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Solar Senior Capital Ltd  (NASDAQ:SUNS)
Q4 2018 Earnings Conference Call
Feb. 22, 2019, 10:00 a.m. ET

Contents:

  • Prepared Remarks
  • Questions and Answers
  • Call Participants

Prepared Remarks:

Operator

Good day, ladies and gentlemen. And welcome to the Solar Senior Capital Fourth Quarter 2018 Earnings Conference Call. At this time, all participants are in a listen-only mode. Later, we will conduct a question-and-answer session, and instructions will follow at that time. (Operator Instructions) As a reminder, this conference call is being recorded.

I would now like to introduce your host for today's conference, Michael Gross, Chairman and Chief Financial Officer (sic) [Chief Executive Officer]. You can -- you may proceed.

Michael S. Gross -- Chairman and Chief Executive Officer

Thank you. Good morning. Welcome to Solar Senior Capital Limited's earnings call for the fiscal year ended December 31, 2018. I'm joined here today by Bruce Spohler, our Chief Operating Officer; and Rich Peteka, our Chief Financial Officer.

Rich, would you please start off by covering the webcast and forward-looking statements.

Richard L. Peteka -- Chief Financial Officer

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 Senior Capital Limited, and that any unauthorized broadcasts in any form are strictly prohibited. This conference call is being webcast on our website at www.solarseniorcap.com. Audio replays of this call will be made available later today, as disclosed in our 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 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 Senior Capital Limited 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.

Michael S. Gross -- Chairman and Chief Executive Officer

Thank you, Rich. During a volatile fourth quarter in the capital market Solar Senior Capital delivered a strong operating performance, given the sell-off in the liquid leveraged loan market, which impacted the valuation for many of our private loans at year-end. SUNS net asset value was down 3% to $16.30 per share. Year-to-date the leverage loan index has already covered the majority of the fourth quarter sell-off. During the fourth quarter, SUNS delivered another consistent net investment income performance with GAAP NII of $0.35 per share for the fourth quarter covering our distributions. Also for the fiscal year, SUNS earnings of a $1.41 per share fully covered its distribution.

At December 31st, the fundamentals of our portfolio companies remain strong. At quarter-end over 98% of our comprehensive portfolio is invested in first lien senior secured loans comprised of approximately 40% asset-based loans and 58% cash flow loans. The general market consensus is that we are late in the credit cycle. Our defensive positioning in first lien loans and our niche specialty ABL verticals should enable us to perform well either during the downturn or continued strong economic environment.

Following the end of the year turmoil, we are seeing some positive signs in our pipeline of an improved upper middle market cash flow lending environment. As a reminder, Solar Capital Partners now has the ability to underwrite and hold across its platform first lien loan tranches of up to $200 million. This scale has achieved through two important strategic initiatives in 2018. The first initiative was a new asset coverage requirement. On October 11th, shareholders of SUNS and our sister BDC, SLRC, overwhelmingly approved the reduction in the asset coverage requirements, thereby accelerating the timing of the modification, which initially have been approved by the company's Board of Directors in early August. As a result, on October 12th, Solar Senior Capital's and our sister company Solar Capitals, asset coverage requirements changed from 200% to 150%.

Given our investment focus on senior secured first lien loan, which have been financed at much higher leverage levels in private funds and banks, we have increased our target leverage ratio to a range of 1.25 times to 1.5 times debt to equity. This new target range allows us for a meaningful and substantial cushion to both the net asset ratio requirement and leverage covenant on our credit facility, which we refinanced to accommodate the increase to the new regulatory leverage.

Importantly, we want to reiterate that the asset coverage modification will not change our investment strategy. It does, however, enhance Solar Senior Capital's ability to further expand our specialty finance lending platform. The consolidation of FLLP in the third quarter made possible by the new asset coverage ratio freed up significant 30% capacity, giving us the flexibility to make acquisitions and expand our specialty finance platform.

Our team has been actively targeting new verticals -- though during 2018, we were cautious as specialty finance company valuations became overheated. It appears the volatility in the fourth quarter has tampered some of these high valuations and we are carefully rebuilding our commercial finance acquisition pipeline. We intend to move closer to our new target leverage range by growing our portfolio over time when the market opportunity presents itself. Consistent with our long-standing conservative investment approach we will be prudent with the use of leverage. We view the increased leverage flexibility simply another investment and risk management tool.

The second initiative in 2018 involved increased the scale of SUNS investment advisors, Solar Capital Partners to enhance its role as a solutions provider with the ability to provide for up to $200 million in a given transaction, while maintaining conservatively diversified portfolios. Scale is particularly important given our focus in cash flow lending to upper middle market sponsor-owned companies, we believe are better resourced to withstand an economic decline than the smaller peers.

During 2018, SCP closed on $2.3 billion of incremental investable capital, including leverage, across two private credit funds and separately managed accounts that are now co-investing alongside Solar Senior Capital and Solar Capital. This brings total investable capital across the platform to approximately $5.4 billion. Most importantly, SUNS is already benefiting from SCP's enhanced scale and the form of new investments are only possible by having larger whole sizes and additional 30% capacity. Bruce will provide details on this important development shortly.

With leverageable 8.63 times net debt to equity at the end of the fourth quarter, SUNS is in a strong liquidity position. At December 31, 2018, when considering the combined credit facilities of SUNS balance sheet and at North Mill and Gemino, there's approximately $250 million of unused capacity across the platform subject to borrowing base limitations. We will continue to be highly disciplined in deploying our available capital.

At this time, I'd like to turn the call over to our Chief Financial Officer, Rich Peteka.

Richard L. Peteka -- Chief Financial Officer

Thank you, Michael. Solar Senior Capital Limited net asset value at December 31st was $261.4 million or $16.30 per share. This compares to a net asset value of $269.7 million or $16.81 per share at September 30, 2018. Solar Senior's investment portfolio at December 31, 2018, at a fair market value of $450.1 million in 47 portfolio companies operating in 20 industries, compared to a fair market value of $465.2 million in 49 portfolio companies operating in 21 industries at September 30th.

At December 31, 2018, SUNS net leverage decreased to 0.63 times from 0.7 times at September 30th. Solar Senior's new target leverage is 1.25 times to 1.5 times debt to equity under the reduced asset coverage requirement. From a P&L perspective, gross investment income for the three months ended December 31, 2018, totaled $10 million versus $11 million for the three months ended September 30th.

Net expenses for the three months ended December 31st were $4.4 million, compared to $5.3 million for the three months ended September 30th. Net investment income for the quarter ended December 31, 2018, was $5.6 million or $0.35 per average share, as compared to $5.8 million or $0.36 per average share for the three months ended September 30th. Below the line, Solar Senior had net realized and unrealized loss for the fourth quarter, totaling $8.2 million, compared to net realized and unrealized loss of $0.4 million for the three months ended September 30th. Accordingly, Solar Senior had a net decrease in net assets resulting from operations of $2.6 million or $0.16 per average share for the three months ended December 31st. This compares to a net increase in net assets resulting from operations of $5.4 million or $0.34 per average share for the three months ended September 30th.

Lastly, our Board of Directors declared a monthly distribution for March 2019 of $11.75 per share, payable on April 3, 2019, to stockholders of record on March 21, 2019.

At this time, I'd like to turn the call over to our Chief Operating Officer, Bruce Spohler.

Bruce J. Spohler -- Chief Operating Officer

Thank you, Rich. Before I provide an update on our fourth quarter activity. Let me take a minute to discuss our approach to valuation in light of the sell-off in the liquid leveraged loan market in the fourth quarter. As Michael mentioned, this resulted in a technical markdown of our portfolio's fair market value. It is important to remember that Solar Senior is not simply a portfolio of leveraged middle market loans. Relative to most of our BDC peers, we are a unique combination of commercial finance businesses, as well as a portfolio of senior secured upper mid-market cash flow loans.

Our valuation process is a combination of bottom-up fundamental credit analysis, with a top-down overlay, where we look to the market technicals and various market metrics from the leveraged loan market for our cash flow loans, as well as valuations of our peers specialty finance comparable companies for our commercial finance businesses. We have applied a consistent approach to valuations throughout our history and we believe that this bottoms up fundamental analysis coupled with a top-down market technical yield analysis is the right approach to providing fair market value. As of today, already approximately two-thirds of the fourth quarter market decline in leveraged loans has already recovered.

Now, turning to the portfolio. In the aggregate at year-end, our investments across our three business lines totaled just over $580 million. This highly diversified portfolio consists of a 161 borrowers with an average investment of approximately $3.6 million or 0.6% of our comprehensive portfolio. As Michael mentioned, the sell-off in the liquid leveraged loan market resulted in a technical markdown for our loans. The result -- the majority of our NAV decline quarter-over-quarter resulted from this technical factor, as well as softness in our commercial finance comparable companies set that we use for valuations as well.

Measured at fair value, close to 100% of SUNS portfolio consisted of senior secured loans, of which over 58% are in first lien cash flow loans, roughly 40% are in first lien asset-based loans and only 1.5% are in second lien secured loans, and less than one-tenth of 1% is in equity. Additionally, roughly 92% of loans have floating rate coupons, which should continue to benefit portfolio performance. Our fixed rate exposure comes from North Mill's factoring portfolio, which contains loans with much shorter duration and higher yields.

SUNS weighted average yield on a fair value basis for its portfolio at year-end was 10.5%. During the fourth quarter SUNS originated $83 million of loans and have repayments of approximately $83 million as well. In the face of the year-end volatility with questions concerning the Fed's direction on monetary policy, we balanced caution with taking advantage of approved -- improved select investment opportunities. Originations for all of 2018 totaled just over $260 million and repayments totaled just over $290 million.

Now, let me take a -- let me provide an update on our credit quality and earnings power of the portfolio. At year-end, 100% of SUNS portfolio was performing.

Now, let me turn to the investment verticals. Cash flow, at year-end our cash flow portfolio totaled $340 million, representing 58% of our comprehensive portfolio. The comp -- the cash flow portfolios comprised of loans to 47 borrowers with an average investment of $7 million. The fair value weighted average asset level yield was 8.1%, up slightly from the prior quarter. Our second lien cash flow exposure approximates 1.7% or $10 million of the $580 million portfolio. We expect this to continue decline over the coming quarters. Given our focus on maintaining a lower risk first lien portfolio, we have not made a new second lien investment in over four years. At year-end, the weighted average EBITDA of our first lien cash flow portfolio was approximately $100 million. Leverage to our investment security was 4.5 times on average and our interest coverage was 2.3 times on average.

In addition, the weighted average revenue growth of our portfolio companies was 9% increase and EBITDA was up 4.2% at year-end, reflecting continued positive trends in our portfolio company fundamentals. In the fourth quarter, we originated cash flow investments of $72.5 million and had repayments of $59 million. For the full year, we originated cash flow investments of $208 million and had repayments or amortization of approximately $218 million.

With the addition of the new private capital that we raised last year, which Michael referenced, SUNS is already benefiting from -- the platforms increased scale and ability to be a solutions provider. During the fourth quarter, SUNS was able to participate across the Solar platform in refinancing core wireless in ABRY Partners portfolio company in the form of an investment in their first lien refinanced loan. The platform broadly committed to $100 million hold for this first lien loan and SUNS was able to invest $12 million in this loan. The loan carries an all-in yield of just under 9%.

Now, let me update you on North Mill. At year-end, North Mill had a portfolio of approximately $122 million, which represented 21% of SUNS total portfolio. It consisted of loans to 80 different borrowers, with an average funded loan of $1.5 million. Weighted average asset level yield of North Mill's portfolio was 17%, which is elevated from prior quarters due to some one-time prepayment fees that we received in the fourth quarter.

During the fourth quarter North Mill funded new loans of $9 million and had repayments of $23.5 million. For the full year, North Mill funded $33 million of new loans and had repayments of $53.5 million. During the fourth quarter, North Mill exited including through liquidation, certain investments which they do in the ordinary course of their business activities. North Mill has selectively taken reserves against the portfolio for these loans and is working to maximize the recovery. During the fourth quarter, North Mill paid the company a cash dividend of $1.4 million, which equates to a 9% annualized yield.

Now, let me turn to Gemino. Gemino at year-end had a portfolio of $108 million, representing 18% SUNS total portfolio. It was comprised of 34 different loans with an average loan size of just over $3 million. The weighted average asset level yield for Gemino was 10.5%. During the fourth quarter, we funded roughly $2 million of new loans and had repayments of roughly $1 million. For the full year of 2018, Gemino funded $22 million of new loans and had repayments of $21 million. For the fourth quarter, Gemino paid SUNS a cash dividend of just under a $1 million, equating to an 11% yield.

In summary, as Michael mentioned, in cash flow lending we have begun to see an improved investment opportunity set for upper middle market loans, as well as our niche ABL markets. We believe Solar Capital Partners, with their increased investment capacity across the platform will result in more investment opportunities for SUNS in cash flow lending and specialty finance. We will not, however, stretch for yield by taking on more risk through either second lien loans or investments in more volatile cyclical industries.

Now, let me turn the call back to Michael.

Michael S. Gross -- Chairman and Chief Executive Officer

Thank you, Bruce. Since the 2011 inception of SUNS, our investment and management decisions have consistently been focused on building long-term value, protecting capital and maintaining alignment with our shareholders. In 2018, we put additional strategic building blocks in place in the form of reduced asset coverage requirements and enhanced platform scale to provide greater flexibility to drive long-term shareholder value. Importantly, we've been prudent in the face of sustained frothy credit markets and remain disciplined not compromising credit quality for yield. The result is a solid portfolio foundation from which to grow.

We maintained investment philosophy of assuming that we are late in the credit cycle and we believe that in the current environment it pays to be cautious. We remain to be seen whether the recent improvement in the upper middle market lending opportunities will be a lasting trend, but we believe through our differentiated origination platform and diversified portfolio that we are well-positioned to navigate through economic cycles.

At approximately 0.63 times net debt to equity, we are under-levered relative to our target range of 1.25 times to 1.5 times and we have substantial dry powder to deploy via our differentiated investment verticals. If the credit cycle does shift, we believe our history of conservatism will enable us to outperform on a relative and absolute basis, and we will be well-positioned to take advantage of market dislocations.

I would like to again, express our appreciation to our shareholders and banks for their overwhelming support to approve the adoption of the modified asset coverage ratio. The greater flexibility does not change our investment strategy rather it meaningfully enhances our ability to grow, build and potentially acquired niche specialty finance businesses as we continue to broaden our diversified commercial finance platform.

In addition, the reduced asset coverage requirement allows us to operate with an increased cushion to the regulatory leverage threshold, which should be a significant benefit in more volatile markets. At last night's close of $16.96 per share, SUNS carries a yield of 8.3%, which represents a significant pre -- discount to the 6.1% implied yield of the S&P/LSTA Leveraged Loan 100 Index. Given the overall credit quality of SUNS diversified portfolio, a differentiated origination engines and our disciplined investment philosophy, we believe SUNS represents an attractive investment on both the relative and absolute value basis.

We thank you for your time this morning and look forward to speaking to you in the next quarter. Operator, would you please open up the line for questions.

Questions and Answers:

Operator

Thank you. (Operator Instructions) And your first question comes from the line of Mickey Schleien with Ladenburg. Your line is now open.

Mickey Schleien -- Ladenburg -- Analyst

Yes. Good morning, Michael and Bruce. I just have one question this morning. If I'm not mistaken there was more deterioration in SUNS NAV on a relative basis than at Solar Capital, but I'm assuming the valuation methodologies are pretty similar, what factors can you attribute that difference to?

Michael S. Gross -- Chairman and Chief Executive Officer

Sure. I think it's hard to -- I don't want to spend too much time on this call talking about Solar. But I just think from a high level portfolio mix as you know is different at SUNS versus Solar in terms of Solar having life sciences, having equipment finance, having Crystal, whereas SUNS has Gemino and North Mill. So, the comp sets that we look to are different and are weighted differently, given their contribution to the overall portfolio. Obviously, cash flow loans are bigger percentage also, Mickey, of SUNS portfolio than Solar's, and so they're going to look more directly to loan index, so it's a combination of mixed factors.

Mickey Schleien -- Ladenburg -- Analyst

Thank you for that. That's all -- those are my only questions this morning.

Michael S. Gross -- Chairman and Chief Executive Officer

Great. Thank you very much.

Operator

Thank you. (Operator Instructions) And your next question comes from the line of Finian O'Shea with Wells Fargo Securities. Your line is now open.

Finian O'Shea -- Wells Fargo Securities -- Analyst

Hey, guys. Good morning, again. Just a higher level market question in regards to your additional emphasis on first lien, just real large this is something that, frankly, I can't remember the time I've heard anyone not say this in most data points or anecdotes point to the -- all of the middle market private credit capital formation revolving around senior debt, and it also seems that second lien has gapped out a little bit or might, perhaps, directly because of this or we have -- perhaps because they tend to be larger credits and are more liquid. So, if you understand what I'm saying, I'm sure by now, where -- how do you look at this. How much more do these -- do the senior and junior markets have to diverge before you really give this a harder look?

Michael S. Gross -- Chairman and Chief Executive Officer

Sure. As you know, because we have our commercial finance businesses and this is true at both platform SUNS and SLRC, as a meaningful part of the portfolios they tend to be higher yielding, and most importantly, for us, they have real covenants and borrowing bases. That's true to North Mill and Gemino, and as well as the Crystal NEF platforms and life science over at Solar. So, for us it's much less, Finian, about where yields are. Obviously, we want to make as much money as possible on each investment, but it really starts with what are the structural protections. What are the covenants. What are the leverage levels. And what are the sacred rights in these documents. And that's what troubled us over the last couple of years is the degradation of terms rather so much than price compression.

And so, what we're really looking for is terms that come back into the documents in the cash flow market. It's been a very long time since we've seen them in the second lien sector, which is why we haven't made a second lien investment in four years. The first lien loans, they do come back quickly during periods of volatility. And we saw a couple of those, we highlighted core. We're able to actually have covenants in Q4 and a few others. So, that's really what will drive our behavior. We can get terms. We'll blend out a nice attractive portfolio yield between cash flow and commercial finance assets, but we want to see real teeth regardless of whether it's a cash flow loan or a commercial finance loan.

Finian O'Shea -- Wells Fargo Securities -- Analyst

Thank you for the color.

Michael S. Gross -- Chairman and Chief Executive Officer

Thank you.

Operator

Thank you. (Operator Instructions) And I'm not showing any further questions at this time. I would now like to hand the call back over to Michael Gross, Chairman and Chief Executive Officer for any closing remarks.

Michael S. Gross -- Chairman and Chief Executive Officer

Hi. We've noticed the comments, but we thank you for your time and your support. Have a good day.

Operator

Ladies and gentlemen, this concludes today's conference. Thank you for participating and have a wonderful day.

Duration: 31 minutes

Call participants:

Michael S. Gross -- Chairman and Chief Executive Officer

Richard L. Peteka -- Chief Financial Officer

Bruce J. Spohler -- Chief Operating Officer

Mickey Schleien -- Ladenburg -- Analyst

Finian O'Shea -- Wells Fargo Securities -- Analyst

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