Monroe Capital Corp (NASDAQ:MRCC) Q2 2022 Earnings Conference Call August 3, 2022 11:00 AM ET

Company Participants

Theodore Koenig - Chairman, President & CEO
Lewis Solimene - CFO & CIO

Conference Call Participants

Kevin Fultz - JMP Securities
Christopher Nolan - Ladenburg Thalmann & Co.
Robert Dodd - Raymond James & Associates

Operator

Welcome to Monroe Capital Corporation's Second Quarter 2022 Earnings Conference Call.

Before we begin, I would like to take a moment to remind our listeners that remarks made during this call may contain certain forward-looking statements, including statements regarding our goals, strategies, beliefs, future potential, operating results or cash flows, particularly in light of the COVID-19 pandemic. Although we believe these statements are reasonable based on management's estimates, assumptions and projections as of today, August 3, 2022, 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, 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 conference over to Ted Koenig, Chief Executive Officer of Monroe Capital Corporation.

Theodore Koenig

Good morning, and thank you to everyone who has joined us on our call today. Welcome to our second quarter 2022 earnings conference call. I am joined by Mick Solimene, our CFO and Chief Investment Officer.

Last evening, we issued our second quarter 2022 earnings press release and filed our 10-Q with the SEC. The negative economic backdrop and the more aggressive Fed action during the second quarter increased both risk premiums and volatility across asset classes, especially in the more liquid public markets. Negative segment and sentiment was also felt in the private markets, but with lower levels of volatility. Credit spreads widened in the various loan markets with a Leveraged Loan 100 Index falling 534 basis points from 97.35% of par at March 31 to 92.01% of par at June 30 and the LCD middle market loan index declining 348 basis points from 97.06% of par at March 31 to 93.50% of par at June 30.

The M&A and related financing markets had a more cautious tone in the first half of the year. According to Refinitiv, U.S. middle market loan volume totaled approximately $133 billion for the first half of the year, approximately 58% lower than 2021's full year. Activity levels though were up during the second quarter in the face of widening credit spreads and an increase in 30-day LIBOR rates from 45 basis points at March 31 to 179 basis points at June 30.

Monroe's pipeline of quality actionable financing opportunities at the platform level remains strong in the face of today's economic headwinds. The Monroe platform's ability to offer underwritten solutions is a real advantage for our clients during periods of market uncertainty.

Turning now to the second quarter results. We are pleased to report adjusted net investment income of $5.4 million or $0.25 per share. This is consistent with adjusted net income of $5.4 million or $0.25 per share for the first quarter.

We also reported NAV of $232.1 million or $10.71 per share as of June 30, 2022, a decrease of $0.59 per share from NAV of $244.9 million or $11.30 per share as of March 31, 2022. The decline in NAV was substantially the result of net unrealized losses on the portfolio, primarily due to market volatility and spread widening throughout the quarter.

During the quarter, MRCC's debt-to-equity leverage increased from 1.30x debt-to-equity to 1.38x debt-to-equity. New origination activity at Monroe remains strong, and we expect to maintain leverage within our targeted leverage range of 1.3 to 1.4x debt-to-equity.

The portfolio is well positioned to benefit from an increase in the short-term interest rates, and substantially all of our borrowers were above their interest rate floors going into the third quarter. Therefore, any additional increases in interest rates should proportionately benefit our investment portfolio. We believe that our existing portfolio companies will be able to navigate a higher interest rate environment. And they are generally well positioned to manage the inflationary supply chain and geopolitical headwinds they are facing.

Our loan portfolio and underwriting focuses continues to be on those companies with defendable market positions, resilient business models, exceptional management teams and strong sponsors or owners. MRCC enjoys a strong strategic advantage in being affiliated with a best-in-class middle-market private credit asset management firm, with approximately $14 billion in assets under management and over 175 employees as of June 30, 2022. We will continue to focus on generating adjusted net investment income that meets or exceeds our dividend and positive long-term NAV performance.

I am now going to turn the call over to Mick who is going to walk you through our financial results.

Lewis Solimene

Thank you, Ted. As of June 30, 2022, our investment portfolio totaled $536 million, down $10 million from $546 million as of March 31, 2022. Our investment portfolio consisted of debt and equity investments in 98 portfolio companies at June 30, 2022, as compared to debt and equity investments in 97 portfolio companies at March 31, 2022.

During the quarter, we made investments in 4 new portfolio companies, with fundings totaling $11.6 million. We also made a $500,000 capital contribution to SLF. In addition, we had revolver, add-on or delayed draw fundings, to existing portfolio companies totaling $9.2 million. During the quarter, we received 2 full payoffs totaling $9.6 million and had loan sales and other ordinary course loan repayments aggregating $9.9 million. Subsequent to the end of the second quarter and the filing of the 10-Q, we had repayments of approximately $27.9 million, net of investment activity. We are well positioned to redeploy this capital carefully into attractive assets that will benefit from increases in interest rates through participating in the substantial pipeline of opportunities generated at Monroe.

At June 30, we had total borrowings of $320 million, including $190 million outstanding under our revolving credit facility and $130 million of our 2026 notes. Total borrowings increased slightly by $1.7 million during the quarter. The revolving credit facility had $65 million of availability as of June 30, subject to borrowing base capacity.

Turning to our results. For the quarter ended June 30, 2022, adjusted net income -- net investment income, a non-GAAP measure, was $5.4 million or $0.25 per share compared to $5.4 million or $0.25 per share in the prior quarter. When considering our target deleverage in the current credit performance at MRCC, we believe that on a run rate basis, our adjusted NII will cover the $0.25 per share quarterly dividend, all other things being equal.

As of June 30, our net asset value was $232.1 million, which decreased from $244.9 million in net asset value as of March 31. Our NAV per share decreased from $11.30 per share at March 31 to $10.71 per share as of June 30. The $0.59 per share NAV decrease was substantially the result of market volatility and spread widening, which increased net unrealized losses. We experienced the same effect approximately 2 years ago at the outset of COVID-19.

Looking to our statement of operations. Total investment income was $13 million during the second quarter, up from $12.5 million in the first quarter, due to higher fee income, partially offset primarily by lower interest income. During the second quarter, we placed no additional borrowers on nonaccrual status. Total nonaccruals approximate 2% of the portfolio at fair value at June 30, down from 2.2% of the portfolio at fair value at March 31.

At June 30, the effective yield on our debt and preferred equity portfolio was 8.5%, up from 8% at March 31. LIBOR rates, which had been at historically low levels, rose during the quarter with 1-month LIBOR at approximately 179 basis points as of June 30 versus approximately 45 basis points as of March 31. We maintain interest rate floors in nearly all our deals with the majority of floors at a level of at least 1%.

As interest rates did not exceed the majority of our floors until the rate reset date at the end of June, the second quarter did not include a significant benefit in interest income from this rising rate environment, and we expect to see a more sizable impact during the third quarter. All other things being equal, a rising interest rate environment will improve the yield on our investment portfolio and increase net investment income as reference rate levels exceed interest rate floor levels.

On most amendments and on virtually all of our newly originated deals, we are focused on pricing our deals as a spread to the secured overnight financing rate, or SOFR, in advance of LIBOR going away, which is expected to occur in 2023.

Moving over to the expense side. Total expenses for the quarter increased from $7.1 million in the first quarter to $8 million in the second quarter, primarily driven by higher incentive fees net of associated fee waivers and income taxes, including excise taxes, partially offset by lower interest and debt financing expense as a result of the repayment of our SBA debentures during the first quarter.

Net loss for the second quarter totaled $12.4 million compared to a net loss of $4.6 million in the first quarter. Net unrealized losses on investments were $13.4 million for the second quarter, primarily driven by the market volatility and spread widening, partially offset by unrealized gains approximating $1 million on foreign currency forward contracts.

As of June 30, the SLF had investments in 62 different borrowers, aggregating $195.2 million at fair value with a weighted average interest rate of 7.1%. The SLF's underlying investments are loans to middle-market borrowers that are generally larger and more sensitive to market spread movements than the rest of MRCC's portfolio, which is focused on lower middle market companies. The SLF's portfolio decreased in value by 3.1% during the quarter from 97.9% of amortized cost as of March 31 to 94.8% of amortized costs as of June 30.

During the second quarter, MRCC received income distributions from SLF of $900,000, consistent with the first quarter. As of June 30, 2022, the SLF had borrowings under its nonrecourse credit facility of $129.6 million and had $45.4 million of available capacity under its credit facility, subject to borrowing base availability.

I will now turn the call back to Ted for some closing remarks before we open up the line for questions.

Theodore Koenig

Thanks, Mick. We feel that MRCC is well positioned to deliver differentiated risk-adjusted returns for our shareholders, especially where our earnings and dividend will benefit from increases in market interest rates. Our overall Monroe Capital platform continues to maintain a very strong pipeline of high-quality investment opportunities for all funds at Monroe, including MRCC. As a firm, we funded over $2.5 billion of new investments in the first half of 2022. We see significant opportunities to deploy capital in sectors with resiliency and growth including technology, business services, health care and opportunistic. We remain highly focused on the primary risks in the economy today and remain selective in our underwriting, where we generally fund less than 5% of all the deals we review on an annual basis.

We have constructed a purposely defensive portfolio under the watch of tenured senior leadership team. And we benefit from a large portfolio management organization that has managed credit through multiple economic cycles. We have made substantial progress on portfolio matters in the last 2 years. We are excited about our investment portfolio and our prospects and continue to believe that Monroe Capital Corporation, which is affiliated with an award-winning best-in-class external manager, provides a very attractive investment opportunity to our shareholders and other investors in the current market.

Thank you all for your time today, and that concludes our prepared remarks. I'm going to ask the operator to open the call now for questions. Thank you.

Question-and-Answer Session

Operator

[Operator Instructions]. Our first question comes from Kevin Fultz from JMP Securities.

Kevin Fultz

Given the evolution of market conditions over the past 2 quarters, I'm curious if you've seen that translate to improved pricing on new deals that you're viewing? And I guess more broadly, if you can discuss the attractiveness of deals you're currently seeing from a risk/reward perspective.

Theodore Koenig

Mick, do you want to start, and then I'll come in on that one?

Lewis Solimene

Sure. So from a deal flow perspective, we still are seeing tremendous actionable opportunities. As Ted said earlier, we've got a pretty significant pipeline. We closed over $2.5 billion of deals in the first half of the year. Pipeline remains strong.

In terms of what we're seeing in terms of opportunities, we have seen better opportunities in terms of greater spread. That's coincident, as you can imagine, with some of the spread widening or the spread widening that we've seen kind of in all markets. So spread's better; terms and conditions, better. And by terms and conditions, I mean tighter documentation as well as covenants. And we have covenants in all of our direct deals that are generally tighter relative to forecast or budget. So this is an advantageous market for us. It's advantageous in the sense that we can be selective around the kinds of opportunities that we're looking at. And in that regard, there are just really good opportunities for us to put capital to work.

Theodore Koenig

Yes. I'll echo what Mick said, Kevin. I think higher spread, lower leverage, better documents are the 3 things that we're seeing. I will tell you, though, it took a little bit of time. The market were still competitive at the beginning of the quarter. We're just starting to see trends now for increased spread.

The first quarter was pretty much business as usual from 2021. We had a lot of fall off into Q1, and there's a lot of liquidity in the market. Deals are getting done. High-quality companies are still commanding premium terms. But what we've seen is we've seen the market start to adjust here towards the back half of Q2, and we've been purposefully, I'll call it, cautious. I think that spreads are going to continue to get better in Q3 and Q4 as the year goes on. And what we're doing as a firm is we're positioning ourselves to get the benefit of that increased risk-adjusted return and as well as be thoughtful in how we approach the market with our existing clients. So that's a quick answer, higher spread, lower leverage, better documents.

Kevin Fultz

Okay. That's all really helpful. And then just looking at nonaccruals. Nonaccruals at fair value came down quarter-over-quarter to 2%. Was there any change to nonaccruals at cost? Or was that stable quarter-over-quarter?

Lewis Solimene

From a cost perspective, quarter-over-quarter, it was basically flat.

Operator

[Operator Instructions]. Our next question comes from Christopher Nolan from Ladenburg Thalmann.

Christopher Nolan

Congratulations, Mick, on your step. What was the EBITDA coverage for your portfolio companies in the main portfolio to your debt positions in the second quarter? And how do you expect that to change with rising rates through the second half of the year?

Lewis Solimene

So in terms of interest coverage, if I look at our portfolio businesses, general interest coverages are going to be between 2.5 and 3.75x. That's the way we -- that's the way the portfolio is constructed. We think there's adequate cushion in our coverage ratios to support good portfolio in the context of foreseeable rate increases, for sure.

Christopher Nolan

Great. And then I guess on asset quality, the SLF had an additional nonaccrual, Port Townsend Holdings.

Lewis Solimene

Correct.

Christopher Nolan

Any color you can provide on the SLF credit quality since it's a middle-market portfolio and it's supposed to be a little bit more conservative than the normal scheduled investments for MRCC?

Lewis Solimene

Yes. So the SLF, as we talked about in the opening remarks, has a little bigger borrower than the MRCC portfolio. There is 1 nonaccrual in that portfolio, Port Townsend Paper Company, which is a corrugated box business. It was placed on nonaccrual this year. Otherwise, the portfolio, if I look at that portfolio, the average mark in that portfolio is down around 310 basis points quarter-over-quarter. We feel good about the quality of that portfolio. We obviously have 1 nonaccrual position that we are -- that we're working with, but feel good about the credit quality of that portfolio, which again is generally larger loans.

Christopher Nolan

Is CBC Restaurants in that portfolio is marked as nonaccrual in the...

Lewis Solimene

That is correct. You are correct. It's a small position, but yes, that's also a nonaccrual.

Operator

Our next question comes from Robert Dodd from Raymond James.

Robert Dodd

Just a more general question, Ted, based on one of your comments. You said you expect spreads to continue to get better in Q3, Q4. I just wonder how confident are you in that? I mean back in COVID, obviously, in March, we all expected spreads to widen fairly materially throughout the year. And that, obviously, not ended up not happening. There's a lot of stimulus and a lot of other things going on at the same time. So what gives you some confidence that they are going to widen, that this time, it will be different. So if you've got any thoughts there.

Theodore Koenig

Yes. I don't expect things to change, Robert, drastically. I think the economy is basically in decent shape. We got a lot of talk about recession. We've got talks about supply chain issues. I think the good companies that we're seeing in our portfolio are performing well. There's a lot of competition for higher-quality companies that are able to project out with certainty what their cash flows are. And what's happening is, and I talked to a lot of the CEOs of other middle-market private credit firms, and there's been a fair amount of price discovery going on over the last 45 days. It used to be that the market was relatively efficient, but I've seen much more price discovery happened in the last 45 days and a lot of discussions where deals are getting done 50, 75 basis points wide of where they would have gotten done in late 2021 or even Q1 2022. So I anticipate the remainder of the year to follow the trend lines of what we've been seeing in the second half of Q2. And what that means is probably 50 to 75 basis points of spread widening. And we're experiencing that across our portfolio.

All I can tell you, when we look at these things, as we look at our own portfolio, when we look at our own kitchen to find out what the market is doing, and that's been our experience. And I want to always -- we try and take a global view of the business here and not try and time markets. And that's why from a Q2 standpoint, as a firm, we're being -- we're trying to be thoughtful in deploying capital, being good partners, being reliable partners but also being thoughtful on when we -- how we deploy capital.

Operator

We have no further questions in queue. I'd like to turn the call back over to Ted Koenig for closing remarks.

Theodore Koenig

Thank you very much for your questions today. I appreciate it. We look forward to obviously answering any other questions on a one-off basis if you have them. I think that just like after the COVID period, the rest of this year is going to be good for private credit. And we're excited to speak to you all next quarter. So thank you for your time today. Bye-bye.

Operator

This concludes today's conference call. Thank you for your participation. You may now disconnect.