Carlyle Secured Lending: Strong Quarter With Stronger Future (NASDAQ:CGBD)

Carlyle Secured Lending overview

I have been covering Carlyle Secured Lending Inc. (NASDAQ:CGBD) since the early January this year, where during this period the BDC has generated 11.8% in total returns, outperforming the overall BDC market by roughly 12%. While initially, my stance was rather bearish due to elevated concentration of portfolio in underperforming investment segment, after seeing the Q4, 2023 and Q1, 2024 results, I turned more bullish as the leverage continued to decrease and portfolio quality improved.

Relatively recently, CGBD issued its Q2 2024 earnings deck, which reveals some interesting data points that are worth considering and contextualize against the current bull thesis here.

Let me now dissect the earnings report and elaborate on why I remain bullish on this BDC.

Thesis review

All in all, the core performance came in at solid levels, where the key metric — net investment income per share — was still strong enough to result in one of the highest dividend coverage ratios in the BDC sector (i.e., base dividend coverage of 128%, even though it has grown by ~ 25% since 2022).

On the total investment income side, CGBD generated $58 million, which is a bit lower than in the previous quarter, mostly due to a cumulative effect from the negative net investment activity over the past couple of quarters (i.e., lower average portfolio balance). The expanse side, however, decreased in sync with the drop in the top-line statistics, as the lower asset base automatically leads to a reduced total interest expense due to lower outstanding debt balance.

As a result of this, the net investment income figure landed at $26 million or $0.51 per share, which is in line with the same quarter last year.

While the net investment income is strong enough to cover nicely the base dividend, distribute supplemental dividends and leave some internally generated liquidity to fund new opportunities, the negative dynamics on the net funding front send indeed a discouraging signal. This is especially considering that portfolio growth is the key avenue on how to achieve organic growth and offset the general spread compression.

As an additional headwind, we could underscore the fact that during this quarter, CGBD recorded a slight uptick in non-accruals. The non-accruals increased in Q2, 2024 to 1.8% of total portfolio fair value as two companies started to exhibit clear signs of potential default.

Yet, according to the Management, finding a somewhat acceptable solution seems like a very likely scenario, providing them with a sufficient comfort to project the non-accrual position dropping back to 1% of total portfolio fair value already next quarter.

Furthermore, if we peel back the onion a bit more on the new investment front, we will notice favorable signals indicating high potential for finally registering a portfolio growth in the upcoming quarters. The key indication here is that the originations have jumped materially higher relative to the prior quarter. Plus,

In the recent earnings call, Justin Plouffe — Chief Executive Officer — gave a nice color on CGBD’s M&A activity and its prospects:

Activity continued to pick up in the second quarter of 2024 as sponsored direct lending volumes reached recent highs driven by strong refinancing, recapitalization and M&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.

Now, the biggest news that were announced together with Q2, 2024 report was that CGBD is set to venture into a merger with Carlyle Secured Lending III, which has already been blessed by the board of directors.

Typically, whenever notable mergers are announced there is a high uncertainty around the potential effects on the combined income generation, portfolio quality as well as the overall strategy. Yet, in this case, I feel more confident about the execution and the end-state as there are simply many overlaps that create natural synergies.

For example, both the sector and first lien focus is almost the same between these two vehicles. Furthermore, both of these BDCs operate under Carlyle investment umbrella, which has so far been one of the main sources of deal origination for CGBD and CSL III.

Apart from these synergetic effects, there are multiple other components that should benefit the existing shareholders of CGBD, such as:

• The combined market cap level after the transaction will exceed $1 billion mark, which will result in an increased scale and liquidity — critical for accommodating larger transactions and accessing cheaper capital.
• The CGBD convertible preferred shares held by Carlyle have a current conversion price of $8.98 which is way below the Q2, 2024 NAV of $16.95, thus being extremely dilutive if exercised. However, right before the actual transaction, Carlyle will exercise these preferred at NAV that will help avoid the consequences of the currently embedded dilution factor.
• As in most mergers, the expectation is that there will be a cost reduction from improved operational excellence, resulting in a total saving of $2.5 million (measured on a LTM basis). This in combination with the uptick in the market cap (i.e., scale) will lead to a decreased expense ratio — i.e., drop of 70 basis points measured against the net assets.

The bottom line

The Q2 2024 earnings report has proved yet again that CGBD is a resilient BDC with an ample margin of safety when it comes to covering the dividend, which is the key driving force for the investment case here. While the net investment income did indeed shrink compared to the previous quarter, the solid transaction (new investment) prospects with an estimated normalization on the non-accrual front already next quarter bode well for future NII generation. At the same time, the proposed merger with Carlyle Secured Lending III is set to bring multiple immediate and long-term benefits for the existing shareholders.

As a result of this, I am maintaining my bullish stance on Carlyle Secured Lending.