NMFC Quick Update: Likely A Strong Q3 Coming

The following information was previously provided to subscribers of Premium BDC Reports along with:

  • NMFC target prices/buying points
  • NMFC risk profile, potential credit issues, and overall rankings
  • NMFC dividend coverage projections (base, best, worst-case scenarios)

This update discusses New Mountain Finance (NMFC) which continues to have a relatively higher dividend yield that is consistently covered, with a defensively positioned portfolio and management that exhibits higher quality indicators including responsiveness to personal requests for information, waived management fees, look-back feature for the capital gains portion of the incentive fee. However, NMFC does not have a best-of-breed fee structure due to income incentive fees not taking into account realized or unrealized losses. Management has “committed to paying quarterly dividends of at least $0.30 over the next seven quarters” through fee waivers.

“New Mountain was built with defensive growth industries and risk control in mind long before COVID hit. The great bulk of NMFC’s loans are in areas that might best be described as repetitive, tech-enabled business services such as enterprise software. Our companies often have large installed client bases of repeat users who depend on their service day-in and day-out. These are the types of defensive growth industries that we think are the right ones at all times, and particularly attractive in difficult times.”

The primary reason that NMFC is a ‘Tier 3’ is mostly due to needing higher amounts of leverage to cover the current dividend as well as previously realized losses of around $91 million over the last ~8 years which is around $0.94 per share using the current share count. However, NMFC’s net asset value (NAV or book value) has only declined by around $0.73 per share (since 2012) partially due to offsetting unrealized gains as well as over-earning the dividends. But of course, NMFC reduced its quarterly dividend from $0.34 to $0.30 starting in Q2 2020 as predicted in previous reports. At the time, the company had spillover or undistributed taxable income (“UTI”) which is typically used for temporary dividend coverage issues. Please do not rely on UTI as an indicator of a ‘safe’ dividend.

There is a chance that NMFC will be upgraded to ‘Tier 2’ over the coming quarters. I will be looking for continued improvement in credit quality including no new non-accruals, increased NAV per share, and realized gains mostly from Edmentum, Inc. (as discussed in this report). More importantly, I will be looking for earnings results closer to the ‘best case’ projections that take into account continued lower borrowing rates, and rotation out of equity positions into income-producing debt positions as discussed in this update.

NMFC Insider Purchases

Steve Klinsky, Founder, CEO and Chairman: “Together, New Mountain professionals have invested over $480 million personally into NMFC and New Mountain’s credit activities. I and management remain as NMFC’s largest shareholders. We have continued to add to our personal positions in the last 12 months and Rob, John, and I have never sold a share.”

NMFC Dividend Coverage Update

On May 4, 2021, NMFC entered into a fee waiver agreement and the Investment Adviser agreed to reduce the base management fees not exceed 1.25% of gross assets through December 31, 2022. Also, management has “committed to paying quarterly dividends of at least $0.30 over the next seven quarters” through additional fee waivers. There is a good chance that management would extend the fee waivers if the company was not covering its dividend but management seems confident that would not be needed.

“We implemented a dividend support program for at least until December 31, 2022, by pledging to charge no more than 1.25% management fee on all assets. For that period, we also pledged to reduce our incentive fee if needed to support the $0.30 per share dividend. We do not currently anticipate needing to use this pledge, but want shareholders to have greater confidence in the dividend.”

Contributing to its dividend coverage is the generous 8% hurdle rate which is applied to “net assets” to determine “pre-incentive fee net investment income” per share before management earns its income incentive fees. As shown in the following table, the company will likely earn around $0.267 per share each quarter before paying management incentive fees covering around 89% of the quarterly dividend which is ‘math’ driven by an annual hurdle rate of 8% on equity. It is important to keep in mind that NMFC could earn less than $0.267 per share but management would not earn an incentive fee for that quarter and the calculation is based on the net asset values from the previous quarter.

Over the next six quarters management is working to improve earnings through lowering its borrowing rates, increasing returns including from its Senior Loan Programs, and rotating the portfolio out of equity positions and non-income-producing assets:

“Equity portfolio with things like Edmentum, Benevis and UniTek and we actually believe there is tremendous potential in those names to create real economic value, but of course for every dollar that’s in a non-yielding piece of equity at non-cash and non-income yielding piece of equity that obviously is a dollar that’s not earning NII in the quarter. Our outlook continues to brighten for those names, and from a timing perspective. The timing of those uncertain right like will you because it’s a lumpy will you exit one of those and convert that into cash, that’s redeployed in NII generative traditional debt securities we just don’t know.”

Subsequent to June 30, 2021, NMFC sold around 34% of its equity position in Edmentum, Inc. which is a good thing for shareholders as management can reinvest the proceeds into other assets with higher income. As shown in the following table, NMFC’s investment is currently valued at over $154 million and accounts for 5.0% of the portfolio. NMFC received total proceeds of almost $48 million and realized gain of around $21 million or $0.22 per share.

“After quarter end, we monetized a portion of our position in Edmentum at an attractive gain, and we remain optimistic about potential gains at other existing portfolio companies. We sold approximately 34% of our equity position to Vistria and their co-investors at that same value, which will show as realized in Q3. We could have rolled our entire position. But we did think it was important to take some chips off the table. The value has grown so meaningfully, it just gets uncomfortable. And there was definitely demand in the newer investor group, even at this higher valuation. But it’s important just from a diversity standpoint, because you use it once and you never know what’s going to happen, right. The twin goals of one, de-risking and monetizing and bringing some cash in that can earn NII as opposed to equity on the one hand versus not selling too early and what I think is an incredibly strong cyclical winner with great execution capabilities.”

It should be noted that NMFC has historical net realized losses and might not need to pay out the gains to shareholders. Management was asked on the recent call and mentioned “we’ll have much more to say on that after the end of the third quarter”:

Q. “On Edmentum, it looks like this puts you in a undistributed earnings situation in some way. I don’t know if it’s how the split is between the ordinary and capital income, but if you can give any color on that, and most importantly, will you be able to retain the spillover or is that something that you’re – will this push you into a higher undistributed income situation?”

A. “It’s a great question and we’re still running the accounting on that as the third quarter evolves. And we’ll have much more to say on that after the end of the third quarter.”

Management has guided for increased amount repayments over the coming quarters which will likely drive lower leverage and has been taken into account with the updated projections:

“Page 23 shows the strength of our new deal activity since the end of the quarter, reflecting the active market that I mentioned in my opening comments. So far in the quarter, we have committed to new investments of $229 million consisting mostly of high quality private financings offset by $151 million of repayments yielding net originations of $78 million. Given the active deal environment, we do have a long list of companies on our repayment watch list, which we believe could be exiting our portfolio throughout the next quarter. These loan repayments represent a material source of cash to fund both our commitments and forward pipeline of new deals.”

There will likely be additional onetime income including accelerated OID related to the prepayments that could drive results closer to the ‘best case’ projections:

Q. “Should we expect potentially an increase in accelerated OID or fees associated with these prepayments that could increase the portfolio yield of these in the near term or are these kinds of more longer dated assets where some of those accelerated fees have kind of already run off?”

A. “There will be a lot of repayments on existing assets. And that’s life as a lender and especially life as a lender that tries to target really quality assets. We do feel very confident, that we can very successfully fill any gaps that are left from repayments, or prepayments, et cetera. And I think on the point around accelerated OID and just extra income that comes from prepayments, that is definitely true. And it’s a mixed bag. Some are going to be longer lived assets and some are going be shorter lived assets. And so I think as velocity is our friend when it comes to releasing a certain amount of modest income. So, that is – I would call it a modest tailwind.”

As discussed in the previous report, management is working to improve its net interest margins by reducing borrowing expenses. In June 2021, the company extended and reduced the borrowing rates on its NMFC Credit Facility. The company redeemed its 5.75% Baby Bond “NMFCL” on March 8, 2021, using the proceeds from its recent private placement of $200 million of 3.875% notes due 2026. These notes were also used to redeem its 5.31% unsecured notes due May 2021.

“On June 4, we amended and extended our NMFC credit facility pushing out our maturity to 2026, while decreasing our applicable spread materially by 40 basis points.”

On May 5, 2021, NMFC and SkyKnight Alpha entered into an agreement to establish a joint venture, NMFC Senior Loan Program IV (“SLP IV”) transferring/contributing 100% of their membership interest in SLP I and SLP II to SLP IV. The purpose of the joint venture is to invest primarily in senior secured loans issued by portfolio companies within its “core industry verticals”. Also, the SLP IV entered into a $370 million revolving credit facility with Wells Fargo at LIBOR plus 1.60% per annum.

Management has guided for a debt-to-equity ratio of 1.20 to 1.25 less cash and excluding SBA borrowings and is taken into account with the updated ‘base case’ projections:

“Page 14 shows that we continue to manage our statutory leverage ratio at a very comfortable level. Gross debt for the first quarter increased by $68 million, but the increase in net asset value of $48 million resulted in a relatively flat statutory leverage ratio of 1.19 times. We continue to have a number of portfolio companies currently in active sale processes. The anticipated culmination of which will give us additional financial flexibility to either reinvest or further delever. Our intention remained to manage the business at a statutory leverage ratio, net of cash of 1.0 to 1.25 times.”

As discussed in previous reports and shown in the table below, NMFC has limited downside and potential upside to rate increases similar to most BDCs:

“As you can see, the vast majority of our assets are floating rate loans, while our liabilities are 55% fixed rate and 45% floating rate. NMFC’s current bounce sheet mix offers our shareholders consistent and stable earnings in all scenarios where LIBOR remains under 1%. If base rates rise above 1% as the economy normalizes or accelerates, there is meaningful upside to NMFC’s net investment income. For example, assuming our current investment portfolio and existing liability structure, if LIBOR reaches 2%, our annual NII would increase by 8.4% or $0.10 per share. At 3% LIBOR, earnings would increase by 19% or $0.23 per share. We believe this positive interest rate optionality offers meaningful value to our shareholders.”

On January 4, 2021, NMFC announced that its Board authorized an extension of its $50 million share repurchase program “to be implemented at the discretion of NMFC’s management team”. Unless further extended by NMFC’s board of directors, the Company expects the repurchase program to be in place until the earlier of December 31, 2021, or until $50 million worth of NMFC’s outstanding shares of common stock have been repurchased.

For Q2 2021, NMFC hit best-case projections covering its dividend simply due to the previously discussed fee waivers. There was a slight decline in its portfolio yield offset by increased portfolio growth and dividend income but leverage remains. Around 95% of dividend coverage is from recurring sources which is an increase from previous quarters.

“95% of total investment income is recurring and cash income remains strong at 80% this quarter. We believe this consistency shows the stability and predictability of our investment income.”

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  • Monday Morning Update – Before the markets open each Monday morning we provide quick updates for the sector including significant events for each BDC along with upcoming earnings, reporting, and ex-dividend dates. Also, we provide a list of the best-priced opportunities along with oversold/overbought conditions, and what to look for in the coming week.
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This information was previously made available to subscribers of Premium BDC Reports. BDCs trade within a wide range of multiples driving higher and lower yields mostly related to portfolio credit quality and dividend coverage potential (not necessarily historical coverage). This means investors need to do their due diligence before buying.