New Mountain Finance Corporation 8.250% Notes due 2028 (NMFCZ) Q4 2014 Earnings Report, Transcript and Summary

Good morning and welcome to the New Mountain Finance Corporation Fourth Quarter 2014 Earnings Conference Call. All participants will be in listen-only mode. [Operator Instructions] Please note this event is being recorded. I would now like to turn the conference over to Rob Hamwee. Please go ahead sir.

Thank you and good morning everyone and welcome to New Mountain Finance Corporation’s fourth quarter earnings call for 2014. With me here today are Steve Klinsky, Chairman of NMFC and CEO of New Mountain Capital; and Dave Cordova, CFO of NMFC. Steve is going to make some introductory remarks. But before he does, I would like to ask Dave to make some important statements regarding today’s call.

Thank you, Rob. 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 on our earnings press release. I would also like to call your attention to the customary Safe Harbor disclosure in our March 02, 2015 press release and on page two of the slide presentation regarding forward-looking statements. Today’s conference call and webcast may include forward-looking statements and projections, and we ask that you refer to our most recent filings with the SEC for important factors that could cause actual results to differ materially from those statements and projections. We do not undertake to update our forward-looking statements or projections unless required to by law. Any references to New Mountain Capital or New Mountain are referring to New Mountain Capital, LLC or its affiliates and may be referring to our investment advisor, New Mountain Finance Advisors BDC, L.L.C. where appropriate. To obtain copies of our latest SEC filings and to access the slide presentation that we will be referencing throughout this call, please visit our website at www.newmountainfinance.com or call us at 212-720-0300. At this time, I’d like to turn the call over to Steve Klinsky who will give some highlights beginning on page four of the slide presentation. Steve?

Rob and Dave will go through the details in a moment but let me start by presenting the highlights of another quarter of steady earnings and dividend performance for New Mountain Finance. New Mountain Finance’s adjusted net investment income for the quarter ended December 31, 2014 was $0.34 per share, right in the middle of our guidance of $0.33 to $0.35 per share. This once again covers our Q4 dividend of $0.34 per share. The company’s book value on December 31 was $13.83 per share, which is down $0.50 from last quarter reflecting overall weakness in the credit markets particularly in energy and below budgeted performance at one of our portfolio credits Edmentum. We are also able to announce our regular dividend for the current quarter ending March 31, 2015. The regular dividend will again be $0.34 per share, consistent with our previously communicated view that we have reached a fully ramped steady state dividend level. The overall credit quality of the company's loan portfolio continues to be strong. We had no new loans placed on nonaccrual this quarter, although we do expect to place a portion of the Edmentum loan on nonaccrual in Q1. We still have had only one issuer with the realized default loss since NMFC was founded, representing less than 0.2% of all cumulative investments made to date. The company invested $226 million in gross originations in Q4 and $156 million net of repayments. In addition to the positive earnings and dividend results of the core business, we continue to execute on strategic initiatives that we believe will create meaningful shareholder value in the coming quarters. We upsized and extended our existing credit facilities. We have begun to utilize our recently issued Small Business Investment Company license. And now that energy credit markets have weakened, NMFC has also formalized a strategic alliance with Five States Energy Capital who we have worked with in past years to help us better seek out defensive and proprietary special opportunities in the energy space. In summary, we are pleased with NMFC’s continued performance and progress. With that, let me turn the call back over to Rob Hamwee, NMFC’s CEO.

Thank you, Steve. Before diving into the details of the quarter, as always, I’d like to give everyone a brief review of NMFC and our strategy. On Page 5, we provided some key financial highlights. As outlined on pages 6 and 7 of our presentation, NMFC is externally managed by New Mountain Capital, a leading private equity firm with approximately $15 billion of assets under management and 100 staff members, including 60 investment professionals. Since the inception of our debt investment program in 2008, we have taken New Mountain’s approach to private equity and applied it to corporate credit with a consistent focus on defensive growth business models and extensive fundamental research within industries that are already well-known to New Mountain. Or, more simply put, we invest in recession resistant businesses that we really know and that we really like. We believe this approach results in a differentiated and sustainable model that allows us to generate attractive risk-adjusted rates of return across changing cycles and market conditions. To achieve our mandate, we utilize the existing New Mountain investment team as our primary underwriting resource. Additionally, I would note here that our public float is now $850 million, up from $150 million at our IPO. Turning to Page 8, you can see our total return performance from our IPO in May 2011 through February 25, 2015. In the nearly four years since our IPO, we have generated a compounded annual return to our investors of 13.2%, significantly above our regular dividend yield and dramatically higher than our peers. Page 9 goes into a little more detail around relative performance against our peer set benchmarking against the 10 largest externally managed BDCs that have been public at least as long as we have. We attribute the success to, one, our differentiated underwriting platform that leverages the capabilities of the core New Mountain private equity team; two, our ability to consistently generate the vast majority of our NII from stable cash interest income and an amount that covers our dividend; three, our focus on running the business with an efficient balance sheet and always fully utilizing inexpensive appropriately structured leverage before accessing more expensive equity; and four, our historical alignment of shareholder and management interest. This issue of alignment has always been important to us and has obviously received increased attention in BDC circles recently. On page 10, we point out some of the key ways in which NMFC attempts to make sure management and shareholder interests are aligned. First, we have one of the lowest effective management fees in the industry, averaging approximately 1.4% per year since our IPO. Second, it unequivocally committed to not issuing equity below book value. Third, we’ve always been focused on keeping our overall expense ratio down both by utilizing an expense cap in the past and through an ongoing shareholder friendly expense allocation policy. Finally, New Mountain employees and NMFC Directors have been large and consistent buyers of our stock and today own nearly $60 million of NMFC’s shares. As outlined on page 12, credit spreads have broadly widened since our last call, although stability seems to be returning to the markets over the last few weeks. The spread widening has been driven by a number of factors, including increased volatility across financial markets in particular energy and to a lesser degree ongoing fund outflows. Risk premiums remain elevated creating an attractive environment to deploy capital. Given the continued focus in the market on the possibility of future short-term and long-term rate increases, we wanted to highlight NMFC’s defensive positioning relative to this potential issue. You can see on page 13, 85% of our portfolio is invested in floating rate debt. Therefore even in the face of a material rise in interest rates, you would not expect to see significant change in our book value. Furthermore, as the table at the bottom of the page demonstrates meaningful rise in short-term rates will generally increase our NII per share with the only exception being a modest rise having a slightly negative impact as the cost of the majority of our borrowings rise, while our interest income does not initially go up given the presence of LIBOR floors on most of our assets. Our highest priority continues to be our focus on risk control and credit performance, which we believe over time, is the single biggest differentiator of total return in the BDC space. If you refer to page 14, you will once again lay out the cost basis of our investments with the 12/31/14 portfolio and our cumulative investments since the inception of our credit business in 2008 and then show what has migrated down the performance ladder. Since inception, we have made investments of over $3.1 billion in 151 portfolio companies, of which only three inclusive of and pro forma for Edmentum, representing just $33 million of cost have migrated to non-accrual and only one representing $4 million of cost has so far resulted in a realized default loss. Over 96% of our portfolio at fair market value is currently rated 1 or 2 on our internal scale. Pages 15 and 16 show leverage multiples for all of our material holdings and investment and leverage levels for the same investment as of the end of the current quarter. Well not a perfect metric to be asset by asset trend and leverage multiple is a good snapshot of credit performance and helps provide some degree of empirical, fundamental support for our internal ratings and marks. As you can see by looking at the two tables, leverage multiples are roughly flat or trending in the right direction with the only material exception being UniTek. Moving on to page 17, we wanted to point out a number of important subsequent events that occurred after December 31. On the negative side, one of our borrowers, Edmentum Inc. released a very weak budget, the impact of which will likely be some type of debt restructuring. NMFC is taking a lead role in these discussions and bringing our Ed Tech private equity resources to bear on the situation. On a positive note, two of our portfolio companies where we had meaningful equity positions, global knowledge in store apart were sold in Q1, generating cumulative realized gains on our equity of $15 million between the two of them. Finally, UniTek completed its restructuring in the January and consistent with our remarks last quarter we remain optimistic about the prospects for our full recovery in the medium term on this investment. A new initiative, we believe will add significant value for our shareholders over time is our newly announced strategic alliance at Five States Energy and their affiliated broker dealer Greenville Securities, to pursue defensive lower middle market energy investments outlined on page 18. Our relationship with Five States arose out of New Mountain’s “deep-dive” in the energy sector nearly three years back. As we spoke to a number of potential local partners in the energy belt, we were particularly struck by Five States deep expertise in petroleum engineering and geology, extensive network of relationships for deal sourcing and a culture and investment track record that emphasis principal protection. We are focused on opportunities that are either not-levered to commodity prices, primarily in mid-stream and infrastructure where our downside is protected irrespective of commodity prices. We believe the recent dramatic decline in oil prices prove to be a powerful catalyst to drive attractive lending opportunities that fit within this model. The chart on page 19 helps track the company’s overall economic performance since its IPO. At the top of the page, we show how the regular quarterly dividend is being covered out of net investment income. As you can see, we continue to cover, to more than cover a 100% of our cumulative regular dividend out of NII. In fact, for the full year we have out earned our dividend by over $0.05 per share. At the bottom of the page, we focus on below the line items. Firstly, we look at realized gains and realized credit and other losses. As you can see looking at the row highlighted in green, we have had success generating real economic gains nearly every quarter through a combination of equity gains, portfolio company dividends, and trading profits. Conversely, to-date we’ve had only one material realized loss of $4 million beyond that the numbers highlighted in orange just show that we are not avoiding non-accruals by selling poor credits at a material loss prior to actual default. The net cumulative impact of this success to-date is highlighted in blue, which shows cumulative net realized gains of $29.3 million since our IPO. Next, we look at unrealized appreciation and depreciation. The decline in the net unrealized appreciation this quarter is detailed on the following page, primarily reflects four things, broad market movement, energy market movement, the Edmentum write-down and Global Knowledge and Storapod’s write-offs. We believe the broad market and energy movements are more transient than reflective of underlined portfolio company performance and expect economic reality to play out new marks over time. Page 21, just gives everyone a little more color on the four names that comprise our energy exposure. The bottom line here is the two large ones that are both comfortably marked at par. In Tenawa’s case of function of very low loan to value and limited direct exposure to accrued volatility, and in Northstar’s case, a function of a parent company guarantee. Sierra and Permian are both niche service businesses that will be impacted by a downturn in drilling activity, but we are in the first lien debt in both cases and leverage levels are modest enough such that we expect both businesses to be able to generate enough cash to service their debt even in a protracted downturn. Moving on to portfolio activity as seen on page 22, we had another active quarter for originations in Q4. We made significant investments in eight portfolio companies and a total gross origination of $226 million. Repayments in Q4 were modest totaling $70 million. We funded some of the originations with asset sales of $23 million, resulting in net originations of $133 million. Shown on page 24, we have had a reasonably active start to Q1 with investments of $65 million. Pages 25 and 26 show the impact of Q4 investment and disposition activity on asset type and yields respectively. Both asset originations and repayments were roughly split between first lien and non-first lien investments. Yield on originations were more than a full percentage point higher than those on disposals and consistent with the portfolio as a whole. The net impact is that port folio yield overall is unchanged at 10.7%. In terms of the portfolio review on page 27, the key statistics as of 12, 31 was very similar to 9, 30. The asset mix remains roughly evenly split between first lien and non-first lien. As always, we maintain a portfolio comprised of companies in the defensive growth industries like business services, software, education and healthcare that we believe will outperform in an uncertain economic environment. Finally, as illustrated on page 28, we have a broadly diversified portfolio since our largest investment of 3.5% of fair value and the top 15 investments accounting for 40% of fair value continuing a gradual trend of increased diversity as the overall business expands. With that I will now turn it over to our CFO, Dave Cordova to discuss the financial statements and key financial metrics. David?

Thank you, Rob. For more details on the financial results in today's commentary please refer to the Form 10-K that was filed last evening with the SEC. Now, I would like to turn your attention to slide 29. The portfolio had just over $1.45 billion in investment at fair value at December 31, 2014 and total assets of just over $1.5 billion. We had total liabilities of $712.7 million of which, total statutory debt outstanding was $633.1 million, excluding $37.5 million of drawn SBA-guaranteed debentures. Net asset value of $802.2 million or $13.83 per share was down $0.50 from the prior quarter. As of December 31, our statutory debt-to-equity ratio was 0.79 to 1. On Slide 30, we show the historical NAV per share and leverage ratios, which are broadly consistent with our current target leverage of between 0.7 to 0.8 to 1. We also show the NAV adjusted for the cumulative impact of special dividends, which portrays a more accurate reflection of true economic value creation. On Slide 31, we show our quarterly income statement results. We believe that our adjusted NII, which excludes the capital gains incentive fee, is the most appropriate measure of our quarterly performance. This slide highlights that while realizations and unrealized appreciation/depreciation can be volatile below the line, we continue to generate stable net investment income above the line. Focusing on the quarter ended December 31, 2014, we earned total investment income of approximately $36.7 million. This represents an increase of 2 million or 6% from the prior quarter, largely attributable to an increase in interest income from a larger asset base. Total net expenses of $17.5 million increased $0.9 million or 5% due to an increase in incentive fees associated with the asset growth as well as an increase in interest expense associated with a higher average debt balance. Net administrative, professional, and other general and administrative expenses were up by $0.3 million. I’d like to make a quick note on the management fee. Since IPO, the base management fee calculation has deducted the borrowings under the SLF Credit Facility. The SLF Credit Facility has historically consisted of primarily lower yields assets at higher advance rates. As a result of the merger of the SLF Credit Facility into the Holdings Credit Facility, there is no longer a standalone SLF Credit Facility. Post credit facility merger and consistent with the methodology since IPO, the Investment Adviser will waive management fees on the leverage associated with those assets that share the same underlying yield characteristics with investments leveraged under the legacy SLF Credit Facility. This results in an effective management fee of 1.4% for the year and the Q4 management fee broadly in line with the prior quarter. It is expected, based on our current portfolio construct, that the 2015 effective management fee will be broadly consistent with the prior years and it is important to note that the Investment Advisor cannot recoup management fees previously waived. In total, this all results in fourth quarter adjusted NII of $19.2 million or $0.34 per weighted average share, which is in the middle of our guidance provided on November 6, 2014 of $0.33 to $0.35 per share and covers our Q4 regular dividend of $0.34 per share. As a result of the net unrealized depreciation in the quarter that Rob discussed earlier, we reduced our capital gains incentive fee accrual by approximately $6.7 million. In total, for the quarter ended December 31, 2014, we had a decrease in net assets resulting from operations of $8.9 million. On Slide 32, I’d like to give a brief summary of our annual performance for 2014. For the year ended December 31, 2014, we had total pro forma adjusted investment income of approximately $135.7 million and total net expenses of $62.3 million. This all result in 2014 total pro forma adjusted net investment income of NMFC and the Predecessor Operating Company of $73.4 million or $1.41 per weighted average share. In total, for the year ended December 31, 2014, we had a total net increase in pro forma capital resulting from operations of approximately $46 million. Finally, for 2014, we declared total regular dividend of $1.36 per share and total special dividend of $0.12 per share resulting in total aggregate dividends of $1.48 per share. As Slide 33 demonstrates, our total investment income is predominantly paid in cash. Though the amount of prepayment fees vary from quarter-to-quarter based on repayments, our historical earnings have consistently shown some material prepayment fee income. Therefore, we show total interest income as a percentage of total investment income both with and without prepayment fees, which is one measurement of the stability and predictability of our investment income. Turning to Slide 34, as briefly discussed earlier, our adjusted NII for the fourth quarter covered our Q4 dividends. Given our belief that our Q1 2015 NII will fall in a previously declared expected range of $0.33 to $0.35 per share, our Board of Directors has declared a Q1 2015 dividend of $0.34 per share, in line with the past 11 quarters. The Q1 2015 quarterly dividend of $0.34 per share will be paid on March 31, 2015 to holders of record on March 17, 2015. Finally, on Slide 35, we highlight our various financing sources, including the convertible notes issued and corporate revolving credit facility closed in 2014. Taking into account SBA-guaranteed debentures related to our SBIC license, we now have $840 million of total pro forma borrowing capacity. As a reminder, our Wells Fargo credit facility covenants 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. During the quarter, we combined and extended the maturity of our Wells Fargo credit facility by three years to December 2019 and increased the capacity of the NMFC credit facility by $30 million. At this time, I would like to turn the call back over to Rob.

Thanks, Dave. In closing, I would just like to say that we continue to be pleased with our performance to-date. Looking into 2015, we believe we are well positioned to both cover our dividend out of NII and maintain our track record of very limited credit losses. Once again, we like to thank you for your support and interest. And at this point, turn things back to the operator to being Q&A. Operator?

Thank you. We will now being the question-and-answer session. [Operator Instructions] Our first question comes today from Ryan Lynch with KBW.

Good morning. Thank you for taking my questions. First one, on Slide 14, you talked about 50% of Edmentum going on non-accrual potentially in Q1. Are you guys just waiting for this restructuring to occur before you actually place this loan on non-accrual? And is 50% of this loan going on non-accrual kind of a good run rate of what we should anticipate?

Yeah, I think that’s our best guess at this time. I mean it’s relatively early on. This kind of all came to our attention in the first quarter, so it’s definitely a subsequent event. And we’re giving you our best guess as to where it’s likely to come out at this point.

So should we expect you guys to accrue income on that loan through Q1?

No, I would expect that it goes on non-accrual as of the first day of Q1.

Okay.

A portion of it.

Sure. I mean you guys have about 8% of your portfolio in energy, do you expect this percentage to get materially larger with the new energy initiative and also obviously with the energy markets getting beaten up recently, how do you view the kind of current market for making energy investments.

I think it’s tricky right now, right? Because nobody wants to try to catch a falling knife on the one hand. On the other hand, particularly with the new alliance and initiative, we are likely to see some things where the risk reward is so skewed in our favor that you can – for almost any state of the world in terms of energy prices, you can structure an attractive security. And if that’s the case, those are type of things we’re going to do. So whether we’re able to execute on none of those or a handful of those, it’s hard to say right now. I think the 8% could get larger, I don’t know if it gets to 12% or 15%, but that would be order of magnitude I would think about, if and only if we’re able to find those types of opportunities that are so skewed in our favor.

Okay. All right. And then can you remind us how you view leverage in terms of total leverage including the SBIC and then also just regulatory leverage?

Yeah, I mean we’re really more focused on regulatory leverage given the way we’ve structured our leverage. I would be very comfortable inclusive of the SBA debt having that number go, the non-statutory number go above one time, but we’re obviously very sensitive to the statutory number and keeping – preserving a very meaningful cushion to the one-to-one. So we’ve historically targeted a range from 0.7 to 0.8.

Okay. And then it looks like you had about $37.5 million currently drawn on the SBIC debt with about $42 million of regulatory capital. Do you have additional debentures currently available to draw down?

Yes, we do.

Okay. And then one…

We would expect the SBA to be a meaningful driver this year of accretive growth all else being equal.

Okay. And then one more kind of technical modeling question, how should we think about administrative profession or other G&A expenses going forward. It looks like you guys had about $2.1 million in the fourth quarter but I think that might also have some taxes in that number. Just kind of how should we think about that number going forward?

Yeah. That also include about $0.3 million of indirect expenses as well and it’s something – as we’ve gotten larger and we’ve gotten some incremental operating leverage, we expect that the BDC one day it will be able to bear all of the expenses but I think the interim consistent with what we disclosed in the financial statement that the investment advisor will continue to evaluate the indirect expenses and to the extent they need to waive any in the future.

Okay, thanks. That’s all from me.

Thanks, Ryan.

The next question comes from Greg Nelson with Wells Fargo.

Hi, good morning guys.

Hi, Greg.

Good morning. Thanks for taking my questions. So I have a few, first, obviously you ramped up the first SLP it’s great that you did it quickly. Thinking about the opportunities do more and the ability to keep those off balance sheet as far as consolidation of leverage, just like to hear your thoughts there.

Yeah. We don’t think there is any issue about keeping the existing SLP leverage off balance sheet. That’s kind of a done deal, so that will be as it is. Our ability to do SLP II or SLP III will really be a function of the developing regulatory views around that. So it’s really pending SEC approval at this point in time and we do have an active dialogue there but obviously impossible to predict which direction that will go in. But just to be clear, no backward looking issues, SLP I is in very good shape.

Alright, perfect. And then just touching on the leverage a little bit, I just like to get obviously if some SBIC capacity, but just hear your appetite for growth and equity issuance in this environment. Obviously what you’ve done quarter-to-date has been a little bit focused heavier on the second lien. So I am just trying to get an idea of how you’re thinking about the current investment environment as it relates to growth and equity versus what you’re deploying in.

Yeah. So far this quarter, we’ve effectively funded our originations with repayments. We had our biggest investment Global Knowledge repay their latest quarter. And so we will continue to do that and we’re always thinking about when and if an equity offering makes sense, there are obviously a lot of factors that would go into that and we’ll continue to evaluate that but we are clearly in the upper end of our leverage target. And so for the time being, we will be funding – other than using the SBA facility, we will be funding investments with monetizations.

Sure. Any kind of off of that, do you see any – have you been seeing better - any opportunities to optimize the portfolio through sales…

Yeah, exactly. So we have been doing some opportunistic rotating if you will of old assets with [drafts] [ph], less attractive yields and putting that – deploying that those proceeds back into some of the new assets that have what we believe are pretty compelling yields.

Sure. And then on the market impact for the unrealized [depreciation] [ph], I think you had about $12.8 million, it’s more than $0.20 a share of NAV. With spreads coming back a little bit and stabilizing here during the quarter, do you expect some of that to come back?

I think we do. We will have to see exactly how the rest of the quarter plays out. But, yeah, I mentioned in my prepared remarks, I think we do believe that ultimately that market movement is transient, is not reflective of anything idiosyncratic in the portfolio other than obviously the Edmentum pieces which we broke out. And so depending on how the market goes, we would expect there would be some recovery there.

Great. And then just one last quick on Edmentum. This is a loan that a few BDCs hold, some have it marked higher, one asset marked 10% about lower than you do, which would be $0.05 to $0.06 NAV, just wanted to get your thoughts here on why you view 50% as the right rate?

It’s hard to go into all the details given the evolving nature of the situation and confidentiality obligations. So all I can say is that’s what we after pretty through analysis working with our auditors, working with our board, felt was the appropriate number. There is volatility around that number in both directions given the – like I said, the evolving situation, but we are comfortable that sitting here today it reflects best guess.

Alright. Thanks for taking my question.

Yeah, anytime.

[Operator Instructions] Our next question comes from Tony Sterne with Boston Provident.

Hi, all. Good morning. Thanks for taking my question.

Sure.

I hate to spend so much on this Edmentum, but I just wanted to get a better understanding of what’s going on there. I saw a few BDCs taking the mark and I called around the Street and Street is now quoting it at $0.02 to $0.07 and I see that you are holding it at $0.50, which maybe as of December. I just wanted to get an understanding for what the ultimate mark could be and how you are thinking about this investment going forward?

We’ve obviously heard about this “Street level”, which is completely meaningless since four people hold virtually the entire security. So there is no trade, there is no basis that we are aware of for that Street quote. So we continue to be very comfortable with the underlying support that not just at 12/31, but like I said, subsequent event, sitting here today, we feel that that’s an appropriate level for change. It could go up, it could go down. But right now, that’s what we feel is the best level.

Thank you.

Welcome.

This concludes our question-and-answer session. I would like to turn the conference back over to Rob Hamwee for any closing remarks.

Great. Thank you, operator. Thanks, everyone. Again, appreciate everyone’s continued interest and support and look forward to speaking again in a few months when we have our Q1 call. Thank you.

The conference has now concluded. Thank you for attending today’s presentation. You may now disconnect.