DBRS Initiates Coverage of THL Credit, Inc. at BBB (low), Stable Trend

DBRS, Inc. (DBRS) assigned a Long-Term Issuer Rating and a Long-Term Senior Debt Rating of BBB (low) to THL Credit, Inc. (THL Credit or the Company). The trend on all ratings is Stable. The Company’s Intrinsic Assessment is BBB (low), while its Support Assessment is SA3, resulting in THL Credit’s final ratings being positioned equal with its IA.

KEY RATING CONSIDERATIONS
The ratings consider the Company’s sound franchise in lending to U.S. middle market companies, solid earnings generation, improving risk profile and appropriately diversified funding. These factors are offset by leverage that is at the high end of the range for the rating, required level of earnings distribution as a registered investment company (RIC) under the 1940 Act (the 40 Act), and a higher than peer level of non-first lien senior secured investments.

The Stable trend reflects DBRS’s view that THL Credit’s earnings are expected to improve modestly as the Company completes the evolution of its business mix to one more focused on sponsored first lien senior secured lending from unsponsored junior lending. While yields in the U.S. middle market remain under pressure due to intense competition from high levels of available capital and liquidity in the market, the Stable trend also considers that the overall fundamentals of the U.S. middle market remain favorable.

RATING DRIVERS
While upward movement in the ratings is not expected in the intermediate term, a sustained improvement in earnings with net investment income as a percentage of investments at cost of 7% accompanied by the Company’s ability to consistently cover the dividend from net investment income, after the incentive fee waiver period, would be viewed positively. Further diversification of the Company’s capital structure by having a higher proportion of unsecured debt financing thus improving financial flexibility, would also be considered a positive for the ratings. Conversely, ratings could be negatively pressured should non-accrual investments be sustained above 2.00% for a prolonged period. Should leverage exceed 0.80x on a consistent basis the ratings could also come under negative pressure.

RATING RATIONALE
THL Credit’s franchise is viewed as sound. It benefits from THL Credit’s relationship with THL Credit Advisors LLC (the Advisor), the credit investing platform for the Company, and which is part owned by THLP Debt Partners, L.P., an affiliate of Thomas H. Lee Partners (THL Partners), a well-established private equity firm. THL Credit also benefits from synergies across the Advisor’s Direct Lending and Tradeable Credit business lines, as well as leveraging THL Partners’ relationships and its investing expertise. At August 31, 2018, the Advisor had $16.0 billion of assets under management across its Direct Lending and Tradeable Credit Strategies, of which THL Credit’s assets are approximately 4%. With five offices in the U.S., the Company has a strong national direct origination platform that emphasizes a regional focus on sourcing transactions from top private equity sponsors and regional banks, which provides THL with access to a broad flow of deals. Importantly, THL Credit has received co-investment exemptive relief from the SEC allowing THL Credit to invest alongside other funds and vehicles of the Advisor.

THL Credit’s credit risk profile continues to improve with the Company’s evolving investment focus on sponsored first lien senior secured investments from its prior focus on unsponsored junior capital investments. While there is an impact on THL Credit’s earnings as these investments typically are lower yielding, DBRS views favorably the shift in the portfolio as it should have a positive impact on investment performance. Moreover, the Company’s focus on middle market companies should also be supportive of improving investment performance as these investments generally have tighter covenants and better access to management. Although THL Credit has made significant strides in repositioning the investment portfolio, there remains several legacy investments from when the Company was more on focused on junior capital for unsponsored companies, a couple of which continue to underperform. Importantly to the ratings, the Company has made good progress in reducing the level of non-accrual investments in the portfolio. At June 30, 2018, investments on non-accrual totaled $9.7 million (at cost), or 1.7% of the investment portfolio at cost, a notable improvement from $56.3 million, or 8.8% at year-end 2017.

Balance sheet leverage (debt-to-equity) is well-managed and is currently in line with the peer average, but at the higher end of the range for the assigned rating level per DBRS methodology. At June 30, 2018, the Company’s debt-to-equity was 0.76x, which compares to the DBRS industry average of 0.75x, and at the high end of management’s target range of 0.6x to 0.8x. DBRS notes that THL Credit continues to be subject to the 200% Asset Coverage Ratio (ACR). THL Credit has indicated that the Company will focus on completing the repositioning of the investment portfolio before seeking approval to adopt the lower ACR ratio as allowed by legislation passed earlier in 2018. DBRS views this as demonstrating prudent capital management.

THL Credit’s earnings generation has been solid even with the shift in the investment portfolio. Through 1H18, annualized net investment income as a percentage of the average investment portfolio at cost during the year continues to be sound at 6.3%, and has averaged 6.6% since 2013, which is well-above the peer average of 4.60%. Total investment income generation continues to be solid. Dividend income has been strengthening primarily due the solid performance of the Logan JV, as well as dividends from other certain investments. Increasing dividend income has offset moderately lower interest income, as THL Credit’s portfolio shifts to include more first lien senior investments, as well as reflecting the slightly reduced investment portfolio. Meanwhile, operating efficiency is slightly above the peer group. DBRS would consider an improvement in operating efficiency to be a positive for the ratings. Expenses, excluding interest expense and fees related to borrowings, management fees, and incentive fees as a percentage of the investment portfolio at cost was 1.16% in 1H18, in line with 2017.

From DBRS’s perspective, THL Credit’s funding profile has an appropriate level of diversity. At June 30, 2018, approximately 43.4% of the Company’s outstanding borrowings was comprised of unsecured term debt. Liquidity is acceptable. THL Credit has approximately $144.0 million of cash and unfunded revolver commitments, which are subject to borrowing base limitations, on its revolving bank facility, as of June 30, 2018. When combined with amortization and prepayments on the investment portfolio, these resources are more than sufficient to meet liquidity needs. Moreover, THL Credit has the ability to increase the revolving facility under the accordion feature by an additional $225.0 million. DBRS notes that refinancing risk is low, with the revolving facility not maturing until December 2022, and the nearest corporate debt maturity not occurring until November 2021. DBRS expects that THL Credit will continue to further strengthen its funding profile by increasing the proportion of funding from unsecured sources.

Notes:
All figures are in U.S. dollars unless otherwise noted.

The applicable methodology is Global Methodology for Rating Finance Companies (November 2017), which can be found on our website under Methodologies.

The primary sources of information used for this rating include company documents and SNL Financial. DBRS considers the information available to it for the purposes of providing this rating was of satisfactory quality.

Lead Analyst: David Laterza, Senior Vice President, Head of U.S. Non-Bank FIG, Global FIG
Rating Committee Chair: Michael Driscoll, Head of North American FIG, Global FIG
Initial Rating Date: September 27, 2018
Last Rating Date: Not applicable as no last rating date.

The rated entity or its related entities did participate in the rating process. DBRS had access to the accounts and other relevant internal documents of the rated entity or its related entities.

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