Crescent Capital BDC, Inc. (CCAP) Q4 2012 Earnings Report, Transcript and Summary

Good morning, and welcome to THL Credit's Earnings Call for its Fourth Fiscal Quarter of and Full Year 2012. It's my pleasure to turn the call over to Ms. Stephanie Sullivan, General Counsel and Chief Compliance Officer of THL Credit. Ms. Sullivan, you may begin.

Thank you, operator. Good morning, and thank you for joining us. With me today are Jim Hunt, our Chief Executive Officer; Terry Olson, our Chief Operating Officer and Chief Financial Officer; and Sam Tillinghast, our Co-President and Chief Risk Officer. Before we begin, please note that statements made on this call may constitute forward-looking statements within the meaning of the Securities Act of 1933, as amended. Such statements reflect various assumptions by THL Credit concerning anticipated results and are not guarantees of future performance and are subject to known and unknown certainties -- uncertainties and other factors that could cause actual results to differ materially from such statements. The uncertainties and other factors are, in some ways, beyond management's control, including the factors described from time to time in our filings with the Securities and Exchange Commission. Although we believe that the assumptions on which any forward-looking statements are based are reasonable, any of those assumptions could prove to be inaccurate and, as a result, the forward-looking statements based on those assumptions also could be incorrect. You should not place undue reliance on these forward-looking statements. THL Credit undertakes no duty to update any forward-looking statements made herein. All forward-looking statements speak only as of the date of this call. A webcast replay of this call will be available until March 12, 2013, starting approximately 2 hours after we conclude this morning. To access the replay, please visit our website at www.thlcredit.com. With that, I'll turn the call over to Jim.

Thank you, Stephanie. Good morning. Thank you for joining us this morning's call, covering the results of THL Credit's fourth quarter and year-ended December 31, 2012. Our earnings announcement and 10-K were released yesterday afternoon, copies of which can be found on our website, along with a Q4 Investor Presentation that we will refer to during this call. This morning, we will provide an overview of THL Credit's investment activities and highlights for the fourth quarter and the full year 2012. We will also offer our views on the current investment environment and how we are positioned for growth. We completed the fourth quarter with 34 portfolio companies valued at approximately $400 million, after investing $105 million during Q4 in 6 new transactions and 3 existing portfolio companies. These new investments were offset by proceeds from repayments of $80 million, resulting in over $25 million of net portfolio growth for the quarter. While prepayment activity with associated premiums was higher than expected, our originations remained strong amid an increasingly competitive environment in the middle market. During 2012, we completed 19 new investment transactions and made 7 follow-on investments, totaling $277 million in debt and equity capital. While the fourth quarter marked the highest number of investments closed since going public, as we have regularly noted when we report earnings, there remains an inherent lumpiness in our pace of deployment and prepayment. The investments I had just mentioned exclude the $24 million in short-term investments in 5 broadly syndicated loans we made during October, leveraging the credit resources of certain investment professionals from our Senior Loan Strategies Group, or SLS, which operates as a subsidiary of our external manager. We sold these loan investments in the fourth quarter and used the proceeds for new investments consistent with our investment strategy. We realized a return to shareholders, including gains and interest of approximately $600,000 from these loans. We view this investment opportunity as a prudent [ph] use of available capital generated from our September equity raise to maximize the cash yield to our shareholders. As of December 31, 2012, we had over $145 million of liquidity from cash resources and our fully undrawn revolver. This capital, coupled with proceeds from ongoing prepayment activity in the sales or expected sales of portions of our largest year-end holdings, Gold and Harrison, provides us with ample liquidity to fund our near-term growth. Pages 13 and 14 in our Q4 investor presentation highlight our growth to date. While our pipeline remains robust, the nature of investment style and the origination cycle for middle market credits, which we target, can result in the variable investment activity from quarter-to-quarter we mentioned, and you can see that trend on Page 14. Before jumping into a few financial highlights and our view on the markets, I'd like to briefly discuss our decision to withdraw our application for a license to operate in SBIC subsidiary and provide you with an update on Greenway II. In January, we announced the withdrawal of the application after it became clear to us that the process, in its 21st month following Green Light-ing, was not moving forward, and it was not the time -- right time to pursue it further with the SBA. That said, we may consider pursuing a license in the future. We do not have specifics from the SBA we can offer at this time on its process. What we do have today is attractively priced senior leverage to deploy in our next stage of growth. Regarding the Greenway II, we are pleased to announce the closing of the fund in February. Greenway II is currently, actively investing alongside the BDC. The fund is structured very similarly to Greenway I as the portfolio company of the BDC from the fee and formulate process. However, it will have multiple investors unlike the single-investor Greenway I construct. Like Greenway I, earnings from Greenway II accrue to the benefit of the shareholder. We look forward to providing further and additional details on fund-related investment activity on our next call in May. Now to turn back to some additional highlights. On the financial side, net assets as of December 31, were $348 million or $13.20 per share compared with $13.21 on September 30. During this quarter, there was an increase in retained earnings and gains, net unrealized appreciation on portfolio, which was offset by a $0.05 per share special dividend we declared in December 2012 that was paid in January 2013. As you may recall, this dividend was related to the increased level of prepayment activity which we experienced during the second half of 2012. Our net investment income for the fourth quarter totaled $9 million or $0.34 per share, compared to $0.33 per -- for dividend paid for the quarter. And we are pleased to announce that on February 27, our Board of Directors approved a quarterly dividend of $0.33 per share for the first fiscal quarter 2013, that is payable on March 29. Overall, the credit quality of our portfolio remains strong. The performance of most of our companies continues to meet or exceed our expectations. As a reminder, portfolio companies that have lagged our underwriting expectations are scored as a 3 in our internal underrating -- our internal rating scale. And in one instance, a portfolio company has been assigned a 4 rating, given weaker but recently improving performance. All of our companies, and in particular, those that are not meeting our expectations, are vigorously supervised. As of December 31, no investments were a nonaccrual. Our portfolio companies in which we have debt investments currently have a weighted average EBITDA of approximately $24 million, excluding 1 portfolio company with a higher EBITDA level not representative of a typical portfolio investment. Our weighted average leverage attachment point in the capital structure is approximately 3.8x EBITDA. Turning to pipeline and markets. Our pipeline remains active today, and it includes an increasing number of unsponsored opportunities. Gold, Inc., which Terry will talk more about, is our most recent unsponsored transaction. While we continue to maintain our cautious view on the economy, we are optimistic that a gradually improving economic backdrop will continue to lead to an increasingly active 2013. We continue to leverage our relationship with our network of sponsors and intermediaries, which remains our hallmark of success in a competitive market. We have now closed 27 investments with 27 different sponsors. These relationships and others have provided a steady flow of recapitalization in refinancing transactions on the sponsored side driven by increased private equity activity and the continuation of the debt maturity wall. The wide middle-market investment fairway, we continue to provide creative structuring solutions for transactions to achieve optimal risk adjusted returns. Solutions include traditional senior substructures, second liens, a higher yielding first lien investments, which may be structured as unitranche investment, to achieve an appropriate return on the risk underwritten. We have also been opportunistic and strategically using our 30% bucket with attractive higher-yielding investments, as you have seen with our investment in LCP Capital, a Duff & Phelps payment right and more recently, with our fourth quarter investments in the income notes of Octagon's most recent CLO. These investment offers an example of where we were able to leverage the credit resources and expertise of certain investment professionals from our SLS team to support our investment committee. We will continue to carefully weigh the most appropriate place in the capital structure to be investing and the associated risk adjusted returns. With ample liquidity for new investments, origination in relationship-centric direct lending platform is yielding attractive opportunities in a competitive marketplace. Our credit discipline is unwavering and focused on seeking appropriate risk-adjusted returns across the capital structures. We will remain prudent and patient in the deployment of shareholder capital. With that, I'll turn the call over to Terry to talk about the investment activity in greater detail and our financial performance.

Thanks, Jim, and good morning, everyone. As Jim mentioned earlier, our investment portfolio, valued at $394 million on a fair market value basis as of December 31, consisted of 34 companies including our investment in Greenway I. As a reminder, we utilized an independent third-party provider -- independent third-party to provide positive insurance on values as part of our quarterly valuation process for all of our investments each quarter. I want to start by describing our 6 new investment transactions and provide you with a little color on each. First, we made a $36.8 million unsponsored investment on the subordinated term loan of Gold, Inc. Gold is a designer and distributor of both private label and brand accessories and travel gear for infants and children and is headquartered in Aurora, Colorado. We made this investment on the last day of 2012 and, subsequent to year end, sold $15.7 million of our holdings, as anticipated at underwriting. We made a $25.4 million investment in the senior secured term loan at Harrison Gypsum. Harrison mines, mills and processes and distributes gypsum and anhydrite products and is based in Norman, Oklahoma. We are in the process of completing the sale of a portion of our holdings. The sale was also anticipated in our underwriting. We made an $11 million investment in the senior secured term loan of Washington Inventory Service, a global provider of outsourced inventory management solutions based in San Diego, California. We made a $10 million investment in a second lien term loan of Pinnacle Operating corporation, a distributor of crop input and precision agricultural services to growers in the Mid-South, with headquarters in Cleveland, Mississippi. We also made a $10 million investment in the income notes of an Octagon CLO managed by Octagon Credit Investors. Finally, from the investment front, we made $1.2 million limited partnership investment in a fund managed by Gryphon Investors. In addition, we made a $10.7 million in follow-on investments in Dr. Fresh and Pomeroy in support of acquisitions and investment in Vision Solutions. We've also announced 2 new investments subsequent to quarter end. In February, we made a $15 million investment in Embarcadero Technologies, who provides data management service solutions to business. $3 million of this investment was sold to Greenway II as anticipated. And yesterday, we also closed on a $20 million investment in Tri-Starr Management Services alongside Greenway II. Headquartered in Portsmith, New Hampshire, TriStar is a third-party logistics provider. Turning to our realizations. This is our most active quarter to date. We had full realization on the debt investments in Texas Honing, BDC Health Care Management, Pomeroy, E&D Solutions, Purple Communications and our small remaining position in Chili's, resulting in proceeds of $80 million, which includes prepayment premiums. We also had partial realization of debt investments in Loadmaster and YP Intermediate Holdings or Yellow Pages, resulting in proceeds of $9.7 million. And as Jim previously mentioned, we exited our broadly syndicated loan divisions during the quarter. The weighted average yield on all investments made in Q4 was 13.2%, with effective yields ranging from 10.3% of second lien loan to approximately 15.5% on the CLO residual interest. As of December 31, the portfolio, at fair value, was invested 26%, first lien debt, including unitranche structures, 18% in second lien debt, 47% in subordinated loans, 7% in income-producing investments, which includes CLO equity and 2% in equity. Our debt investments based on funded loans were invested 57% fixed-rate loans and 43% invested in floating rate. The weighted average yield on all of our income-producing investments as of December 31, was 13.9%, 13.7% for our debt-only securities. Additional details on the portfolio, its composition, credit profile and yields are highlighted on Pages 15 through 19 of our Q4 Investor Presentation. From our portfolio, we derived $16.4 million in investment income in the fourth quarter. $15.1 million was from interest income and included approximately $2.4 million from prepayment premiums and the acceleration of unamortized discount. Other income of $800,000 included principally fees from income on our managed fund at Greenway I. We generated $53.1 million investment income for the year ended December 31, 2012, including $2.6 million of income from Greenway I. During the quarter, we incurred $6.8 million of expenses, including $5.1 million of base management fees, $2.3 million of incentive fees, $1.8 million in general, administrative and professional fees, $1.2 million in fees and expenses related to our credit facility. Incentive fees included the benefit of $100,000 related to the reversal of previously accrued GAAP incentive fee expense related to unrealized depreciation. Expenses for the year totaled $23 million and included $4.9 million of base management fees, $7 million of incentive fees. 2012 expenses also included $6.3 million in general, administrative and professional fees, $4.1 million related to our credit facility and $600,000 related to excise taxes on undistributed earnings and income taxes related to a blocker subsidiary. Net investment income for the quarter was $9 million or $0.34 per share, compared to a dividend paid of $0.33 per share related to the fourth quarter, and is exclusive of the $0.05 special dividend Jim previously mentioned. Net investment income for the year was -- year-ended 2012 was $30.2 million or $1.38 per share. This compares to $1.34 per share of dividends paid for 2012. Consistent with our past practice, we intend to pay dividends that are generally aligned with earnings, but the timing and expense -- extent of any special dividends will be determined by our Board and driven by portfolio-specific events and tax considerations at the time. We realized net gains of $176,000 in the quarter, which included $356,000 in connection with the sale of our broadly syndicated loans, offset by approximately $180,000 in amounts paid under our interest rate swap. The net change in unrealized appreciation of $890,000 during the quarter was impacted by the reversal of 100 -- $1.6 million of previously unrealized depreciation of the portfolio -- of liquidated portfolio companies, changes in portfolio company valuations, which were impacted by capital markets conditions and the performance of certain investments. We also recognized a $450,000 provision for taxes related to unrealized depreciation -- appreciation on an investment held on a tax blocker. A deferred tax liability related to this provision is reflected on the balance sheet. With respect to our liquidity, we had $5 million of cash and $140 million of borrowing capacity on our credit facility at December 31, 2012. We believe this capital proceeds generated from recent prepayments provide us with ample capital to equip our current pipeline and fund investment opportunities into 2013. With that, I'll turn the call back over to Jim.

Thanks, Terry. With sequestration and the payroll tax effect raising questions on the U.S. economy, I asked Sam Tillinghast, whom the majority of you know, who serves as our Co-President, Head of our Houston office, and importantly, serves as our Chief Risk Officer, to address these macro factors. Importantly, Sam will speak to our selecting and structuring investments in light of various economic scenarios. Additionally, he will cover our system for investment supervision. Sam?

Thanks, Jim. First, let me reiterate the macro environment caution, which THL credit has built our portfolio since our inception. THL Credit was started in 2007 as the credit crisis and economic downturn was just beginning. And successfully weathered the worst such crisis in our careers, we've consistently underwritten all of our investments that focused on revenue visibility, stability of cash flow and historical performance. For each transaction, we sized the appropriate amount of debt based on our analysis of trough EBITDA, a thorough analysis of potential downside scenarios. Invest in transactions with our intention to hold to maturity, and with that intention, we always assume the borrower will experience at least one significant downturn in the economy, and we underwrite to that assumption. Prior to every investment, we perform extensive forecasting and sensitivity analysis with a focus on cash generation, liquidity and fixed charge coverage. This approach to only selecting opportunities that meet our high underwriting standards and to the structuring each transaction to withstand significant changes in the macroeconomic environment, our portfolio is well-positioned in the face of the sequestration and the payroll tax increase. That being said, we are mindful of the potential multiplier effect from any federal employee force reduction and potential impact of the exploration of the payroll tax holiday on lower-income consumers. With that in mind, let me take another moment to explain our process for the monitoring and supervision of our investments. As a team we review our portfolio weekly, addressing areas in which we have concern. We also address whether any credit risk scores should be changed. Every portfolio investment is more formally presented on a semi-annual basis to review the validity of our original investment thesis and update all significant risks. We received monthly financial statements on almost all of our borrowers and analyze each borrower’s performance relative to their budget and our original underwriting expectations. This monthly analysis is distributed to all our investment professionals and includes a review of the borrower’s liquidity profile. Our risk management culture is to focus quickly and early on any sign of softness, conduct calls with management teams on a quarterly basis or more frequent, if appropriate. We have Board rolls via observation rights for the majority of our borrowers, which provides us with invaluable early insights and the opportunity to add value to strategic discussions and initiatives. With our own Board of Directors, we review macro risk to the portfolio, such as commodity exposure, changes to energy prices, industry or geographic concentrations and the potential effects of budget or fiscal issues of federal or state governments. This supervision and monitoring process, combined with our rigorous investment selections and structuring has enabled us to build a resilient and durable investment portfolio. And with that, I'll turn the call back over to Jim.

Thank you, Sam. I'd like to now open the line for questions, operator.

[Operator Instructions] Our first question comes from Greg Mason of KBW. Greg M. Mason - Keefe, Bruyette, & Woods, Inc., Research Division: First, Jim, I wanted to see if you could talk a little bit more about the pipeline, particularly the press release, you said that you're seeing an increased number of unsponsored deal opportunities. Could you talk about why the unsponsored channel seems to be opening back up? I think it's been closed for your comments on the last several calls, and how big can that unsponsored channel be for you guys right now?

It'll be interesting -- I think, that's a good question and one we're watching closely. To go back to the 30,000-foot level, our pipeline is managed in a system we call the Chalkboard, which is a heavily customized version of a CRM system. So new transactions come in, they go through our funnel, our allocation process. Those we find attractive, we screen, and right now, the Chalkboard is reflecting the unsponsored pipeline at about 42% of the pipeline, which is the highest we've now seen and is now probably -- well, certainly, the approaching third year anniversary of going public and then, preceding that. So this is -- I am hoping it's a canary in the coal mine for a more positive economy. I also -- I would say, unsponsored companies are a situation where an owner of the business has optimism. They're choosing to stay owners of the business as opposed to putting it through a change of control process. So they -- it could reflect the end of a period deleveraging of companies and a reduction of risk, reduction of debt, and now more optimism in acquiring a competitor affecting a generational change in an entrepreneurially owned business. So it could be any of those factors, but we're certainly comfortable with our process and culture to equip that growing unsponsored component. Greg M. Mason - Keefe, Bruyette, & Woods, Inc., Research Division: Okay, great. And then you talked about, on Greenway II, the economics were similar to Greenway Fund I. Would it be reasonable to assume the size would be similar to that $150 million of Greenway Fund I?

I think, on that, more will be more revealed in our -- I think, that's a reasonable assumption, Greg, but I think, more details will be released at our early May call. Greg M. Mason - Keefe, Bruyette, & Woods, Inc., Research Division: Okay, great. And then one more question and I'll hop back in the pipeline. The Gryphon Partners LP investment, do you expect that investment is going to grow with additional capital calls or what is your thought process behind investing in a private middle market equity fund?

The -- so, as you've probably observed, we're a little underweighted on equity. And if you look at our choices made over the last number of years, we frankly preferred the equity return and our seniority in the capital structure to equity choices we had. This was a little bit of a one-off opportunity with a sponsor we know well, we had financed previously, and there were special aspects about the opportunity. So again, going back to that broad risk-adjusted return culture, this was a specific instance that will grow slightly through additional capital calls, but not materially so, that was a fit for the balance sheet, but we're -- in that, certainly sub-5% equity as a component of our portfolio in aggregate, and this would be just a sliver within that -- with that cap, which we're a long -- informal cap, which we're a long way from.

Our next question goes from John Stilmar of JMP Securities.

Jim, just to follow on that last point, is that sort of one of the concepts of creating a well-structured equity versus just equity in companies, that it would let you to invest with pretty well-known manager in the CLO space of Octagon? And how should we think about that kind of, is it sort of an episodic opportunistic trade or investment? Or should we think about that kind of as an emerging theme for the opportunistic bucket for THL going forward?

Well, I would say, again -- and John, it's a good question, because if you go up to 30,000 feet, at the end of the day, the risk-adjusted return has to be right. And even though -- Sam and I have lots of experience as CLO investors and managers in our past working together, but what made the specific situation, which I think, it's correct to think about it as opportunistic, attractive is, now, 7 or 8 months ago, our SLS team joined us, and with their assistance, select individuals assisting our investment committee, we have the knowledge of their ability to, in essence, re-underwrite the portfolio and give us a far greater insight into just what is that risk-adjusted return scenario. So I think, you're correct in calling it opportunistic. And in the light -- with the backdrop of -- upon the manager's acquisition of SLS, we have far more resources to respond appropriately in that specific situation.

Okay, perfect. And then, with regards to some of the originate and self, for some of the loans you that sold already now in the first quarter, portions of which were originated in the fourth, how much of those were kind of restructured first-out pieces? Are those sold to kind of carry pursue [ph] just pieces to other investors? And can you talk about what the distribution capabilities are? Well, not capabilities, but sort of the environment distributions and sort of reselling pieces versus several different flavors that maybe out there that we've kind of talked about in the past. I was wondering if you could give us a little bit more color on kind of first quarter activity.

Yes, John, I'm going to address the first half, and then I'm going to ask Sam to talk about the structure on the transaction he led and how the investment was structured. In general, our senior team generally wears 2 hats. Sam serves as the Head of our Houston office. He heads any finance-related investments we have industry -- overarching industry responsibly, and then serves as our Chief Risk Officer. Chris Flynn here, in Boston, heads the Boston Investment team and has responsibility for distribution of any investment that exceeds an appropriate hold position for the BDC. He's our capital markets czar. And in the -- and so one of the reasons why Greenway I, now Greenway II, is such an attractive fit for both the investors in Greenway and for the BDC, is that it allows us to capture larger investments that [indiscernible] could responsibly afford. So the Greenway institutional investor gets a very attractive economic structure and a slice across our portfolio. And we, in turn, are able to capture larger investments and give the issuer certainty that the transaction is done. Additionally, it's important that we can drive the documents and the diligence. That's incredibly important to us. So in the instance of -- one transaction we, as an investment committee, carefully consider taking what we regard as an outside position with a -- it's a case where we have a high degree of clarity and confidence in our ability to syndicate. So in that instance, in the first instance of Gold, we've brought in Greenway and co-investors in exactly the same security that the BDC would hold. So there was no crunching [ph], if you will, on bringing in those investments. Sam?

On the Harrison transaction, John, we came in with another investor at close, both with the intention that we would sell out a first -- a first-out piece. And so our intention there is just to hold the last out piece along with other investor. Generally speaking, John, you asked about just the market. We are seeing more of this kind of thing where lenders are wanting to team up with each other and do more club transactions. There's a lot of discussion about that at conferences and among different lenders. And it's something that we think we'll probably be doing more of this year.

Okay. And then finally, just wondering if you can give us an update, at least in the first quarter, from your perspective. Obviously, you talked about a strong and growing pipeline. There's obviously the first quarter drop off, and some have sort of articulated that the first quarter demand may have been kind of pulled forward, at least into the fourth quarter. Obviously, repayments are the counterbalance that as we start thinking about portfolio. But wondering if you can kind of just paint a picture for what you're seeing so far in the first quarter of this year just with regards an origination environment and whether your unsponsored kind of growing pipeline may skew some of those -- well not skew, but just sort of give you guys maybe a more advantageous outlook than maybe we're seeing, just kind of an overall market volume. Just curious about your perspectives, and that's my last question.

With respect to that, John, we are enjoying an active quarter. And it -- the first 2 weeks of year were slow, and if this -- we're getting close to the end of the quarter, but it has been a quarter of active new originations, and we've had no prepayments.

And I'd add to that John. This is Terry. I would not anticipate the level of prepayment premium and accelerated amortization that we saw in what I would characterize as an outsized Q3 and Q4 in terms of earnings contribution. And I think, the $0.05 special dividend was reflective of paying back some of that. But I would not anticipate the level we've seen in Q3 and Q4 in the next quarter or 2.

Our next question is from Ron Driscoll [ph] of Wells Fargo Securities.

As we model forward our originations and yields, and you guys start using your credit facility, will advance rates cause a slight portfolio mix shifts? Or is that kind of immaterial as you guys grow?

The borrowing base reflects our historic and probable investment mix, so we do not anticipate a change there.

Okay. And then one last question with kind of target leverage. You guys are currently at .14x [ph] , I believe, where do you feel comfortable bringing leverage kind of as you focus a little bit more in the junior debt space?

If you look at our mix, Ron [ph], it has grown to be a higher portion, second lien and unitranche, then at our inception. Today, we're less -- a little less than half second lien in mezz, and the market has migrated to be -- sorry, it's a little less than half mezz. When you add second lien in, Terry, it's probably 60%-ish. The -- so the market today, it's very common that we have the opportunity to help a borrower constitute the right-hand side of their balance sheet. And it's typical for us to contemplate the opportunity as unitranche, second lien and mezz, and I think, that's going to continue. And I think, our financing does contemplate. We -- so our borrowing base allows us to do more junior capital investments, but I think the current mix probably will be reflective of us going forward. Then to your last question, we're probably comfortable at the 0.5, 0.6 leverage level relative to our portfolio. One of the things that got us -- Sam talked about building the business carefully and responsibly in what's been an unusual economic environment. And part of that has been focusing on investments that didn't need leverage to hit our target returns. And I would say that, that remains one facet of our philosophy. So 0.5, 0.6 leverage, which is, as you've noted in reflecting on where we are today, that's a long way from where we are today. And as Terry pointed out, we've got significant capital in place to do that.

So operator, I see that we're through the Q&A queue. So if there are no further questions, we'd like to thank everybody for their participation. We look forward to seeing you in early May, and have a good rest of the week.

Thank you. Ladies and gentlemen, this concludes the conference for today. You may all disconnect, and have a wonderful day.