DBRS Morningstar Confirms THL Credit, Inc. at BBB (low), Trend Stable

DBRS, Inc. (DBRS Morningstar) confirmed the BBB (low) Long-Term Issuer Rating and Long-Term Senior Debt rating of THL Credit, Inc. (TCRD or the Company). The trend on all ratings is Stable. The Company’s Intrinsic Assessment (IA) is BBB (low), while its Support Assessment is SA3, resulting in TCRD’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, the notable progress in improving its risk profile through the exit from legacy investments and evolution of its investment strategy, as well as its appropriately managed leverage. These factors are offset by earnings generation that has been challenged during the transformation period and the required level of earnings distribution as a registered investment company (RIC) under the 1940 Act (the 40 Act), as well as an elevated level of non-accruals that is expected to moderate in 2H19.

The Stable trend reflects DBRS Morningstar’s expectation that TCRD will continue to advance its exit from those remaining investments that are not consistent with its sponsored first lien senior secured investment strategy, resulting in a lower risk balance sheet and improved earnings performance. Moreover, the Stable trend reflects that while U.S. economic growth is slowing and global uncertainties continue to pose potential challenges, performance of the U.S. middle market is expected to remain acceptable.

RATING DRIVERS
While upward movement in the ratings is not expected in the intermediate term, completion of the exit from legacy investments while adhering to the new investment strategy and consistently generating solid earnings would be viewed positively. Diversification of the Company’s capital structure that includes a higher proportion of unsecured debt that improves financial flexibility would also be considered a positive for the ratings. Conversely, should consistent profitability not be restored within the next four quarters, ratings could come under negative pressure. A sustained increase in balance sheet leverage that approaches the bank covenant could also result in negative ratings pressure.

RATING RATIONALE
TCRD has made notable progress since 1Q18 in improving the risk profile of its investment portfolio. The Company has transformed its investment portfolio to one focused on sponsored first lien senior secured investments from its prior focus that included unsponsored and junior capital investments. Indeed, at June 30, 2019, first lien senior secured loans comprised 82% of the investment portfolio when including the Company’s investment in its Logan JV, which is substantially invested in first lien senior secured loans. Non-income producing equity positions comprise just 2% of the investment portfolio compared to 6% at the end of 1Q18. Meanwhile, non-sponsored investments accounted for just four names, or 9% of the investment portfolio at fair value, compared to seven names and 17% of the portfolio at end of 1Q18.

Importantly, TCRD continues to improve the diversification of the investment portfolio. The average hold size of the Company’s most recent 15 investments was 1.2% of the investment portfolio, well within its target of no larger than 2.5%. As of the Company’s August 2019 earnings call, the Company still had seven investments that exceeded its hold size target, improved from 14 positions a year ago. Although TCRD has made significant strides in repositioning the investment portfolio, there were two investments on non-accrual status at June 30, 2019, totaling $39.6 million (at cost), or an elevated 7.8% of the investment portfolio at cost. DBRS Morningstar notes that one of these investments is expected to be removed from non-accrual in 3Q19 as it completes its bankruptcy liquidation. While earnings at TCRD have been negatively impacted by the shift in strategy as these investments typically are lower yielding, DBRS Morningstar views favorably the shift in the portfolio as it should have a positive impact on investment performance.

TCRD’s franchise is considered sound, benefiting from its position within the broader THL Credit Advisors LLC (THL Credit or the Advisor) platform. The Company has access to the attractive investment opportunities sourced by the wide-ranging THL Credit platform, 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. At June 30, 2019, the Advisor had nearly $17.0 billion of assets under management across its Direct Lending and Tradeable Credit Strategies. TCRD also benefits from synergies across the Advisor’s Direct Lending and Tradeable Credit business lines, including leveraging THL Credit’s relationships, investing expertise, and risk management. With five offices in the U.S., the Advisor 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 TCRD with access to a broad flow of deals. Indeed, THL Credit’s Direct Lending platform has committed over $800 million in 38 new investments since January 1, 2018. TCRD has received co-investment exemptive relief from the SEC allowing TCRD to invest alongside other funds and vehicles of the Advisor.

TCRD’s earnings generation has been challenged over recent quarters, primarily attributable to the repositioning initiative. The Company reported a net decrease in net assets from operations (the BDC equivalent of a net loss) for 1H19, reflecting the reduction in size of the investment portfolio and lower yields, as well as both unrealized and realized losses on the investment portfolio. DBRS Morningstar sees TCRD’s underlying earnings generation ability as acceptable and supportive of the ratings as investment portfolio yields, while lower, are still in line with the ratings and operating efficiency has improved. Through 1H19, annualized net investment income as a percentage of the average investment portfolio at cost continues to be sound at 6.12%, and has averaged 6.22% since 2014, which is supportive of the ratings per DBRS Morningstar methodology. Dividend income, which is less predictable, has risen as a component of total investment income as the Logan JV grows and delivers sound operating performance, as well as from controlling equity investments in portfolio companies that are performing strongly. Importantly, the Company has restored its ability to cover its dividend through the generation of net investment income. With the improvement in origination volumes and the progress made in addressing legacy investments, DBRS Morningstar expects earnings to improve in 2H19 and into 2020.

Balance sheet leverage (debt-to-equity) has been well-managed through the transformation initiative. At June 30, 2019, debt-to-equity was 0.80x, which is comfortably below the Company’s longer-term target for leverage and is in line with the DBRS Morningstar industry peer average. In June 2019, the Company’s shareholders approved the adoption of the lower Asset Coverage Ratio as allowed by the Small Business Credit Availability Act of 2018. Beginning in 2020, and assuming investment portfolio repositioning continues, TCRD expects to target a leverage ratio of 1.05x to 1.15x. This would provide a meaningful buffer to the regulatory limit of 2.0x, and under DBRS Morningstar’s methodology, would be supportive of the ratings.

TCRD’s funding is adequately diversified for its size with funding sourced from its secured bank facility, as well as unsecured notes. At June 30, 2019, approximately 52% of the Company’s outstanding borrowings were comprised of unsecured notes. Liquidity is managed appropriately, with approximately $91.2 million of cash and unfunded revolver commitments, which are subject to borrowing base limitations on its revolving bank facility. This compares to unfunded commitments to portfolio companies of $35.1 million at 2Q19. DBRS Morningstar notes that TCRD has the ability to increase the revolving facility under the accordion feature by an additional $310 million.

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

The applicable methodology is Global Methodology for Rating Non-Bank Financials (September 2019), which can be found on our website under Methodologies & Criteria.

The primary sources of information used for this rating include Company Documents and S&P Global Market Intelligence. DBRS Morningstar considers the information available to it for the purposes of providing this rating was of satisfactory quality.

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

For more information on this credit or on this industry, visit www.dbrs.com.

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