SLR Investment Corp. (SLRC) Q4 2012 Earnings Report, Transcript and Summary

Good day, ladies and gentlemen, and welcome to the Year-end 2012 Solar Capital Ltd. Earnings Conference Call. My name is Erin, and I'll be your coordinator for today. [Operator Instructions] As a reminder, this conference is being recorded for replay purposes. I will now turn the presentation over to your host for today's call, Mr. Michael Gross, Chairman and CEO. Please proceed, sir.

Thank you, and good morning. Welcome to Solar Capital Ltd.'s earnings call for the year ended December 31, 2012. I'm joined here today by Bruce Spohler, our Chief Operating Officer; and Richard Peteka; our Chief Financial Officer. Rich, before we begin, would you please start off by covering the webcast and forward-looking statements.

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 replays 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. We believe 2012 was a pivotal year for the BDC sector, despite periods of market volatility caused by political events, positive economic indicators and continued monetary easing, volatile liquid capital markets. Capital inflows impacted the opportunity set on both the asset and liability side of the BDC balance sheet. Particularly during periods with frenzied market conditions like last year, we believe that mandatory discretion and inherence to core investment principles are critical toward BDC's long-term success. At Solar Capital, we continue to operate with an ownership mentality. The same mind that we've always maintained as one of the largest investors in our own common stock resulting in a highly successful year. We are pleased with our financial results for 2012. At December 31st, our NAV was $22.70 per share, a 3% increase for the year and consistent with the Q3 ending NAV. For the fourth quarter, we delivered $0.63 per share of net investment income, resulting in approximately $2.36 of net investment income per share for the full year, excluding onetime financing charges. Our taxable earnings fully covered dividends for the year. In addition to a strong finish to 2012, we completed several strategic initiatives that position us well for 2013 and the future. First, we took advantage of the attractive conditions in the liquid capital market to term out and further diversify our capital structure. Specifically, in May, we raised $75 million of private fixed-rate 5-year notes from a diverse group of insurance companies. Midyear, we increased the size of our multi-lender credit facility and extended the maturity. For both of our credit facilities totaling $625 million, we reduced the borrowing rates. In November, we issued $100 million of 30-year, fixed-rate senior unsecured retail notes. And today, we have now have $800 million of borrowing capacity with a weighted average maturity of 2019. 40% of this capacity is either fixed-rate or is hedged against rising interest rates. In August, we raised $45 million of equity in response to reverse inquiry from one institutional investor. Post year-end, we raised an additional $145 million of net proceeds in our first underwritten share offering since our IPO 3 years ago. Together, these proceeds allow us to take full advantage of our borrowing base while staying well within our target leverage. The attractive market conditions that enable us to optimize our capital structure for future growth caused us to be highly selective on the asset side of our balance sheet. The high yield and liquid leverage loan markets experienced meaningful spread compression and loosening of terms as 2012 progressed. The benefit of investing in our niche, the U.S. middle market, is that the impact of opportunity set was far less pronounced. We maintained a conservative prudent approach to portfolio growth in 2012. As a result of our direct origination platform, we were still able to source several unique investments with attractive risk-reward characteristics. For the full-year, we originated over $610 million, par value of new investments, $275 million of which was invested in Crystal Financial, a portfolio company that we acquired at the end of the fourth quarter. We evaluated this opportunity for almost a year and believe it offers a superior risk return profile than other investments available during the second half of the year. We acquired substantially all of the outstanding equity of the commercial finance company, which focuses on providing asset-based and other secured financing solutions to U.S. middle-market companies with unique financing situations. Crystal Financial's management team, including all its prior businesses has underwritten and closed more than $20 billion of transactions for its clients since 1993. In addition to the quarterly cash investment income we expect to earn in this investment, the asset has significant strategic value. Crystal's strong origination platform has little overlap with our existing platform, providing us with the asset to a new opportunity set that has low correlation with our existing portfolio. Their team's distinct expertise and focus broadens Solar Capital's spectrum of financing solutions and our permanent capital enhances Crystal Financial's ability to meet its clients' needs. Bruce will provide additional color during his review of our portfolio activity. Over $250 million of our originations for the year, or nearly 75%, excluding Crystal, occurred in the first half of the year, prior to the overheating of the liquid capital markets. During the second half of the year, the adherence to our strict underwriting criteria and use of our investment capacity to acquire Crystal Financial resulted in less traditional investment activity. During the year, we had redemptions and sales of approximately $325 million, and during the fourth quarter, redemptions totaled approximately $111 million and we had sales around $1 million in one asset. Our redemptions for the year meaningfully reduced our percentage of 2006, 2007 vintage assets to 15% of our portfolio. Both Weetabix and AMC, which we sold -- which we redeemed in the fourth quarter, were picked assets that had been marked as low as the 50s during the market trough. These were redeemed at par. In summary, in 2012, we built long-term shareholder value by capitalizing on market conditions to optimize our balance sheet and by taking a cautious and strategic approach to portfolio growth. In 2013, we are focused on sourcing proprietary investments that meet our strict underwriting standards. Our capital-raising efforts provide us with over $400 million of credit capacity to invest in new assets with prudent risk levels at acceptable returns. At year-end, pro forma for our January equity raise our leverage was 0.33x debt to equity. We continue to be at our origination pace at $400 million per year and currently, we're not -- we have not had any meaningful redemptions since yearend. Finally, our Board of Directors declared a quarterly dividend of $0.60 per share which was more than covered by our GAAP and taxable earnings in Q4. The first quarter 2013 dividend will be paid on April 2, 2013 to holders of record as of March 21, 2013. At this time, I'll turn the call over to our Chief Financial Officer, Rich Peteka, to take you through some of our financial highlights.

Thank you, Michael. Solar Capital Ltd's. net asset value at the end of the year was $878.3 million or $22.70 per share, consistent with our net asset value at September 30, 2012. As of December 31st, we had investments in 40 portfolio companies in 23 industries, totaling approximately $1.4 billion at fair value. At December 31, 2011, we had investments in 42 portfolio companies in 24 industries with a fair value totaling approximately $1.05 billion. The approximate 33% increase in our portfolio year-over-year reflects both continued net growth of our portfolio, as well as a net increase in its fair value. At the end of 2012, the weighted average yield on a combined debt and preferred portfolio was 14.2% measured at fair value. Gross investment income for the 3 months and full-year ended December 31, 2012, totaled $41.5 million and $153.3 million, respectively. Total expenses for the 3 months and full-year period ended December 31, 2012, was $17.3 million and $71.3 million, respectively, including the nonrecurring expenses related to our new $525 million credit facility and our $75 million senior secured notes issued during the second quarter. Net investment income for the 3 months ended December 31, 2012, was $24.2 million or $0.63 per share. Pro forma for the nonrecurring charges, net investment income for the full year was $87.8 million or $2.36 per average share. Net realized and unrealized losses totaled less than $1 million for our fourth fiscal quarter. Net realized and unrealized gains were $33.8 million for the full-year, and were driven primarily by general market improvements and modest yield tightening during 2012. During the fourth quarter, we removed both DirectBuy and Granite Global from our nonaccrual status as a result of recapitalization events at both companies. Granite Global paid all its past due interest in cash. Accordingly, we had no loans on nonaccrual status at December 31, 2012. However, we expect to place Rug Doctor on a non-accrual status during Q1 of 2013. The company was current on its interest through December 31, 2012, but on January 31st, we received notice from the company that its next scheduled payment would be blocked by their senior lenders. At December 31st, Rug Doctor was valued at $43.3 million. At this time, I'd like to turn the call over to our Chief Operating Officer, Bruce Spohler.

Thank you, Rich. Overall, the operating trends of our portfolio companies remained steady. As we've highlighted before, during our underwriting process, we focused primarily on a company's ability to generate free cash flow as the primary driver to both de-risk and eventually repay our investments. The defensive portfolio that we constructed concentrated in noncyclical industries continues to perform well in this low growth environment. At the end of 2012, the fair market value of our portfolio was approximately $1.4 billion, of which 100% was performing. At 12/31, the fair value weighted average mark on our portfolio, excluding our common equity, was approximately 97% at par, consistent with the prior quarter. Approximately 34% of the fair value of our investment portfolio was in secured assets. When considering Crystal's underlying portfolio, approximately 57% of the total fair value will be in secured assets. We had investments in 40 portfolio companies, operating across 23 industries and our income-producing assets represented approximately 96% of the portfolio. The weighted average investment risk rating remains at 2, measured at fair market value at the end of year -- year-end, based on our 1 to 4 risk rating scale with 1 representing the least amount of risk. Before I give you an overview of our activity in Q4, I'd like to spend a moment on portfolio developments. Our 2 assets are non-accrual at 9/30, both completed restructurings during the fourth quarter, with positive outcomes that caused us to return both assets to fuller growth status. First off, in November, DirectBuy completed its restructuring. Pro rata with the other holders in the original second lien tranche, Solar Capital's $25 million par value investment was converted into approximately $7.5 million of a new secured loan, as well as an equity claim, which represented approximately 7.5% of the common equity. In total, the holders of our tranche received 100% of the common equity. The fair value of the new loan equates to a $0.30 mark on our original par investment from the former security, up from $0.20 at 9/30. The company's financial performance has been improving with new memberships at existing franchisees trending positive. In December, Granite Global completed recapitalization. The sponsor invested over $27 million of additional equity together with the mezzanine lenders collecting -- collectively investing approximately $10 million as additional mezzanine capital to support this transaction. Solar Capital invested $7.5 million as our pro rata share of the add-on investment to the existing mezzanine. Proceeds of this recapitalization were used to pay down a portion of the senior debt and to facilitate the funding of a couple of add-on acquisitions. The attachment point and total leverage to our tranche improved dramatically as a result of this recapitalization. In conjunction with the transaction, we received all past due interest and have returned our investment to full accrual status. The company's financial performance continues to improve. As Rich mentioned, post year-end, we placed our investment in Rug Doctor on non-accrual. We are in active discussions with the company, as well as the sponsor, to resolve this situation, and we view our attachment point at 2.4x as a very positive factor in maximizing our realizable value. Lastly, DS Waters is performing in line with expectations. Customer growth continues to drive both increased revenues and EBITDA over prior-year results. Importantly, the integration of Standard Coffee, acquired in early 2012, remains on schedule and the cost efficiencies are being realized as anticipated by management. On the origination front, during Q4, we committed approximately $300 million par value in 2 new and 4 existing portfolio companies. Our principal repayments totaled approximately $111 million, and we sold just over $1 million of our position in NXP publicly traded common equity, which left just over $4 million in NXP post year-end. In January, we're happy to report that we sold our remaining NXP shares. At the time of Solar Capital's IPO in early 2010, our position at NXP was valued at approximately $1.5 million. Our cumulative realized gains since the IPO for the sale of our NXP shares approaches $30 million, underlying the importance of the patience of our capital to maximize realizable value. I'll now highlight some of our new fourth quarter investments. During Q4, we funded a $25 million second lien investment in Endurance Group, the leading provider of Web hosting and domain registration services in the U.S., offering highly predictable and recurring revenue stream. A portion of the company's refinancing will fund tuck-in acquisitions. Our sister fund, Solar Senior, had invested in the previous secured tranches of this company, and thus, we're extremely familiar with the credit. The all-in yield in this investment exceeds 10.5%. Additionally, we invested $5 million in the incremental second lien term loan for Trident Health Services to support tuck-in acquisition in the company's core mobile X-ray footprint. Solar Capital's total investment in the company now approaches $43 million, pro forma total leverage for this transaction is 4.5x and the all-in yields on our loan exceeds 12.5%. During the fourth quarter, we received full repayments on 3 investments. In conjunction with the acquisition of the company by Bright Foods of China, our approximately $55 million investment in Weetabix was redeemed at par. At the trough of the credit cycle in December 2008, we carried Weetabix at a weighted average mark in the mid-50s. Again, with the benefit of patient capital, we were able to realize an IRR in excess of 12%, and a multiple of our invested capital, 1.8x. During Q4, our $33 million investment in the unit tranche security of Grocery Outlet was redeemed at a premium to par in conjunction with the company's refinancing. Solar initially invested in Grocery Outlet in 2011 as part of a refinancing of the company's then existing capital structure. Our IRR realization on this investment approaches 17%. Lastly, we redeemed out of the unit tranche of C&D Solutions at a premium to par. Solar Capital invested $17 million in C&D Solutions in July of 2012, and this IRR approached 19% albeit over a short haul period. As Michael mentioned, at the end of the year, we funded a $275 million equity investment into Crystal Financial, which is a commercial finance company focused on providing asset-based and other secured financing solutions to mid-market companies. At December 28th, Crystal had secured loan portfolio totaling approximately $400 million, consisting of loans to 22 different issuers. All of its loans are floating rate, with an average loan size of $18 million and an average yield on the portfolio of approximately 12%. At year-end, total leverage on the Crystal portfolio was approximately 0.5x debt-to-equity. We believe that this asset offers a highly attractive risk return profile, given the cash paid, senior secured nature of the underlying loans. On a quarterly basis, this asset will pay us a cash dividend, which will be included in our net investment income going forward. Now I'd like to turn the call back over to Michael.

Thank you, Bruce. In conclusion, we believe that our disciplined approach during year of frenzied market conditions should generate long-term shareholder value. We took advantage of the heated conditions on liquid capital markets to reset our capital structure. We remain conservative on the investment side. The strategic investment portfolio of Crystal Financial provides us the new source of net investment income with what we believe is a better risk profile than other opportunities available in the current market environment. For 2013, we will continue to be prudent and highly selective in deploying our capital given the frothy credit markets. As a result of our efforts to optimize our balance sheet, we now have over $400 million of credit capacity available to invest in defensive credits with attractive risk reward metrics. In 2012, we originated over $600 million of investments, which was bolstered by acquisition of Crystal. We continue to believe that a $400 million year -- per year origination pace provides a measured, prudent portfolio growth, which may be somewhat offset by redemptions. Our underwriting model does not depend on forecasting macroeconomic conditions. As Bruce mentioned, we underwrite to a low growth environment so I will leave it to others to predict 2013 and beyond. We're in the business of delivering stable, steady income in the form of consistent dividends while managing our downside risk. 2012 was a highly successful year for us, and we believe Solar Capital is well-positioned to continue to perform well in 2013 and beyond. Finally, we continue to believe that Solar Capital offers an attractive value proposition relative to other high current income alternatives. As of yesterday's close, our shares carried an annualized dividend yield of 9.6%. This is significantly higher than the Barclays U.S. corporate high yield index, which is yielding only 5.9% on assets that are generally unsecured, do not have covenant protection and typically carry higher leverage. At 11:00 this morning, we'll be hosting our earnings call for the full year 2012 operations for Solar Senior Capital or SUNS. Our ability to provide senior secured financing through this vehicle enhanced our origination team's ability to meet our clients' capital needs. We continue to see real benefits of the value proposition in Solar Capital's deal flow. Thank you for your time. Operator, at this time, will you please open the line for questions.

[Operator Instructions] Your next question comes from the line of Arren Cyganovich.

Appreciate the comments on the environment, and I guess, it's not necessarily a forecast, but you believe you can generate about $400 million of new originations currently with your current pipeline of opportunities. Maybe with respect to that, you could talk a little bit about the repay expectations and whether or not you would expect to have portfolio growth from your opportunities this year?

Yes, I think, as we mentioned, we really have not seen anything significant year-to-date, in the way of redemptions. The only thing of note is what's been put out publicly, which is our second lien investment in Asurion, which was less than $20 million, was refinanced in connection with the company's refinancing earlier this year. But other than that, we have not seen any additional redemptions. As you know, it's difficult for us to look out and see redemptions. We're not privy to all of that dialogue with our underlying issuers. But what I would say, Arren, is that, as you know, we have churned in excess of 80% of the portfolio over the last 2.5 years. So we would expect that redemptions would abate here as we move into 2013.

And I think with the combination of our existing platform with Crystal, we would expect net-net origination growth for the year.

Great. That's helpful. And maybe just talk about the environment with respect to you, maybe how today's more frothy environment compares to some past markets. I know we've kind of had some periods over the last few years where we've had some increase in activity and then the widen out with different credit spread events. Maybe just talk about today's environment and maybe relative to the really frothy market back in '07?

The biggest differentiating factor between now and when things kind of peaked out last time around was that, at that time, people were financing high multiples of EBITDA off of, frankly, peak earnings. And I think we feel today that we're nowhere near peak earnings of the economy portfolio companies given how modest the recovery has been to date. I think the other big difference is you're not seeing preponderance of picked tight [ph] structures in the middle market at all today, whereas during the last go-around you did. So I think, yes, things are a little more frothy, but not nearly as frothy as the liquid markets. And where you're seeing modest leverage growth and compression of rates, but you're not seeing compromise in capital structures.

Okay. That's helpful. And then lastly, on Rug Doctor, with I think roughly around the 80% mark on that position, how comfortable are you with that mark for now? And also, I think, the average yield in the K was around 17.5%. Is that the yield on the market value or yield at cost -- or yield at par, I mean?

I'm sorry, can you repeat that?

The average, weighted average yield on Rug Doctor position, I believe, was around 17.5%. Is that on par or is that on...

No, it's market value.

Market value. Okay. And then just in terms of the valuation of it, how are you coming through with that...

At the end of the year, given -- at the end of the year, the Rug Doctor had less than a 1 year maturity on the investment. And so as we have in the past, we tend to value those investments on an enterprise value basis. So it's more looking at a multiple cash flow with equity value business-wise. So at year-end, we're comfortable with that number, obviously, since we're -- value was more as an equity-type security now, there will be some volatility given performance of the company. But as of year-end, we're clearly comfortable with that mark.

And your next question comes from the line of Stephen Laws.

Can you maybe give us a little bit of idea on what's the new capital in January. Kind of how you see leverage increasing the pace of that from here, as well as how the mix will be between, say, traditional kind of Solar Capital investments versus stuff in the Crystal pipeline?

I think what we -- at pro forma for the offering were about 0.33% debt-to-equity at year-end. I think with an assumed pay of $400 million and modest redemptions, we'll get back to our target leverage of 0.7x as the year progresses. Obviously, we can't predict when and if that happens, but that's clearly the intent to access our debt, which is locked up with $250 million invested at a substantial higher yields.

And I think with respect to Crystal, as we mentioned, they've got an excess of $130 million of capacity on their existing balance sheet to fund growth, which in the near term, will just boost our return on our investment there.

And your next question comes from the line of Mickey Schleien. Mickey M. Schleien - Ladenburg Thalmann & Co. Inc., Research Division: I wanted to ask about the sort of the level of expected yield on the Crystal investment that we can look forward to -- the portfolio -- their portfolio, I suppose, because they're lending to larger companies, produces a couple hundred basis points less than your portfolio. Taking into account their expense structure and their leverage, what can we look for in terms of a dividend yield on that investment?

Sure. And just to be clear, we invest in similar-sized businesses, Mickey, they're really just taking an asset-oriented approach for the primary source of repayment as contrasted with our cash flow orientation. But businesses tends to be consistent. And I think the way we look at their yields, as we mentioned on the portfolio, it approaches 12% at year-end. We think that somewhere in that 11% plus or minus is a good target for our expected return once you take into account leverage and then the cost of leverage in expenses. But be mindful that we view that as actually a -- while it is a lower return than our current portfolio return, we view it as a premium return given the lower risk inherent in the senior secured nature of their assets. Mickey M. Schleien - Ladenburg Thalmann & Co. Inc., Research Division: Sure, I understand. And I think you said that they're going to upstream a dividend quarterly. Is that correct?

Yes, that is the intent.

And your next question comes from the line of Doug Mewhirter.

It's Doug Mewhirter from SunTrust. Most of my questions have been answered. Just 2 questions. First, on Crystal, I don't know if you've even decided this yet, but will Crystal be, will they even be allowed to retain any of their earnings or you're looking at more as a pure pass-through sort of almost a purely almost a variable dividend in terms of how they -- almost like you're investing in another BDC to put it another way?

Yes, we do view it as a pass-through of their underlying investment income.

Okay. My second question is little more big picture. It's obvious that CLL market and high yield markets, the liquid markets, have gone a little crazy in terms of spread compression. And you said it has had a small impact mostly on your own spreads, but not an outsized impact. Are there any particular areas on a credit structure or industries where that impact has had a more or less of an impact with the influence from the liquid market?

Not really. I think it's kind of, I don't want to say it's across the board, but it's fairly consistent. I mean, the other thing we're seeing, just to the environment, that I think activity seasonally is generally always slower. January, February, after year-end, I think it's actually a little slower than we've seen historically, there seems to be less middle-market companies for sale in the private equity community. There seems to be a lack of property to look at and so we are -- we've seen kind of a relatively slow start to the year in terms of new things on the subordinated side.

[Operator Instructions] Your next question comes from the line of John Stilmar.

This first question is with regards to all the headlines and sequestration. I know there's a couple of investments that you have in the defense arena or maybe you have [ph] businesses that surround [ph] military bases. How do you guys think about as kind of [indiscernible] looming sequestration and either the risks and maybe potential opportunities in your portfolio that this might pose?

Yes, I think, as you know, at Solar Capital, going back closer to the time of our IPO in 2010, we did have more exposure to government services generally, whether it's NISC or Booz Allen and those, as you know, we've been repaid. So we really don't have much exposure over at Solar. And as we look to our portfolio, we really don't expect to have any near-term impact. As you know, our big sector at Solar is food and beverage. So I guess, to the extent, on the margin, derivatively, to the extent that impacts employment in the government services sector, perhaps there's going to be some trickle-down impact. But we don't think it will be material from Solar's perspective. We do have a little bit of exposure over Solar Senior, which we'll address in our next conference call.

Right. Absolutely. And then the second point, it was certainly touched on, but maybe pulling back up, you obviously have -- it's been a great performing investment with mid-cap financial, you made this Crystal acquisition, how should we start thinking about as you're sort of expanding your footprint, it seems like the sourcing and origination platform is probably a lot bigger than we would just see from just SLRC or SUNS, just from the network of your investments. Can we start thinking -- as we start thinking about '13 and maybe even '14 sort of a long-term business plan, is this a conscious strategy of yours to sort of expand the footprint of the management team and your sourcing ability, sort of i.e. your own capital?

It absolutely is. I think, we view ourselves as -- our core competency is investing in levered companies, whether that's senior subordinate or asset base, I think the important thing for us is whether it's someone line Crystal, is that we still -- our control in investment decision is here. Bruce and I are on the investment committee, we don't want that to change. To the extent we do find other opportunities or teams want backed, their teams that we're going to have to spend a year with like we did in Crystal before making a decision to invest in it and it's the business that is very consistent with our culture and approach.

[Operator Instructions] Your next question comes from the line of Ryan Lynch [ph] .

About how much pass-through income was received from Granite in Q4?

Just about -- a little over $2 million.

Okay. And then one other kind of quick question. Your Grocery Outlet [indiscernible] you said they were both repaid at premiums to par. Can you guys tell us what kind of premiums they were repaid at?

There was a couple of points. It was not the material driver though of our NII.

Okay. A couple of a point in each one?

Yes.

And I would now like to turn the call back over to Michael Gross, Chairman and CEO, for closing remarks.

Thank you very much for all your time. We look forward to talking to those who are involved in SUNS in the next 20 minutes. And if not, we'll talk to you in a couple of months after Q1. Take care.

Thank you for your participation in today's conference. This concludes the presentation. You may now disconnect. Good day.