SLR Investment Corp. (SLRC) Q3 2012 Earnings Report, Transcript and Summary

Good day, ladies and gentlemen. Welcome to the Q3 2012 Solar Capital Ltd. Earnings Conference Call. My name is Chantilly, and I'll be your operator for today. [Operator Instructions] As a reminder, this conference is being recorded for replay purposes. I would now like to turn the conference over to your host for today, Mr. Michael Gross, Chairman and CEO. You may proceed, sir.

Thank you, and good morning. Welcome to Solar Capital Ltd.'s earnings call for the third quarter ended September 30, 2012. I'm joined here today by our Chief Operating Officer, Bruce Spohler; and our Chief Financial Officer, Rich Peteka. Rich, before we begin, would you start off by covering the webcast and forward-looking statements, please?

Of course. Thanks, Michael. I'd like to remind everyone that today's call and webcast are being recorded. Please note that they are the property of Solar Capital Ltd., and that any unauthorized broadcasts, in any form, are strictly prohibited. This conference call is being webcast on our website at www.solarcapltd.com. Audio replay of this call will be made available later today as disclosed in our earnings press release. I'd also like to call your attention to the customary disclosures in our press release regarding forward-looking information. Statements made in today's conference call and webcast may constitute forward-looking statements, which relate to future events or our future performance or financial condition. These statements are not guarantees of our future performance, financial condition or results and involve a number of risks and uncertainties. Actual results may differ materially as a result of a number of factors, including those described from time to time in our filings with the SEC. Solar Capital Ltd. undertakes no duty to update any forward-looking statements, unless required to do so by law. To obtain copies of our latest SEC filings, please visit our website or call us at (212) 993-1670. At this time, I'd like to turn the call back to our Chairman and Chief Executive Officer, Michael Gross.

Thank you, Rich. Before we discuss our third quarter results, which we released after close last night, I would like to take this moment to extend our deepest sympathies to the victims of Hurricane Sandy and our prayers for countless others whose lives, homes and businesses have been severely impacted by this devastating and far-reaching storm. Our thoughts are with all of them as they begin the arduous process of rebuilding their homes and communities. Also, we appreciate the effort that many of you who reside and work in the metropolitan area have taken in order to participate in our earnings call today during this very trying time. In the third quarter, leverage credit markets in the United States were driven by strong market technicals and unprecedented monetary easing by the Federal Reserve. The Fed's promise of sustained low rates and abundant liquidity fueled strong demand for higher-yielding assets and a powerful and broad-based risk on trade. In a liquid loan market, a hot new issue market in the third quarter set off a repricing run enabling a number of issuers to refinance on much more attractive terms. Activity in the liquid syndicated high yield and bank loan markets have a spillover effect on the middle market pricing although to a more muted degree. Middle market loan volume was slightly higher compared to the previous quarter, but year-to-date volume of about [ph] 60% of the volume in 2011 over the same period. Refinancing transactions represented about -- over 40% of middle market loan volume during the quarter. Although tight credit markets have created opportunities to monetize select investments and realize gains, it is imperative to maintain strict adherence to our investment discipline as we redeploy the capital. We will continue to focus our efforts on proprietary originations and leveraging our deep relationships with the sponsor community to source attractive investments that meet our risk and return parameters. Importantly, we continue to see the relative opportunities in middle market lending as having a more favorable risk return profile than in liquid loan and high yield markets. We expect to be patient and highly selective in making new investments. In the third quarter, our net asset value increased to $22.70 a share compared to $22.51 per share in the prior quarter. The portfolio generated net investment income of $0.50 per share, continuing our positive earnings momentum and importantly, covering our quarterly dividend payment. Since the end of Q1, our net investment portfolio has grown approximately 16%. Growth in net investment income was driven by almost a full quarter run rate on our second quarter origination, and based on current visibility, we expect fourth quarter recurring investment income to continue to cover our dividend. Overall, the fundamentals of our portfolio remain strong and credit quality is stable. At the end of third quarter, just over 98% of our income-producing assets were performing, and we expect the 2 small non-accrual positions to come up non-accrual status in this quarter -- in the fourth quarter. The fair value weighted average market of our portfolio, excluding common equity, was approximately 97% at September 30. We continue to believe there's excess reliable value above our current net asset value as we monetize the portfolio. The continued strong performance of our portfolio allowed us to make further enhancements to our capital structure during the quarter. In early August, we announced the addition of a new lender, which committed $40 million to our senior secured credit facility that was recently extended to July 2016. New commitment increased our current credit capacity to $700 million. In addition, in late August, we raised approximately $45 million of common equity in a direct registered offering of 2 million shares of our common stock to an institutional investor at $22.51 per share, consistent with the prior quarter's book value. The share offering reflects Solar Capital's continued proven access the capital markets for equity and debt capital. We will continue to take advantage of windows of opportunity to enhance our balance sheet. At the end of the third quarter, our leverage was 0.28x debt to equity, and we had approximately $322 million available to us to invest in new opportunities. Finally, our Board of Directors declared a quarterly dividend of $0.60 per share, which we expect to be covered by our GAAP and taxable earnings in Q4. The fourth quarter 2012 dividend will be paid on January 3, 2013, to holders of record as of December 20, 2012. At this turn -- time, I'll turn the call over to our Chief Financial Officer, Rich Peteka, to take you through the financial highlights.

Thanks, Michael. Solar Capital Ltd. net asset value at September 30 was $877.6 million or $22.70 per share compared to $824.9 million or $22.51 per share at June 30, 2012. As of September 30, we had investments in 41 portfolio companies and 23 industries, totaling $1.17 billion at fair value. At September 30 -- 31, 2011, we had investments in 42 portfolio companies and 24 industries, totaling $1.05 billion. The 12% increase in portfolio value for the 9 months ended September 30, 2012, reflects both continued net growth of our portfolio, as well as the net increase in its fair value. At the end of Q3, the weighted average yield on income-producing investments measured at fair value was approximately 13.9%. Gross investment income for the 3 and 9 months ended September 30, 2012, totaled $40.6 million and $111.8 million, respectively. Total expenses for the 3- and 9-month periods ended September 30, 2012, were $18.4 million and $54.0 million, respectively. Therefore, net investment income for the 3 and 9 months ended September 30, 2012, was $22.3 million or $0.60 per average share and $57.7 million or $1.57 per average share, respectively. Net realized and unrealized gains totaled approximately $8 million for the third quarter and $34.7 million for the 9-month period ended September 30, 2012. Net realized and unrealized gains were driven primarily by the general increase in the fair value of our portfolio. At this time, I'd like to turn the call over to our Chief Operating Officer, Bruce Spohler.

Thank you, Rich. I'd like to start by making on overall observation that our portfolio companies, in general, are optimistic about their respective businesses. However, they continue to be cautious regarding the macro and economic uncertainties. One general theme that emerges is stable performance and steady deleveraging in an environment of muted top line growth and a focus on cost efficiencies. Our investment priority remains to invest in recession-resilient, stable companies that can generate cash flow and reduce leverage throughout an economic cycle. Let me give you an overview of the portfolio. At the end of the third quarter, the fair market value of our investment portfolio was approximately $1.2 billion. The fair value weighted average yield on our income-producing investments was approximately 14%, consistent with the prior quarter. As of 9/30, 41% of the fair value of our portfolio was in secured assets. We have investments in 41 companies, operating across 23 industries. The weighted average investment risk rating of the portfolio remained at approximately 2, measured at fair market value at the end of the quarter, based on our 1 to 4 risk rating scale, with 1 representing the least amount of risk. Now I would like to provide you an update on a few of our existing portfolio companies. DS Waters. Since our last update, we can report that the company continues to perform in line with expectations. Customer growth has driven both increased revenues and EBITDA over the prior year. In addition, the integration of the coffee acquisition is on schedule, and cost efficiencies are being realized as anticipated by management. Our third-party independent valuation firm valued our investment in the company's second lien loan at 103.5% of par, and our investment in our senior preferred units at approximately $0.85, or $0.846, to be exact. DS Waters' strong operating performance, in conjunction with strong market conditions, has resulted in its first and second lien term loans being quoted at a significant premium to par and in line with their respective call prices, reflecting the market's view of the company's debt securities. Now let me turn to our non-accrual assets. DirectBuy. In Q4 2011, we placed DirectBuy on non-accrual. We continue to be in active dialogue with the sponsor, bondholders and company's management, concerning a restructuring transaction that we expect to take place during Q4. DirectBuy is the largest domestic franchisor of membership-based buying centers, which allows customers to purchase products direct from manufacturers. As of September 30, JPMorgan, the sole book runner of the existing notes, had this asset quoted at $0.20 of par, resulting in a fair value for our investment of $5 million. We believe this valuation reflects the underlying fundamentals of DirectBuy's business and expect this asset to return to accrual status during this quarter. Granite Global. Last quarter, we placed Granite Global on non-accrual status. The company is the leading provider of outsourced insurance-related services such as claims adjusting for property, casualty and auto lines to Canadian-based insurance companies. We continue to be in active dialogue with the sponsor and the company's other lenders. At 9/30, our third-party valuation firm valued this asset that $0.85 of par, resulting in a fair value of the $15.7 million. We believe this valuation reflects the underlying fundamentals of Granite's business, including its improving trends, and we continue to believe that the investment will return to full accrual status during this quarter. Now let me touch on one of our 2007 investments, Weetabix. Last quarter, we announced that Weetabix had agreed to be acquired by China's Bright Foods. The company expects the transaction to close today, at which time, our $55.7 million investment is expected to be repaid in full. These pre-credit crisis legacy investments had some of the lowest yields in our portfolio. The full repayment will reduce the portfolio's non-U.S. dollar currency exposure by more than half. In addition, Weetabix's repayment will reduce our PIK exposure and allow Solar to reinvest the proceeds in cash pay loans at higher yields across the portfolio. Weetabix had a weighted average mark in the mid-50s back in the trough of December 2008. With the benefit of our patient capital base, we were able to realize a high-single-digit IRR on the Weetabix investment. I'd also like to bring your attention to a name change regarding one of our investments listed on our Q3 schedule of investments, Allegis Technologies, which is a carve-out from Fidelity. This investment had previously been named FIS Health Care Holdings. Just to remind you, Allegis is a leading provider of software services and card-based technologies for health care benefits. In August, we funded a $28 million mezzanine investment, offering an all-in yield in the high 12% area at total leverage levels of under 5x at 4.7. On the origination front, during the third quarter, we committed approximately $27 million par value into 2 new and 1 existing portfolio companies. Our principal repayments in sales totaled approximately $71.5 million for the quarter. Now I'll provide some color on some of the activity. We committed CAD 10 million in a first lien term loan investment to easyfinancial Services, which is a consumer lending subsidiary of easyhome, a publicly traded business in Toronto, which is a leading merchandise leasing company. These funds were used to support the company's strategy to grow its consumer loan portfolio. Our loan, which is a first lien loan, was structured with a yield in the mid-12s. We expect to increase our investment over time in conjunction with the projected growth of the borrower's accounts receivable days. In addition, we invested approximately $17 million in a secondary market purchase of a unit tranche loan to T&D Solutions Holdings. T&D is a leading maintenance provider for electric transmission and distribution lines, primarily in the Gulf Coast and South Mid-Atlantic regions of the U.S. As a result of our relationship with the sponsor, we were able to conduct primary due diligence on this secondary purchase. It's levered under 3x and offers a 13% cash coupon. During the quarter, our portfolio experienced 2 repayments. The first was a full repayment at a premium to par of our $35 million secured term loan to National Vision, a leading value-oriented optical retailer owned by Berkshire Partners. Also, during the third quarter, Asurion, the leading provider of a cell phone warranty services, refinanced approximately 55% of its second lien loan, which resulted in a repayment to Solar of $22.5 million at $1.03 on par. Portfolio continues to hold an $18.5 million fair value remaining exposure to the second lien tranche, in addition to our approximately $13 million investment at fair value in Asurion's subordinated debt. Solar originally invested in Asurion back in 2007 and had invested in this credit multiple times over the last several years. The company continues to perform exceptionally well. Now I'd like to turn the call back over to Michael.

Thank you, Bruce. We are pleased with the underlying performance and credit quality of our investments. And with the current portfolio, it's defensely positioned to weather an even economic climate. As long-time investors in the leveraged finance industry, we understand the importance of being patient, maintain our investment discipline and exercising prudence in periods of economic uncertainty in overheated markets. To the management team's significant 6% ownership of Solar, our interest are well aligned with shareholders who are making investment decisions. Maintaining our best in discipline is critical to delivering steady performance through credit cycles for our long-term investors. A month into Q4, we are seeing an attractive pipeline of new investment opportunities, but will continue to be judicious and highly selective in committing capital to investments we believe that meet our risk return profile. During the quarter, we enhanced Solar Capital's capital structure by increasing our debt capacity through the addition of a new lender and by issuing 2 million shares of our common stock. We believe it is prudent to take advantage of opportunities to optimize the long-term capital structure in ways that can provide greater funding flexibility and stability. Based on current visibility, we expect fourth quarter investment income to continue to cover our fourth quarter dividend. At 11:00 this morning, we'll be hosting an earnings call for our third quarter 2012 operations for Solar Senior Capital or SUNS. Our ability to provide senior secured financing through this vehicle enhances our origination team's ability to meet our clients' capital needs. We are seeing benefits of this value proposition in Solar Capital's deal flow. Thank you for your time. Operator, at this time, we will open up the line for questions.

[Operator Instructions] Your first question comes from the line of Vernon Plack with BB&T Capital Markets. Vernon C. Plack - BB&T Capital Markets, Research Division: One question, Michael, in terms of the portfolio. Given your comments on the market, the need to be selective, and payoffs such as Weetabix, can we expect the portfolio to shrink a little bit during this quarter?

Modestly, yes. I mean, with upcoming changes, yes.

Your next question comes from the line of Mickey Schleien with Ladenburg. Mickey M. Schleien - Ladenburg Thalmann & Co. Inc., Research Division: My question regards the timing of the issuance of equity. I'm trying to understand why you went ahead and did that given that you're already running with some of the lowest leverage in the group. And you're cautious on the outlook for the market. And I'm confused why you would introduce the drag of additional equity at this time?

Yes, 2 reasons. One, it wasn't something we went out after. It was a reverse inquiry. An investor came to us, one investor specifically, and we thought it was an opportunistic way to issue equity without any market disruption whatsoever. Frankly, once we offered, we had other people contact us to do the same. We turned it down. It also allowed us to put another $40 million of credit facility on our balance sheet to kind of match it, if you will, and give us a lot of dry powder going forward. So we think it was opportunistic and the right thing to do. And frankly, if you look at our activity over the last 1 year, 2 years, we probably issued the least amount of equity of anybody, and given how much we own the company, we're very focused on not taking dilution. Mickey M. Schleien - Ladenburg Thalmann & Co. Inc., Research Division: Okay, I appreciate that. Just a few housekeeping questions. Were there any material prepayment or origination fees in the quarter? And how much were they?

No, there were none. Mickey M. Schleien - Ladenburg Thalmann & Co. Inc., Research Division: And what portion of the portfolio ballpark is in fixed-rate instruments?

Sure. Fixed rate is approximately 60% consistent with last quarter. Mickey M. Schleien - Ladenburg Thalmann & Co. Inc., Research Division: And lastly, within the senior secured basket, can you give us a sense of the breakdown between first lien, second lien, unit tranche and anything else that's in there?

We can get back to you on that, Mickey. It's predominantly unit tranche and second lien.

Your next question comes from the line of John Stilmar with JMP Securities.

Really quickly. As we've talked about -- through several other BDCs and obviously, your cautiousness about the environment, it seems like we've got a very voracious debt market, but PE volume has been certainly coming down. How would you characterize volume relative to quality? Are you -- in terms of the pipeline for Solar? Are you seeing a great number of deals that you're having to raise the bar in terms of selectivity, such kind of that the acceptance rate has fallen and that's sort of where we sit today? Or is it that deal flow is now even starting to kind of tailor off as the liquid markets are just not even allowing kind of a tailored double-digit return to start to become a little bit more part of -- like the standard deal flow? I'm just curious as to get a measure of quality versus management into the volume numbers that we see from other market statistics.

Sure. Yes, I think the quantity of deal flow, John, continues to be strong. I think the underlying mix of the deal flow has shifted of late, and what I mean by that is the percentage of the deal flow that we're seeing that is recapitalization or refinancing has ramped up, not surprising, given the strength of the liquid credit markets. And the number of new M&A platform creations and add-on acquisitions has tailed off a little bit during Q3. But there still seems to be a pretty strong deal flow. To your comment, we are just saying no an awful lot because we feel that the risk parameters have migrated to historic highs, and so we are being hyper-selective in this environment.

Great. And then as we put it in context, there's a Weetabix and then the resolution from DirectBuy, and as we've started -- and Asurion. Originally, when Solar came public, there was the larger liquid credit portfolio that would benefit from the spread-tightening environment that we've seen. And this quarter, we obviously saw some of those benefits through monetization. Is this really kind of -- given the frothiness of the liquid loan market today, are we really kind of at this point in the portfolio where we're starting to kind of come across that seam of a transition between the larger liquid loans to more kind of smaller credit-oriented investments that may be a little bit more prudent and a little bit more elongated, at least in terms of capital deployment? And what I mean by that is if I look at some of the investments that you made, they're smaller in dollar size, but certainly have a pretty attractive yield. And given your discipline, at least from a credit outlook, they certainly pass what seems to be a higher credit bar. So I'm wondering if this -- if that characterization of your portfolio would be fair and accurate.

What I would say is, politely, no. The average EBITDA, John, across the portfolio continues to be north of $50 million. So we're still looking at the large and the mid-market in terms of opportunities. We are not going downmarket, if I understand your question correctly, and lending to smaller issuers. There is always a situation or 2 where we have to start in the $20 million to $40 million EBITDA and then grow with the business as they grow organically or through add-on acquisitions allows us to deploy additional capital into the investment. But the strategy has not shifted at all. And as you know, north of 80% of our portfolio has turned since going public in 2010. So we have put the majority of these assets on post credit crisis and are continuing to focus on the large and the mid-market. But I do think, to your commentary, that the pressure at the large-end liquid markets does bring risk. I think it's true across all of the mid-market, to the levels that you need to be that much more prudent in terms of asset selection.

[Operator Instructions] And your next question comes from the line of Greg Mason with Stifel, Nicolaus. Greg M. Mason - Stifel, Nicolaus & Co., Inc., Research Division: Could you talk a little bit about Granite Global, your expectations it will come back on accrual status in the fourth quarter? How -- is there any recapture of previous income? Or how is that going to impact the income statement next quarter?

Sure. It is our expectation that it will come back on this quarter, as we mentioned. And we do expect, concurrent with that, to be able to recapture the interest income that has been on non-accrual to date. So more to come, but we think that's going to be a very successful outcome with additional capital being invested by the equity sponsor and full support of the lender group. Greg M. Mason - Stifel, Nicolaus & Co., Inc., Research Division: Okay, great. And then my next question was on the preferred units of DS Water. Last quarter, they were at $119 million cost and fair value. This quarter, cost went up by almost $5 million, yet fair value was up by about $3 million, so it didn't go up lockstep with the accrual of the PIK income. Can you talk about why that is and how those numbers are reflected on the income statement, the movements in those 2 numbers?

Yes, Greg, this is Rich. As with all PIK investments, and this one is all PIK, it's based on flexibility. The company's operating performance continues to do well and meet expectations, if not exceed that, at least, in the near term. As far as PIK goes, we accrued -- the $5 million change is roughly the amount of income that's been accrued and added to both par value, but it's also added to cost at the same ratio. And it's just a question of where our third-party values of those assets and in this case, I think they valued it at approximately $0.845 or $0.846. So what you're seeing in value is a valuation estimate by a third party. And what you're seeing in the cost in par value is the consistent increase and then pull at that [ph] income is capitalized into cost. Greg M. Mason - Stifel, Nicolaus & Co., Inc., Research Division: So to make sure I'm thinking of that right, the $5 million increase in cost and par comes in as revenue. And then you have a reversal of kind of unrealized depreciation below the NOI line. Is that how it flows into the income statement?

Yes, and that's no different from previous quarters. Greg M. Mason - Stifel, Nicolaus & Co., Inc., Research Division: And then so Michael and Bruce, if we think about -- it sounds like underlying fundamental comments on DS Waters is that they're doing everything that you think they should, yet the valuation as a percent of par was written down a little bit this quarter. Can you talk about why that might be or how -- just how we should be thinking about DS Waters going forward?

Look, I think, if you look at the delta, it's not a big number. And effectively, the way this investor gets by [ph] with an independent third party is by looking at the underlying equity value of the company. And so there will be some fluctuation quarter-to-quarter given that we're kind of in a closet [ph] equity position here. So you shouldn't be surprised in one quarter be down a couple of points, another quarter could be up a couple of points. Because what happens is the valuations look at market multiples or comparable companies and those don’t stay fixed quarter-to-quarter.

Your next question comes from the line of Jonathan Bock with Wells Fargo Securities.

A lot of them has been asked. However, guys, one quick item related to Weetabix. Could you expect an exit fee associated with that or are a potential, we'll call it, maybe a success fee that might enter income that quarter or this quarter?

The short answer is no just because we originally invested back in 2007. So any call protections expired at this point in time. But as we mentioned, it is a testament, I think, to the patience of the capital, given that we had this marked back in the day in the low 50s and here we are getting full value. So we're happy to take our full value and redeploy the proceeds.

Agreed. Then maybe a question on upfront fees, in general, to the extent that one is making investments in this environment. Can you maybe talk about what one can expect in terms of upfront fees and how that's changed and whether or not you, as a lender, are obviously interested in collecting a little bit more in terms of points upfront over the life of a loan rather than perhaps taking in the form of a higher coupon?

Nothing's really changed. We typically get 1 to 2 points in a given transaction. And we don't take that to income in the quarter received, but it gets amortized over the life of the loan. So for us, it's just a component of the yield we get in a given investment.

Then I guess, one additional item as it relates to the entirety of the market. So you mentioned you're being prudent in asset selection, which we agree, in this environment, obviously, that's warranted. But maybe discuss for us what are some of the parameters around what would make an investment prudent in this environment versus imprudent, understanding every deal is different. However, there are certain leverage multiples that one is never interested in exceeding or perhaps certain structures or covenants that one would not feel comfortable investing without. So a little color on what it means to be prudent in this environment, we'd appreciate.

Sure. I think, as we mentioned earlier, we continue to focus on the large and the mid-market. We believe that that is where we have the deepest relationships and the most comfort from an underwriting perspective. Companies that we think will grow and migrate into the large liquid markets create a natural churn as we get refinanced or the businesses get sold. We continue to see leverage lows in the portfolio in the mid- to high 4x, which, again, is where we're comfortable. It doesn't mean we won't, from time to time, invest in the 5s, where we see strong free cash flow in the near term that will de-risk that investment. So I think we're continuing to look at how we've looked at credit for the duration of our careers, close to 30 years each, and find that it's really about looking at businesses that are stable, and can generate good, strong free cash flows throughout an economic cycle at prudent leverage levels. Because even stable businesses, if you put too much debt service, by definition, can create challenges with any volatility in earnings. So I don't think any of our underwriting parameters have changed in this environment.

Okay. And then one last question. As it relates to the available debt capacity, obviously, there's quite a bit of investment capacity that could meet your needs for several quarters. Would it be fair to say that growing the equity account probably is going to be a little bit of a lower priority as we move forward over the next couple of quarters through new investment activity?

Yes, I think that's a very reasonable assumption, yes.

At this time, we have no additional questions. Now I'd like to turn the call back over to Mr. Gross for closing remarks.

Again, we thank you all for your participation today, especially those of you are in the New York metropolitan area where it's probably been difficult to do so. And for those of you who are interested, we look forward to speaking to you on our Solar Senior Conference Call in 25 minutes. Thank you. Bye-bye.

Ladies and gentlemen, that concludes today's conference. Thank you for your participation. You may now disconnect. Have a great day.