Carlyle Secured Lending Q2 2024 Earnings Call Transcript

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August 5, 2024

There are 6 speakers on the call.

Operator

Good day and thank you for standing by. Welcome to the Carlyle Secured Lending Second Quarter 2024 Earnings Conference Call. At this time, all participants are in a listen only mode. After the speakers' presentation, there will be a question and answer Relations. Please go ahead.

Speaker 1

Good morning, and welcome to Cardholder Care Lending's conference call to discuss the earnings results for the Q2 of 2024 and the proposed merger of CGBD with Carlyle Secured Lending 3. I'm joined by Justin Plough, our Chief Executive Officer and Tom Hennigan, our Chief Financial Officer. This morning, we issued a press release with our presentation of our results, which are available on the Investor Relations section of our website. In addition to our quarterly earnings press release, we issued a release announcing that Carlisle Secured Lending has entered into a merger agreement with Carlisle Secured Lending 3. Throughout today's call Carlyle Secured Lending will be referred to as CGBD and Carlyle Secured Lending 3 will be referred to as CSL 3.

Speaker 1

CGBD has posted a presentation outlining the transaction on the Investor Relations section of its website, which has also been filed with the SEC and which will be referenced on today's call. Following our remarks today, we will hold a question and answer session for analysts and institutional investors. This call is being webcast and a replay will be available on our website. Any forward looking statements made today do not guarantee future performance and any undue reliance should not be placed on them. Today's conference call may include forward looking statements reflecting our views with respect to, among other things, the timing or likelihood of the closing of the proposed merger, the expected synergies associated with the proposed merger, the ability to realize anticipated benefits of the proposed merger and our future operating results and financial performance.

Speaker 1

These statements are based on current management expectations and involve inherent risks and uncertainties, including those identified in the Risk Factors sections of our 10 ks and our 10 Q, which will be filed for the quarter following market close today. These risks and uncertainties could cause actual results to differ materially from those indicated. CGBD assumes no obligation to update any forward looking statements at any time. Please note that any additional information regarding the proposed merger and the solicitation of proxies in connection with the matters requiring CGB's stockholder approval will be available in the proxy statement and prospectus that CGBD intends to file with the SEC in the coming weeks. With that, I'll turn the call over to Justin, CGBD's Chief Executive Officer.

Speaker 2

Thanks, Nishal. Good morning, everyone. Thank you all for joining. I'm Justin Pluff, the CEO of the Carlyle BDCs and Deputy CIO for Global Credit at Carlyle. On today's call, I will give an overview of our Q2 2024 results and discuss our proposed merger between CGBD and CSL3, including the ways in which Carlyle will support the transaction to make it especially compelling for CGBD shareholders.

Speaker 2

I'll finish with a few comments on the quarter's investment activity and portfolio positioning before handing the call over to our CFO, Tom Hennigan. In the Q2, our financial performance continued to benefit from the higher base rate environment with some headwinds from spread compression on new deals. Both of these trends were largely consistent with the broader direct lending market. During the quarter, we generated net investment income of $0.51 per share, which represents an annualized yield of more than 12% based on our 6.30 NAV. Our Board of Directors declared a total 3rd quarter dividend of $0.47 per share consisting of our base dividend of $0.40 plus 0 point 0 $7 supplemental dividend.

Speaker 2

Our net asset value as of June 30 was $16.95 per share, down $0.12 or approximately 0.7% from March 31 because of unrealized depreciation from some of our watch list names. Following another strong quarter, we are excited to announce that CGBD has entered into a merger agreement to acquire Carlyle Secured Lending 3. We believe this transaction will deliver a number of strategic benefits, including an increase in scale and liquidity, elimination of the preferred stock held by Carlyle, a reduction in costs and an increase in operational efficiencies and accretion to both earnings and NAV per share.

Speaker 3

Now I'd like to dive a

Speaker 2

little bit deeper into each attribute that this merger brings. 1st, scale and liquidity. With an anticipated market capitalization of over $1,000,000,000 as a combined company, we expect this transaction to provide increased scale and liquidity to shareholders, creating potential for increased institutional ownership, a broader investor base and enhanced trading liquidity. 2nd, I'll touch on the convertible preferred shares held by Carlisle. Now as many of you know, these shares were issued by CGBD as part of an investment Carlisle made to support the BDC during the market dislocation resulting from the COVID pandemic.

Speaker 2

These shares have a current conversion price of $8.98 compared to quarter end NAV of $16.95 and therefore could be dilutive if exercised. As part of this transaction, Carlyle will exchange its convertible preferred shares at NAV as determined shortly before merger close. This will avoid 5% to 8% dilution for CGPD shareholders. We believe that this is a significant value for CGPD shareholders that could lead to improved trading prices. 3rd, we expect this merger to reduce costs and drive operational efficiencies by eliminating duplicative expenses.

Speaker 2

We estimate total annual cost savings to be approximately $2,500,000 on an LTM basis through increased scale as well as streamlining certain processes compared to the 2 entities continuing to operate separately. The larger combined asset base will also improve our expense ratio to approximately 70 basis points on net assets, while also potentially providing CGBD with greater access to the debt capital markets and a lower cost of capital. Finally, we believe that this transaction is accretive to both NAV per share and net investment income per share on a fully diluted basis. This is due both to the preferred stock exchange and the substantial overlap in strategy and portfolio composition between the two vehicles.

Speaker 3

We

Speaker 2

also expect the transaction to be accretive to net investment income per share in the long term with improved combined portfolio metrics, a lower expense ratio and increased investment capacity. Given our recent trading levels, we have structured the merger to enable potential NAV accretion if CGBD is trading at a premium to NAV shortly before the merger close. Tom will discuss that more later in this call. Carlyle is committed to the long term success of CGBD and we believe that this transaction will benefit shareholders of both CGBD and CSL-three. To further support the merger, an affiliate of Carlyle will cover certain merger related expenses up to a total cap of $5,000,000 which we believe should cover all transaction costs.

Speaker 2

Now before I turn the call over to Tom, I want to briefly discuss the market environment. Activity continued to pick up in the Q2 of 2024 as sponsored direct lending volumes reached recent highs, driven by strong refinancing, recapitalization and M and A activity. Spreads and covenants continue to face pressure from borrowers, but the core middle market where we operate continues to see comparatively less pressure than the large cap market. Originations in the second quarter were up significantly year over year and our pipeline continues to expand with both core cash flow and differentiated deal flow. Our goal is to drive performance with a consistent approach to direct lending anchored in disciplined credit selection and conservative portfolio management.

Speaker 2

We continue to benefit from the 1 Carlyle platform, which differentiates us in the core middle market. While increasing origination activity is a positive for our strategy, we are most focused on the overall credit performance of our existing portfolio. Our portfolio remains highly diversified and it's comprised of 180 investments in 126 companies across more than 25 industries. The median EBITDA across our core portfolio at quarter end was $82,000,000 The average exposure in any single portfolio company is less than 1% and 94% of our investments are in senior secured loans. As always, discipline and consistency drove performance in the 2nd quarter.

Speaker 2

We expect these tenants to drive performance in future quarters. With that, I'll now hand the call over to our Chief Financial Officer, Tom Hennigan.

Speaker 3

Thank you, Justin. Today, I'll begin with an overview of the terms and structure of the proposed merger. I'll then discuss Q2 financial results and portfolio performance before concluding with detail on our balance sheet positioning. 1st, I want to point all of our shareholders to the additional materials we've posted to CGBD's Investor Relations website. I'll note, we expect to file a proxy and registration statement in the upcoming weeks to begin the process of soliciting merger approval from CGBD shareholders.

Speaker 3

As Justin previewed, we're excited to announce we've entered into agreement with CSL3 to merge in a stock for stock transaction with a floating exchange rate that has the potential to be accretive to shareholders. To reiterate Carlyle supports for the merger, it is agreed to exchange its existing convertible preferred shares for common stock, which will occur shortly before close of the proposed merger. Based on the current conversion price of $8.98 per share, this crystallizes accretion to both NAV per share and quarterly net investment income per share on a fully diluted basis. Carlyle will be subject to a 2 year cured lockup following the exchange, reinforcing Carlyle's continued long term commitment to CGBD. An affiliate of Carlyle has also agreed to bear up to $5,000,000 in transaction fees and expenses in certain circumstances, which is expected to mitigate any potential dilution from merger expenses for shareholders.

Speaker 3

The transaction has been structured with a floating exchange rate construct that enables the potential for additional NAV per share accretion at close. In our merger presentation, Slide 16 outlines 3 potential scenarios and how they would impact CGBD. As you'll see on the slide, if CGBD is trading at or below one times NAV per share, the bridge will be conducted on a NAV for NAV exchange. But if CGBD is trading aboveonex NAV per share, CGBD and CSO III shareholders will equally split the premium at merger close up to 1.11 times with all premium thereafter going to CGBD shareholders. This construct ensures the transaction is at a minimum NAV neutral while allowing CSL 3 shareholders to participate in upside if CGBD is trading above NAV shortly before the close of the merger.

Speaker 3

Our core investment strategy will remain unchanged. The combined company will continue to focus on directly originated primarily 1st lien sponsor back loans to U. S. Companies in the middle market. Turning to the portfolio, total assets for the pro form a combined company are expected to increase to over $2,500,000,000 by transaction close.

Speaker 3

Based on current portfolio data, CSO III has near 100% overlap with CGBD and the combined company on a pro form a basis as of June 30 has 127 portfolio companies and 183 investments and total senior secured exposure of over 90%. Key portfolio diversification and risk metrics all will improve. Concentration of CGBDs top 1, 5 and 10 investments were all improved from current levels. We expect non accruals as a percentage of fair value and also debt investments with risk ratings 3 to 5 representing investments that have been downgraded on our internal risk rating scale all to improve, as you can see on Slides 18 and 19 of the merger presentation. Given the significant portfolio overlap, we believe the merger will result in cost synergies for shareholders with annual cost savings expected to be about $2,500,000 The elimination of duplicative expenses should result in over 20% decrease in operating expenses from the 2nd quarter combined levels, which implies a pro form a target expense ratio of under 70 basis points on net assets.

Speaker 3

Increased scale also has the potential to provide a wider and more efficient refinancing alternatives, which could reduce our cost of debt through improved access to the institutional debt capital markets. Leading up to merger close, we also anticipate calling all remaining uncalled capital from CSL3 shareholders and we'll seek to return CGBD to the midpoint of our target leverage range. Given the increased level of deal activity Justin mentioned, we're confident we can deploy this capital into attractive investments. All of CGBD's financing facilities will continue in regular course and we expect CSL3's existing asset based credit facility would transfer over to CGBD at closing of the merger. The transaction has been unanimously approved by the CGBD Board of Directors and the CSL3 Board of Trustees at the recommendation of the special committees of both CGBD and CSL-three.

Speaker 3

I want to highlight that in addition to the benefits for CGBD shareholders we've been focused on, the transaction also enables CSL 3 investors to retain access to the proven investment strategy they sought exposure to with the benefits of the greater scale of the combined entity, liquidity of a listed BDC and the potential to trade at a premium to NAV. Taken together, we think this is a compelling value proposition for these new CGBD investors. Finally, CGBD's advisor will remain unchanged and we anticipate the transaction closing in Q1 of 2025, subject to approval from CGBD shareholders, certain regulatory approval and satisfaction or waiver of other customary closing conditions. Now moving on to a more detailed review of this quarter's results. CGBD had another strong quarter on the earnings front.

Speaker 3

Total investment income for the Q2 was $58,000,000 down slightly from prior quarter due to a lower average portfolio balance and a decrease in prepayment and amendment fees. Total expenses of $31,000,000 also decreased versus prior quarter, primarily due to reduced total interest expense from a lower average outstanding debt balance. The result with net investment income for the Q2 of $26,000,000 or $0.51 per share, which is generally in line with the prior year comparable period. Our Board of Directors declared that dividends the Q3 of 2024 at a total level of $0.47 per share. That's comprised of the $0.40 base dividend plus a $0.07 supplemental dividend, which is payable to shareholders of record as of the close of business on September 30.

Speaker 3

This total dividend level reflects our variable supplemental dividend policy of paying out at least 50% of excess earnings, which allows us to be flexible as the portfolio evolves and base rates fluctuate. Our base dividend coverage of 128% for the quarter remains above the BDC peer set average and we've grown the base dividend 25% since 2022. At the same time, this total dividend level also represents an attractive yield of 11% based on the recent share price. Looking ahead, we remain highly confident in our ability to comfortably meet and exceed our $0.40 base dividend and continue paying out supplemental dividends each quarter. On valuations, our total aggregate realized and unrealized net loss was about $8,000,000 for the quarter.

Speaker 3

The largest contributor was a $7,000,000 loss in our position in emergency communications network, ECA. So a majority of that $8,000,000 loss from that one position. And we actually exited that investment last week at a level slightly better than our $6.30 mark. So the full downside for that position is already reflected in our $6.30 This decrease in valuations partially offset by Q2 earnings exceeded the dividend resulted in our NAV decreasing modestly from $17.07 to $16.95 per share. Turning to credit performance, we continue to see overall stability in credit quality across the portfolio.

Speaker 3

Non accruals increased this quarter to 1.8% of total investments at fair value as we added a net 2 borrowers to non accrual status. However, we exited ECN and we've been working towards a favorable solution with the other borrowers. So that ends for the upcoming quarter, we expect investments on non accrual to drop back below 1% as a percentage of fair value. I'll finish by touching on our financing facilities and leverage. We continue to be well positioned on the right side of our balance sheet.

Speaker 3

In early July, we closed a reset of the 20 fifteen-one CLO, extending the reinvestment period and maturity date by 4 years and reducing the cost of debt by more than 20 basis points within that vehicle. Leverage is down quarter over quarter and we have capacity to deploy capital into attractive opportunities in an accelerating deal environment as we've been operating conservatively at the lower end of our target range. Statutory leverage was about 1.1 times and net financial leverage ended the quarter modestly lower at 0.9 times. This positioning allows us to remain opportunistic as the macroeconomic environment evolves and deal activity looks to pick up in the second half of twenty twenty four. With that, I'll turn the call back over to Justin.

Speaker 2

Thanks, Tom. Before we move to Q and A, I want to reemphasize the compelling merger proposal for CGBD. This merger is between 2 entities that are wholly aligned. We're adding meaningful scale without increasing risk through combining with a known Carlyle managed portfolio. The consistency of our investment approach between the 2 BDCs positions us for a smooth integration process and we expect the transaction will be significantly beneficial to shareholders with accretion to both NII and NAV per share.

Speaker 2

Market demand for private credit remains high. We continue to focus on sourcing transactions with significant equity cushions, conservative leverage levels and attractive spreads relative to market levels. With attractive new originations, stable portfolio and low levels of non accrual, CGPD shareholders are benefiting from the continued execution of our strategy. As always, we remain committed to delivering a resilient, stable cash flow stream to our investors through consistent income and solid credit performance. I'd like to now hand the call over to the operator to take your questions.

Speaker 2

Thank you.

Operator

Thank from the line of Finian O'Shea with WFS. Your line is open. Please go ahead.

Speaker 4

Hey, thank you. Good morning, everyone.

Speaker 3

Good morning, Ben.

Speaker 4

How are you? On the merger, I think it's 25 expected close. Does that mean you're anticipating like an extended sort of outreach campaign? And can you remind us of the shareholder base profile of Carlyle III? Thanks.

Speaker 2

Sure. So we do have to get shareholder vote from CGBD shareholders. So that is a legal process and that's part of the reason why it will take a bit of time. The CSL III shareholders do not have a vote here because they sort of signed up for this when they initially invested in that fund. So there shouldn't be too much of a delay on that end of things.

Speaker 2

The CSL III shareholder base are people that Carlyle placed to, but there's not significant concentration. But again, without a vote, we wouldn't expect that to impact the merger process at all.

Speaker 3

And Sid, we'd expect, although it's very compelling transaction for CGBD shareholders, it always just takes so much time to gather up such a diverse base of investors for any of these votes. So we'd anticipate that the process to take normal courses as other BDC mergers.

Speaker 4

Okay. That's helpful. Thanks. And I guess, Justin, thought I'd ask looking at the screen today and this week, if you have any views on how the current volatility we're in might impact the bank's positioning to compete on sponsored finance transactions if it's too early to tell or if you think they would be still in a strong position to lean in or whatnot?

Speaker 2

Yes. Certainly early to tell how this all plays out in the second half of the year. But we've been focused for a long time now on making sure the credit quality of the portfolio is excellent because we've seen the pressure on spreads. So we feel very well positioned if we're heading into a more volatile environment. And it does stand to reason Fin that in more volatile environments, our capital becomes more valuable to borrowers.

Speaker 2

So I think we're well positioned if it does turn out to be a volatile second half of the year, but we'll have to see.

Speaker 4

Okay. One final if I may on, if there's any based on the transaction exchange ratio at close, that's obviously into the future, but if the incentive fee will account for merger accretion?

Speaker 2

If the incentive fee will account for merger accretion? Sorry, I'm not sure I quite follow the question.

Speaker 4

Yes. That's due to the maybe better for Tom. Based on where the stock is, there might be a I don't know, I think I can't even explain it too well, but it's very common in a BDC merger due to the accounting and that will elevate or reduce depending on where Carlyle trades when it presumably goes NAV for NAV. And that could change the GAAP revenue and NOI. So like will you accrue sorry, go ahead.

Speaker 3

No, because it's Fin, we wouldn't expect any impact from the merger math on our incentive fees.

Speaker 4

Okay. Thanks so much. All from me.

Operator

Thank you. And one moment as we move on to our next question. And our next question is going to come from the line of Melissa Wedel with JPMorgan. Your line is open. Please go ahead.

Speaker 5

Good morning. Thanks for taking my questions today. I wanted to talk about the merger and combining the portfolios. I understand that's a couple of quarters out. But at a high level, would you view the smaller portfolio that the loans in that portfolio has been brought on to CGBB's balance sheet Or would those be appropriate to put into the credit fund?

Speaker 3

Melissa, it's Tom. There's substantial overlap between the two funds in terms of the borrowers. In fact, almost every single position at CSL III is also held at CGBD, obviously, varying levels. So we'd anticipate looking at keeping in place our current facilities and allocating the loans primarily to our existing credit facilities and potentially based on some of the lower spread transactions, potentially allocating those, we're thinking that as good investments down the road for the JV. So I think we'd be looking at based on the investment profile, the yield profile is spreading them across the vehicle.

Speaker 3

But I think for the most part though the yield profile is in line with the BDC is that most of those we'd anticipate would be held directly by the BDC.

Speaker 5

Okay. And then can you remind us when you think about the credit fund and sort of the runway there, how much I guess that's the question, how much runway is there to grow that JV? I assume that's another avenue where you would look to explore NAV or I'm sorry, NII accretion?

Speaker 3

Look, I think currently we're probably looking to maintain the JV level. Certainly, we're always looking at the best ways to improve our ROE. Right now, I think we're looking to maintain the JV size and dividends coming from those JVs. Not a huge growth that

Speaker 5

we have. Got it. Final question for me, just around the fee structure. We've seen a number of these transactions before. And I think as we've seen portfolio shift increasingly 1st lien, sometimes we've seen managers make adjustments to the fee structure.

Speaker 5

Just curious if that's something that's been a topic of discussion with the Board? Thank you.

Speaker 2

Yes. We don't anticipate changing our fee structure as part of the merger. We think our fees are in line with market given the performance that we've had. But I do want to emphasize, Carlisle is paying all transaction expenses and we're getting out of our preferred shares at NAV, which avoids something like a 5% to 8% potential dilution to CGPD shareholders. So those are really the two areas where Carlyle is contributing to the transaction.

Speaker 5

Thank you.

Operator

Thank you. This time. And I would like to hand the conference back over to Justin Bluff for closing remarks.

Speaker 2

Well, thank you everyone. We really appreciate your joining. Sure we'll be speaking to you in the future. That will conclude today's call.

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