiencing some effect from rising input costs, rising freight costs, things like that. So the companies that have migrated in that kind of three category have seen some margin impact because of that.

And in those cases, those companies are very, very focused on margin improvement by the kinds of actions that companies typically take, passing price increases ultimately along to their customer, strategically reducing costs or things like that.

What you don't see in our kind of broad portfolio risk rating distributions that we actually -- also during the quarter had migration out of the three into the two category as some of our companies that experienced some of the early effects of inflation and supply chain, we're able to effectively pass along price increases, execute strategic investment initiatives and get margins kind of back in line.

So, we continue to see kind of an evolving landscape as companies adapt and adjust to market in economic conditions.

Bryce Rowe

Got it. It makes a ton of sense. Appreciate the comments this morning. Thanks.

Mick Solimene

Thank you.

Operator

And with no other questions at this time, I'd like to turn things back to the company for closing remarks.

Theodore Koenig

Thank you all for joining us today. We enjoy the conversation as well as the questions and we look forward to speaking again next quarter. So, be safe and we'll speak to you soon. And like always, to the extent anyone has any questions in the interim before our next quarterly call, feel free to reach out to Mick directly. And we're always willing and wanting to engage. So, thank you all. Have a good day.

Operator

And that will conclude today's conference. Again, thank you all for joining us. You may now disconnect.