Apollo Investment Corporation (NASDAQ:AINV)
Wells Fargo Specialty Finance Symposium Conference Call
May 21, 2014 9:15 AM ET
Edward J. Goldthorpe – President
Okay, so moving on to the next presentation, it is an absolute pleasure to introduce, Ted Goldthorpe, the Chief Investment Officer of Apollo Investment Corporation. This is the first time Apollo Investment Corporation has presented at the Wells Fargo Specialty Finance Conference, and we appreciate that because believe it or not normally they report earnings this time of the year, they report at year end. And they decided to move the date of the call to accommodate this conference, and then Greg and Ted we really very much appreciate that and so I look forward to introducing, Ted Goldthorpe, go ahead and take it away.
Edward J. Goldthorpe
Thank you, John. Good morning, that’s actually true story. We’ve missed the Wells conference and got berated for it, for the last couple of years. So we actually really did move up our board meeting and earnings necessary events.
So very happy to be here, I was going to make the same comment. So I don’t have a whole bunch of prepared remarks. So please hopefully you guys have lots of questions. I’m going to spend most of the time today talking about the sector, which I just think about what's going on today in the BDC space and the opportunities for the space which I think are unbelievably compelling.
The other foot side of that obviously is where the sector is trading today because there is some short-term headwinds. So I’ll spend most of my time today talking about the sector and less time talking about Apollo.
It’s our disclaimers you guys can read those. So, this is who we are. I think you guys have seen a lot of the BDC speak yesterday. So I think you guys are pretty well versed in what we do. We are a provider of debt solutions to the middle market in the U.S and we target investments that are 20 to 250 most of our average investments around $30 million today. So our average investment size has come down, and we’ve invested $13 billion since our IPO.
The next thing talked about a little bit of our competitive advantages, which we obviously go through, but really the BDC space has one characteristic that is a huge advantage which is we’re not subject to ratings, we’re not subject to NAIC ratings or anything else. We don’t have origination constrains and we all permanent capital.
And so if you think about what’s short in the world today is illiquid capital and we talk about that a little bit latter, but we think that the whole space actually has a massive, massive advantage vis-à-vis other capital providers.
Obviously we’re attached to a very large global manager Apollo. We get tons and tons of benefits out of this, which we can walk through in detail, obviously we get a lot of sourcing. We source half our deals from the broader platform. We obviously get a lot of diligence benefits. We get a lot of industry expertise. So we could drive a ton of benefit from Apollo and quite frankly, since I’ve been here it’s been a big positive surprise that I think us TPG and Ares all benefit from be attached to a very smart global asset manager.
And if you think about our investment objectives, it’s first and foremost, it’s about principal protection, and then we focus on return later. So it’s not about return, it’s about risk-adjusted returns and that’s kind of where we focused.
So this is a snapshot of our company today obviously secured debt now makes up a very large part of our business, and it’s increasing every quarter. So we are 56% secured debt, we are 27% unsecured debt, I wouldn’t be surprised to see that secured debt number go over 60% relatively soon, and just where we see the best risk award today. We just think there is no – it’s very little opportunities on the bottom of the capital structure. With $3.5 billion of assets, see the number of portfolio companies we’ve almost doubled the number of portfolio companies and our assets really haven’t grown that much.
So obviously we’ve reduced concentration exposure pressure book for the last couple of years. You can see the bottom-middle is, we’ve maintained yields pretty effectively over the last two or three years despite the fact we are in zero interest rate environment and that just goes back to where it was seen earlier which is the spread between liquid and illiquid risk is wide as I’ve seen it in my carrier. We are really capturing the benefits of that.
So, when you look at where triple Cs are rated look at our portfolio, and you look at the amount of secured debt, a lot of people scratch their heads, it all has to do with ratings. So you think about who is buying syndicated loans, who is buying high yield bonds, these are all institutions that are very, very ratings constraints, liquidity constraints, obviously keep harping on the same theme. We are not constrained by that and so, it was just a real shortage of people playing in our sandbox and that’s a huge advantage for our shareholders.
And if you look at the bottom right, and this is a differentiator for Apollo, every BDC has gone a different way, so the BDC’s were pretty comparable seven or eight years ago. Today we’ve all gone a different direction, so at Apollo we decided to focus on what we call our specialty verticals. So these are areas like, oil and gas, aviation, certain types of strategic structure products, we’ll talk about that later.
But we also are very focused on places like infrastructure and mining, project finance. And what do all these things have in common, these are all the things that the banks used to do. So we are basically doing what the big investment banks used to do. And they just are very, very constrained in today’s environment given the regulatory environment. And we’ll talk about that more. And obviously if you guys look at my career history, I’ve intimate experience with the regulatory headwinds faced by large institutions.
So this is a great slide, but it’s a busy slide, so I’ll try and summarize it, and my eyes aren’t very good. So I’m having – I got kind of read it off the tele prompter, so here is – this is what BDCs look like pre-crisis, and what the BDC’s looks like post-crisis, so call it BDC 1.0 versus 2.0, you can call whatever you want. But this is why we think the BDC space is really, really interesting, if you look at the amount of unsecured debt in these portfolios before the crisis and post-crisis. We think the BDC space has done a great job, derisking their overall portfolios.
So the amount of secured debt has obviously increased, the key thing on the first pie-chart there is the amount of unsecured debt and the amount of reductionary spend, so we think the BDCs today are we don’t know where we are in the credit cycle, we can go pretty far into it. And if you look at the comments from my bosses at Apollo you would take that Apollo is not overly positive on syndicated credit right now. So we think the BDCs are in much better position to withstand a credit shock or change in the markets than they were kind of pre-crisis.
Second bullet point this is very important, is concentration, BDCs are wrong sometimes. We are not going to make money on every investment. And so we think the key is reducing portfolio of concentration. So BDCs have obviously done that, so the average position size now is 1.9% of assets this is for the sector, this is not for us.
Next column this is also very important to you, BDCs were 90% relying on revolver financing. Today, we are all tapping the institutional markets, so us and Ares and all the large institutions have had really, really beneficial impacts to the institutional debt markets. We’ve done two 30-year bond deals no covenants, callable mean to mean that’s basically equity that’s great for our shareholders.
And so when you start layering in additional debt and I don’t think any of the BDCs gets credit for this. We have much more stable funding than we did pre-crisis. So pre-crisis, 90% was revolver funding. Today it’s like of about a third, you need some revolver financing to finance foreign borrowings, because the hedge, a natural hedge.
But don’t be surprised, the number go lower and lower and lower, I don’t think anybody it’s not lost on anybody that there is going to be pressure in the future of all the regulatory change for banks to provide revolver financing. So I think we’re all – we in our selves are that type of liabilities. You can see a lot of us are investment grade rated which gives you access to lots of different markets that we don’t have access to before.
And this bottom slide and this is LTM, so we didn’t pick a moment in time, we picked a last 12-month period, the price-to-book of the BDC space is today that it was lower than what it was before and the ROEs are higher.
So in conclusion, that’s a very long – I have spent a lot of time on this one slide, but I think this is the key that why should we invest in BDCs. They are cheaper than they were before. The liability structure is much more stable and the books are much more de-risked today than they were five years ago. And we think that’s a very compelling investment opportunity and relative to where they were seven years ago.
This is a new slide by the way I have never used this one before. So this is something I’ve talked about a lot, you look at the bank de-leverage and people talk about this quite a bit in the U.S. I think the bottom left is the key thing for you guys to look at. Really what the BDCs do is analogous to what is referred to as Level 3 assets, assets that don’t really have pulls. So there has been $350 billion of reduction in Level 3 assets in the large investment banks.
And you look in the right, a lot of people talk about the growth in the BDC space. And is it sustainable and is it too competitive? And I would say, no. I mean there is just a massive shortage of illiquid capital. So there has been $350 billion of Level 3 asset reduction in the last couple of years by the large investment banks. And that is – that dwarfs the size of the total BDC space.
So not saying is it’s not apples-to-apples, there is a lot of Level 3 assets, the BDC space don’t plan, and obviously some capital has been raised away from BDC space. But this I think that just goes to highlight, just the dramatic shortage of illiquid risk, illiquid capital today to provide solutions for corporations.
So again a busy slide, but the reason this is so busy is I think it hammers on the point. Regulatory changes have been with us for five or six years, but the reality is, it’s taken a long time for these regulations to actually come out. So if you go through these one by, one by, one by, one by, one, we benefit from all of these things.
The Volcker Rule, the CLOs getting the game rules or risk potential rules. These new leveraged lending guidelines that came out six months ago. These rules have not been in place for very long, the Volcker Rule just came out in the last couple of months. The leverage lending guidelines, it’s still pretty opaque and a lot of the investment bankers are still looking for guidance. But with every passing week, there’s more and more articles about what’s going on with the OCC and Fed and pressure on large investment banks.
And see kind of walk through all the stuff and this is all, I’m not going to hit on every single one of these. The only point I want to make is, this is good for us, it’s making harder – the banks are under lot of pressure to de-risk their balance sheets and exit from “risky activities”. And these activities obviously – this is hurting our ROEs. And we are doing a lot of things the banks used to do. So a lot of the things that we are doing today at Apollo are all things that I used to do at Goldman Sachs.
We actually think that this is a great thing for us and we encourage, obviously, I won’t be giving my own views on regulatory reforms, but as every rule comes out, we only benefit from them.
So I think this is a replenishing slide and by the way you can definitely propose what am I about to say, but this is just good food for thought as a lot of things we are going to say in the presentation today. And you look at us versus – a lot of people, one of my peers got up here yesterday, and compared all the BDCs each other and he was analyzing actually that’s the wrong analysis.
I think if you look at our space versus investment banks or regional banks. And we do different things and everything else. But by and large, a lot of us provide capital to different counter parties. You look at this slide, I think this is pretty compelling. So you look at the asset yields of the BDCs versus investment banks and regional banks. And by the way the BDC space trades at a significant discount to both of these today.
So you are looking at where the asset yields are, you look at the bottom left which is the amount of leverage that BDC use vis-à-vis investment banks and regional banks. In many cases, we are using one-tenths the leverage.
The one thing you may get confused about in the bottom left, this is the gross leverage, we just did as apples-to-apples with how the regional banks and investment banks actually report their leverage statistics, obviously we are under the clinical one-to-one test. The one-to-one test is calculated differently than the way the banks calculate their leverage. And in the bottom right, you can see ROEs in our space, are had been substantially higher over the last 12 months, 18 months, two years.
So, again, you can definitely (indiscernible) thought higher ROEs, higher ROAs much less leverage. And I think let’s just hit on the middle one, the middle box on the left side of the slide, the G&A of these banks alone is higher than the total fees on the BDCs. So for every dollar of revenue that these banks generate it’s $0.70, $0.75 of costs, that shareholders are paying whether it’s through compensation or G&A and you can see obviously on the left what you are paying for BDC. So people ask questions all the time of the fees and the BDCs, again we think they are relatively fair when you put it in the context of this slide here.
So there is my speech in the space. I will talk a little bit about our company but again I’m not going to spend a whole bunch of time on it. This just goes through our investment process. Here we are very big investment process, hard to buy things, easy to sell. We have a very rigorous investment community process. This is a slide that I’m sure all my peers have put up as well and it’s very important pick a manager.
So this, one of the big sources of Apollo vis-à-vis our peers is we did a wholesale repositioning of the business. When Greg and I came into the business about two years ago, we re-analyzed the whole business. Where is the best risk were for our shareholders. And I think we came up with a couple of conclusions; one is let’s go to places where other people are not, and so that was the start of our specialty vertical business.
So we’ve built out five or six of them today and had massive benefits from that which you’ll see in a second. And number two, when some of our peers were early on this, we were later on this, but 2.5 years ago, we decided, let’s move up the capital structure.
If you look at the market today, and where mezzanine prices, we’re one of the largest mezzanine providers in the world today. The risk is, and I just saw last night that a lot of them don’t understand this term, but the risk today is just not that compelling. The risk today in mez is just asymmetrically bed. So if you can do a 10% mez deal at 7 times of leverage, where your first dollars in it six times and you are wrong. And I said earlier, we are going to be wrong sometimes, you’ll lose all your money. So your loss giving defaults is horrible.
So we think, born or capital structure risk today and obviously I’m speaking of broad generalis obviously there is some goodness out there, there it’s not that interesting. We think about high-yield or triple Cs same thing, if you think upside, downside comparable risk reward equation.
So again we’ve been able to kind of transition our book into 56% secured risk, as I said earlier, I wouldn’t be surprised to see this move even higher so top of the capital structure. A much greater percentage of our books in floating rate exposure, rates are going higher at some point, I already told the same things 12 months ago, I have been wrong, but rates were higher.
So whether it’s 12 months or 18 months, two years, five years rates are going higher. So as I said earlier, we are pushing out all our liabilities as far as we can and locking up as much financing as we can. The cheapest thing you can buy today is financing. So we are doing as much of that as we can.
And then, number two on the asset side we are obviously moving much more into floating rate risk. So that number again I think fully dramatically increased over the next 12 months, obviously specialty verticals, we had dose specialty verticals, we had industry expertise but no real differentiating specialty verticals, it’s now a third of our business. Our attachment point in terms of credit quality is down.
So our net leverage is 5.5 times than our book. If you look at it by vintage, it’s been going down every single vintage. So our newest vintages are much lower than this. I think this year our average attachment point is 4.9 times. So substantially below, comparable coverage again financed out there, interest coverage is up.
And at the bottom, this is an issue for Apollo in the past, you just reduced borrower concentration. So our average position size has come down by $12 million. I think that’s probably where we it will stay, I don’t think it’s going to go down to too much more, but let’s see. And you can see on the right side, we’ve done all this and maintained yields.
So again a lot of talking on the slide, but to summarize it we boot-up the capital structure. We’ve gotten a lot more clearing rate risk, we’ve maintained yields. And we’ve got taken down our – we can improve the credit quality of our portfolio. So this is probably the slide that summarizes Apollo the best and it’s probably something we’re probably most proud of over the last two years. And I think this trend will continue over the next kind of 12 months.
So we talk a lot about our specialty verticals, obviously on a very quick. For those of you, who have seen us speak before I talk about these a lot. Just to think about where can you get off-market returns? Where is the shortage of capital? And where is your massive demand for capital and these are kind of three areas, we can go into a whole much other areas that, but these are just ones we highlighted because we talked about the one.
If you look at the second box in the right and the yields we generated on these businesses. The average yield is 12.5% and so again just to compare to where middle-market unit tranche loans are today by the way, we still think it’s a great business or to think about this vis-à-vis liquid markets. Complexity, you get paid for complexity, so our peers have a unit tranches. This is not something people can do them. So they say, it’s not as easy as just going and buying a triple C bond.
And so unit tranches, specialty verticals these are all very differentiated, these require real amounts of people. When you guys looking at BDCs, it’s really hard as a BDC to have five couple and a couple of Bloomberg’s and trying to do some of these transactions. You really need big platform, and if you look at the large BDCs, it’s 70, 80, 100 employees these are not, when you think about this rustle overhang because on this SEC rule which makes no sense, I mean the reality is these are operating businesses. There is real people, there is a lot of industry expertise, all of us have been big, big investments in origination. These aren’t big mutual funds. They are very, very different.
So when you look at this, complexity has given us off-market returns. And when you think about these things, we just did recent aircraft transaction, just to highlight risk reward where we provided a large carry that you guys all know very well, those unsecured bonds we’re trading with a 400 spread. We did a secured financing for them at 15%, so you may say, well how is that possible, hiking 1100 basis points of premium and you are secured and they are unsecured. And the answer is what I said before, there is complexity, it's not that easy to do these transactions, it’s they are unrated, it’s illiquid and massively principal protective. So we are getting really off-market returns for the risk we’re taking, taking liquidity risk versus credit risk.
So how investment current market? So again, a large part of this is sponsor finance, I don’t talk about it much because again a lot of our peers talk about it ad nauseam, and they are very good at talking about it. But sponsors are obviously very important to our business, but half of our business is sponsor finance. So when you look at this, this pretty good slide, its shows that middle-market lending activity, if you look at number one, middle-market actually, say, is a too high, and the answer is no it’s not, I mean the reality is middle-market lending is still way below where it was probably six years ago. Unlike of large syndicated markets. So, number two is activity is definitely picking up.
So again, we’re slow to come back for a whole host of reasons, but now in the economy things have stabilized. The scar tissue of the crisis with every passing year kind of moves farther and farther away. So people are asking us to do M&A financings and real economic activity versus just repricings and dividends and that’s highlighted number two.
Number three; this is a really broad spectrum. Obviously we typically originate stuff 10%, 11%, 12%. So obviously much higher than number three, but number two just highlights it. If you look at where in 2007 it’s spread between middle market loans and large corporate loans, they basically were on top of each other. And you look today there is a pretty light spread between the two, still 150 basis points. If you go back through the data, defaults are lower, severities are lower than – there is a problem. So again, we just continue the middle market thing. We think it just continues to provide great opportunities for our business.
And the fourth; just highlights credit spreads. It’s not that indicative of our business because we don’t do this really that much, but credit spreads obviously have tightened quite dramatically, but are not so crazy in the context of history.
So I think I’ll kind of wrap up with this, which is I think you’re going to continue to see us do what we’ve been doing, move more into senior secured risk, move more into floating-rate assets, really focus – one thing that we set out to do two and a half years ago is optimize our 30% basket. I think we’ve done a okay job, not a great job.
We haven’t found a lot of ways to do that, but I think that’s a big opportunity for us. Today our 30% basket yields 120 basis points wider than our 70% basket. If you look at some of our peers, they’re doing in the range 400 basis points, 500 basis points, 600 basis points wider in spreads in those buckets. Some people have done some things that we just don’t think it’s core to what we do. And others have strategic things that we think are really interesting.
So this is a focus for us. I’d say Greg and I have not found a whole bunch of great ways to do this and a good way for our shareholders. And I think this last point on specialty verticals, don’t be surprised to see us do a whole bunch of new ones for this, again just continue to take advantage of the dislocation that’s happening around the world with financial institutions.
So in the right, I’d say, this just highlights further value, like, again we can make a huge debate about this, but with high yield even 5% - with high yield in Europe yielding sub 4% and the BDC space yielding 10% with the BDCs having proprietary origination, they have largely bank debt versus bonds, again which continues to pick the space below book today that is very, very compelling vis-à-vis other alternatives for yield.
So with that, we have a bunch of appendixes, but why don’t I stop there and open it up for questions.
Edward J. Goldthorpe
Yes, hi. How are you doing?
You showed a slide where your weighted average yield is coming down and it seems like there is just yield compression in general obviously in the current environment amongst BDCs and just frankly the credit environment we’re in right now where it’s just tough to find great ideas, but in addition to that your concentration risk has come down, which is obviously a good thing from an investor standpoint because if you have the fall through portfolio those are more limiting now. But I guess I’m just curious with concentration risk down, yields coming down, a tough credit investor environment in general, your secured exposure potentially going up, how sustainable is your current dividend and I guess where do you see that going in the future?
Edward J. Goldthorpe
Yes, that was a great question. At the end of the day we’re all about risk/reward and so we’ve been comfortably over-earning dividend for two and a half years. We see no reason why we can’t do that on a go-forward basis.
If we’re in a zero interest rate environment in perpetuity, obviously there maybe some continued pressure. But that being said, if you look at our, I’ll speak it specifically. Anybody who tells that yields haven’t come down in the middle market is lying to you like that they have. Spreads have come down for unit tranches and other things. If you look at our business specifically and you look at this last quarter, for example, the yield compression is explained by three names. We had a big expensive 15.6% loan that got taken out. We’ve rolled exposure in two lower yielding situations.
We do actually strip those out. We actually didn’t have that much yield compression this past quarter. This quarter we’re not really seeing it. So like in our business unlike the liquid markets, it kind of seems to step function. Like our yields will be stable and they’ll build unit tranches of price 25 bps lower. And, so, I mean the answer is this. The answer is we’re focused on protecting principle. So we are not going to stress for yield. We are not going to go chase things to maintain the asset yields in our book, but we feel really good about our dividend, like yesterday we earned $0.22 and the dividend is $0.20. We pay 90% of our income. So we’re comfortable over-earning our dividend. We feel really good about our dividends today. We do all models and shock it and do all kind of things to it. We feel really good about it. So I can’t tell you what our dividend is going to be in five years, but I mean the reality for us and this is something that’s unique to Apollo, 30% of our assets yield less than 10%.
So we don’t need to grow. I mean if we continue to originate where we’re originating, which is 10%, 11%, 12% we can do that and harvest to 8% to 10% assets. So, yes, do the math, you pick up 200 basis points and a 30-year book, there’s opportunities for NII growth without issuing stock, without doing anything crazy. So we don’t think we have (indiscernible). We’re finding lots and lots of things to do at 10% to 12%. We have a third of our book in 8% to 10% assets. So from our perspective there is a lot of organic NII growth embedded in the business today. So, yes, I can’t wait for this question.
No, it’s a good question. Only because BDC indices or BDCs within the index and the potential – this is the likely reconstitution, has caused this base to trade-off a bit. And so it creates the question a lot of our investors here have asked today is what is like to like at or below book with the stock price at or below book? How does that as an operating executive change your view in terms of what you’re investing in, in terms of current yield, whether you need to grow or issue in order to supplement fee income et cetera? It’s just main question that people are wanting to know with the stocks where they are today and how you’re reacting to the current environment.
Edward J. Goldthorpe
Yes, I think it went to ferocious like type of wrestle, which is short-term overhang on the space. June 27, just watch for a big catalyst for our space to revalue. The answer to the question is what I said before. We’ve have $1 billion of liquidity in our portfolio. So we don’t need to grow. So if you look at what we’ve done in the last two and a half years, we’ve really not grown assets that much. Really what we’ve done is what I call high-grading. The first thing we did is we took anything that we thought was at any kind of credit risk or credit risk we’re uncomfortable with, sold it, monetized it, did all kinds of things and replaced it what we think are good risk reward asset.
So now, I just said earlier, we’ve got $1 billion liquidity. So we don’t need our stock price above book in order for us to continue to grow NII. We don’t need our stock price. It doesn’t really matter what stock price is today for us to continue to monetize lower yielding assets and re-deploy them in higher yield deploying assets.
For stock price book for long periods of time, I am not loosing sleep at night. I don’t watch our stock price that closely. I can’t control it, I watch it only, because you have seen, I’ve done a bunch of insider purchases. So sort of away from that, it doesn’t matter like I don’t really care where our stock price is on a day-to-day basis.
What we care about is where it is over a long term and our shareholders are happy. I think people realize what’s happened in the last three months is really out of the control of – the sector is totally divorced itself from fundamentals. And there is technical overhang from some of index exclusions. Oh, yes.
Some of what you’ve done has been basically in-house, some of it was strategic vertical and some of it’s been strategic relationship with some people are really good at middle market loan origination. As you go forward, how do you think about growing in-house capabilities as opposed to additional partnerships. And what are the risks associated with the strategic partnerships? And how do you think about that?
Edward J. Goldthorpe
Yes, so listen at the end of the day origination is everything, obviously underwriting is super important, but the key is to increase the size of your funnel and you have more shots on. I am Canadian, so if you have more shots on goal. Then you are going to have better credit quality crush portfolio, I’m a huge believer in that.
So we’ve invested all of our headcount in origination. That being said roll back two years ago, when we did our corporate transactions. So we partnered with a Chicago based middle-market lender, we think they are very smart called Madison Capital, they backed us the results that is phenomenally good. They like a lot of other people, they don’t buy an insurance company, there were capital constrained. So when they are in the market competing with GE and they are really smart guys, who compete in that space.
They are capital constrained. So we are not capital constrained. They have got a bunch. They have got 20 plus originators running around source some deals. So we basically entered into partnership with them, where they source L+450, L+500, L+400 loans. We put it into the crippled vehicles and it has been a very, very successful partnership.
We are not going to go and hire 25 people to run around in the zero to three times business, it’s not overdue. And that partnerships have been unbelievably successful for us. So listen, it’s a I think it’s a one off – I think these are kind of like one-off dialog. We are in very interesting dialog with all the large investment banks, for example. They have huge front-ends. They see lots of stuff and they can’t do anything. They can’t do it anymore.
So it’s natural for us to partner with people like that, who have complementary business model to us. The flip side of that is we are going to continue to hire originators that is just so strategic to our business. Outsourcing origination is a good short-term strategy. I don’t think it’s a good long-term strategy. So I think they will see us continue to hire a lot of origination.
Anything else? Great, thank you very much.
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