Something curious is happening at New Mountain Finance (NMFC). While analysts are fixated on tightening spreads and potential rate cuts, a silent but significant shift in the company's portfolio structure might be signaling a hidden strength. This under-the-radar trend could be the key to not only weathering the coming storm but also accelerating New Mountain Finance's performance in the years ahead.

The clue? A dramatic increase in second lien repayments.

On the surface, this might seem like a cause for concern. Second lien loans, by nature, carry higher yields than their first lien counterparts. A flurry of repayments could indicate NMFC is losing out on those juicier returns.

But John Kline, NMFC's President and CEO, paints a different picture. In the Q1 2024 Earnings Call [Q1 2024 Transcript], he suggests this uptick in second lien repayments is not a sign of weakness, but a reflection of astute credit selection. He points out that NMFC tends to reserve its second lien capacity for its "highest conviction opportunities." These companies, benefiting from NMFC's support and savvy, have thrived, enabling them to sell or refinance their capital structures, often at favorable terms.

Here's the twist: these refinancings, combined with NMFC's existing relationships with these borrowers, often provide an opportunity for the company to "rotate" from second lien to first lien positions. This was explicitly highlighted in the Q1 2024 earnings call with examples like OEConnection and TriTech.

This "second lien whisperer" strategy, as we might call it, could be a stroke of genius.

Why This Strategy Matters

Risk Reduction: By converting second liens into first liens, NMFC is strategically improving its position in the capital structure. This reduces risk significantly, particularly crucial in an uncertain economic environment.Spread Resilience: While unitranche loan spreads might be tightening, NMFC is finding that the spreads on these "rotated" first liens are almost as attractive as the original second liens. This provides a buffer against the broader spread compression trend.Relationship Leverage: NMFC is capitalizing on its existing relationships to secure these advantageous rotations. This speaks volumes about the trust and confidence the company has built with its borrowers.Strategic Positioning: By focusing on first lien and unitranche loans, NMFC is aligning itself with the dominant trend in sponsor-backed financing. This ensures the company remains at the heart of deal flow as the market picks up.

The Numbers Speak for Themselves

In Q1 2024, second lien positions constituted 14% of NMFC's portfolio, down from 18% a year earlier. Post quarter-end repayments further reduced this exposure to just 10%.

This strategic shift is not just a one-off occurrence. It's a pattern that's been developing over several quarters, subtly reshaping NMFC's portfolio into a more robust and resilient entity.

Second Lien Exposure Over Time

The Hypothesis

NMFC's "second lien whisperer" strategy is a key differentiator that's not fully appreciated by the market. By carefully nurturing its high-conviction second lien investments and then strategically rotating into first lien positions, the company is building a portfolio uniquely positioned for both risk mitigation and spread resilience.

Key Data Points

Second lien exposure: Declining from 18% to 10% over the past year.First lien and unitranche exposure: Increasing steadily.Portfolio company leverage: Decreasing slightly.Weighted average interest coverage: Stable at 1.7x.Overall internal risk rating: At its highest level in recent history (96.5% green rated assets). [Q1 2024 Transcript]

Conclusion

While the future remains uncertain, one thing is clear: NMFC is not simply riding the wave of rising rates. The company is actively shaping its destiny, leveraging its "second lien whisperer" strategy to fortify its portfolio and capitalize on emerging opportunities. As the market dynamics shift and evolve, this hidden strength could become New Mountain Finance's defining advantage.

"Fun Fact: New Mountain Finance's management team has a long history of successful investing. The firm's private equity funds have never experienced a bankruptcy or missed an interest payment, a testament to their disciplined approach and expertise."