Crescent Capital BDC, Inc. (CCAP) Q2 2013 Earnings Report, Transcript and Summary

Good morning, and welcome to THL Credit's earnings conference call for its second fiscal quarter of 2013. It is 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. Stephanie Paré Sullivan: 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 Chris Flynn, one of our Managing Directors. 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, are not guarantees of future performance and are subject to known and unknown 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 August 15, 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, and thank you for joining this morning's call covering THL Credit's second fiscal quarter of 2013. Our earnings announcement in 10-Q were released yesterday afternoon, copies of which can be found on our website, along with the Q2 investor presentation that we will refer to during this call. On today's call, we will provide an overview of THL Credit's investment activities and financial highlights for the second fiscal quarter of 2013. We will also offer our views on the current investment environment. In June, we completed an equity offering of 7.6 million shares at a premium to our March 31 book value raising approximately $106 million of net proceeds. The proceeds were used to repay $92 million of borrowings outstanding under our revolver and to fund new investment opportunities. At quarter end, we had $204 million of liquidity through cash on hand and available capacity on our revolver to fund our growth. We completed Q2 with investments in 46 companies with a fair value of a $507 million after investing $132 million during the quarter in 8 new transactions, including investments in 6 new portfolio companies as well as investments in 2 existing portfolios. One is a part of a purchase from another debt holder, the other a small investment in connection with a recapitalization. Additionally, we had realizations of $66 million through sales, refinancings and repayments. Despite what continues to be a slow M&A market, we continue to add actionable investment opportunities to our pipeline across our 5 offices, reflecting a mix of both sponsored and unsponsored transactions. With an adequate economic outlook, strong origination and ample liquidity, we feel that we are in a good position to prudently invest across the capital structure of new portfolio companies. Our investment activity in the second quarter reflects more first and second lien investments, bringing this component of the portfolio to 53%, up from 44% at the end of Q1 2013. Historically, we've had some variability in the mix of the portfolio each quarter, reflecting what we see at the time of investment as the best risk-adjusted return to our shareholders. Page 11 in our Q2 presentation reflects our growth today. Depending upon the pace of the investment closings and prepayment activity, our net portfolio growth can vary on a quarterly basis as you can see on Page 12. Our net investment income for the second quarter totaled $13.3 million or $0.49 per share due largely from dividends received from Surgery Partners and Yellow Pages as part of recapitalizations of both companies. Net assets as of June 30 were $460 million or $13.58 per share or an increase of $0.38 per share from March 31. The increases to NAV reflect the dividends and gains noted above, the net unrealized appreciation of our interest rate derivative and investments in the accretive impact of our recent equity offering. We are pleased to announce that on August 2, our Board of Directors approved a quarterly dividend of $0.34 per share for the third quarter and a special dividend from the Surgery and Yellow Pages proceeds of $0.08 per share, both payable on September 30. With approximately 80% of our portfolio companies receiving a credit score of 1 or 2 on a scale of 5, we believe the credit quality of our portfolio remain strong. The performance of most of our companies continues to meet or exceed our expectations. One 4-rated investment has been placed on nonaccrual status during the quarter, which represents 1.3% of our portfolio on a fair value basis. We also had 1 investment moved to a 4 during the quarter. For each of our investments rated as a 3 or 4, we continue to closely monitor their performance to protect our capital. Our portfolio companies in which we have debt investments currently have a weighted average EBITDA of approximately $33 million. Our weighted average leverage attachment point in the capital structure is approximately 4x EBITDA. With that, I'll turn the call over to Terry to talk about the investment activity in greater detail in our financial performance.

Thanks, Jim. And good morning, everyone. I wanted to start by describing our 8 new investment transactions, which include 6 new investments and refinancings of 2 existing companies as well and provide you a little color on each. First, in April we made a $15 million investment in the second lien term loan of Florida-based Surgery Center Holdings shortly after receiving a $19.3 million in proceeds including a prepayment premium from the realization of a subordinated term loan in the company. We also received $1.2 million of dividends from our equity investment in Surgery. We made an $11.2 million investment in the senior secured term loan of Ingenio Acquisition, an e-commerce based provider of personal and professional advice, company's headquartered in San Francisco, California. We made a $25.9 million investment in the subordinated term loan of Wingspan Portfolio Holdings, a specialized mortgage services company, which is headquartered in Plano, Texas. We made a $31.4 million investment in the senior secured term loan of Holland Intermediate Acquisition Corp., a land services company that provides services through the energy -- throughout the energy production cycle. Holland's headquarter in Fort Worth, Texas. We made a $14.3 million investment in the senior secured term loan of Cydcor in connection with the refinancing of this existing portfolio company. As you may recall, Cydcor is the provider of outsourced face-to-face customer acquisition services to businesses. We also made a $18.7 million investment in the second lien term loan of Expert Global Solutions, a provider of business process outsourcing services with a focus on customer relationship and accounts receivable management. Expert is headquartered in Horsham, Pennsylvania. We also made a $15 million investment in the second lien term loan of Blue Coat Systems, a provider of Internet security and network acceleration services to businesses. Blue Coat is headquartered in Sunnyvale, California. And lastly, we made a follow-on investment of $10.3 million in the senior secured term loan of CRS Reprocessing. The weighted average yield on all investments made in Q2 was 11.1% with yields of 10.7% on first lien loans representing almost 50% of new investments; 10.5% on second lien loans; and 14.1% on subordinated loans. You'll see that we've provided additional details on Page 14 of our investor presentation and in the 10-Q on the breakdown of the yields. I'd like to make a note that post quarter end, we've closed on $25 million of new investments and have 2 others totaling $38 million that are expected to close shortly. As of June 30, the portfolio at fair value was invested 30% in first lien debt including unitranche structures, 24% in second lien debt, 36% in subordinated loans, 9% in income-producing investments, which includes CLO subordinated notes and 1% in equity securities. This compares to a portfolio as of March 31, which was invested 26% in first lien debt, 18% in second liens, 34 -- 43% in sub-debt and 11% in income-producing securities. Our debt investments based on funded loans as of June 30 were 53% in fixed-rate loans and 47% floating rate loans. Additional details on the portfolio, its composition, credit profiling yields are highlighted on pages 13 through 17 of our Q2 investor presentation. Realizations during the quarter included $8.3 million in proceeds from the repayment of our debt in Firebirds, which includes a prepayment premium. $1.7 million in proceeds from our remaining debt of Yellow Pages. $3.4 million from the partial repayment of our debt investments in AIM Media Texas Operating, which includes a prepayment premium. And $18 million from the sale of a portion of THL Credit investments to a separate account managing connection with Greenway II and a co-investor as anticipated at the time of THL Credit's initial investments in each of these portfolio companies. From the portfolio, we derived $22.7 million in investment income in the second quarter of which $16.9 million was from interest income, $4.5 million was from dividend income and $1.3 million was from other income including fees of our managed funds including Greenway I and Greenway II. As Jim mentioned during the quarter, we received $7.2 million in proceeds from equity investments in Surgery Partners and Yellow Pages as a result of recapitalization for both companies. We recorded $4.5 million of dividend income and $2.8 million of realized gains with an estimated tax provision totaling $1.6 million, $0.5 million of this provision reflected in net investment income and $1.1 million reflected as a component of realized gain. This accounting classification of the proceeds is consistent with the anticipated tax characterization and the related provision reflects our best estimate of the liability based on information currently available to us and is subject to change once actual tax information is received from the applicable underlying portfolio company. Interest income included prepayment premiums of approximately $800,000 and $1.2 million in acceleration of unamortized discounts and fees related primarily to the exits and refinancings I previously mentioned. Other income of approximately $1.3 million included $510,000 of structuring and amendment fees as well as approximately $750,000 of income from our managed funds, Greenway I and II and related separate account. During the quarter, we incurred $8.9 million of expenses before taxes including $1.7 million in base management fees, $3.7 million in incentive fees, $1.8 million of administrator expenses, and $1 million of general and administrative expenses and professional fees and $1.7 million in fees and expenses related to our credit facility. We also recognized a $500,000 provision for estimated taxes in connection with the dividend component of the proceeds received from Yellow Pages. Net investment income for the quarter was $13.3 million or $0.49 a share and was meaningfully higher than our prior quarter results due principally to dividend income, prepayment premiums and the accelerated amortization of discount fees. For our derivative -- interest rate derivative, we realized a net loss of $104,000 during the quarter as a result of the amount paid under this interest rate swap and had a positive change in unrealized depreciation of the swap of $846,000, which reflected changes in swap rates in the market. The net decrease in unrealized appreciation of $681,000 during the quarter was a result of a reversal of unrealized appreciations on investments repaid or recapitalized as well as changes in portfolio company valuations, which were principally the result of performance of certain investments. We also recognized a $596,000 benefit for taxes related to change in unrealized appreciation of 2 investments held in tax blockers and a deferred tax liability related to this provision as reflected on our balance sheet. With that, I'll turn the call back over to Jim.

Thanks, Terry. Chris Flynn, a member of our investment committee and Head of our Investment teams in our Boston, New York and Chicago offices is joining the call to discuss recent developments.

Thanks, Jim. It is a pleasure to address the significant expansion of our Direct Lending team. But first I want to highlight that our credit first culture has remained unchanged and that core principle was a key driving influence when we were interviewing candidates and adding to our investment team roster. As many of you know, we built our business from the 3-office footprint, Boston, Houston and Los Angeles. But I'm now pleased to note that over the last several months, we have added Direct Lending teams alongside our advisers' Senior Loan Strategy colleagues in both New York and Chicago. The 3 key hires are Monty Cook, Dan Letizia and Chris Babick. Monty Cook is a Managing Director in the New York office responsible for origination in New York, Philadelphia and Connecticut. Monty joins us from Deutsche Bank and his network will add differentiated transaction flow. Monty joins Lee Incandela, a Vice President who moved from our Boston office to New York. Lee has been with us for over 3 years and will be responsible for origination and transaction execution with Monty. In Chicago, Dan Letizia joined as a Director and Chris Babick as a Vice President. Dan joins us from CIT where he managed credit underwriting for the Midwest region and CIT's sponsors group. Chris joins from J.P. Morgan's middle market leverage finance group where he was responsible for structuring and syndicating opportunities. Together, Chris and Dan will be responsible for origination and investment execution for the Midwest. We are excited to join their existing relationships with that of THL Credit in the Midwest. Incrementally, addressing the New York and Chicago market is key to our continued growth. Monty, Dan, Chris and Lee have immediately been accretive to our pipeline of actionable opportunities given their solid relationships coupled with their strong credit backgrounds. I want to pause here for a minute and expand on what I mean when I say actionable opportunities as it is a critical part of our strategy and therefore, our hiring approach. As a firm, we believe a skilled credit professional is the best originator of new business, given their ability to clearly articulate constructive and consistent feedback to our transaction sources. A quick pass on an opportunity with constructive feedback is value-added. More importantly, a quick yes on a transaction with a clearly defined path to outlining diligence and documentation, provides the certainty of execution that is still valued in the lower middle market and the market sector. The success of our origination model is not quality (sic) [quantity] driven, but quality driven. We believe having a solid credit professional on the front end is critical to that execution. As Jim mentioned earlier, our pipeline continues to be strong. We are pleased with the uptick in unsponsored transactions given some continued softness in the M&A market having closed 3 unsponsored transactions thus far in 2013 compared to 2 for all of 2012. While the market continues to be competitive, we feel that rewards participants with proven performance and creative capital solutions. It is not unusual for us to provide multiple capital solutions on each opportunity. This flexibility has improved our win rate. With that, I'll turn it back to Jim.

Thanks, Chris. I'd like to close our formal remarks with a quick summary. We are pleased with $76 million of net growth in the portfolio this quarter and continued strong credit quality. We feel we had a successful equity offering raising $106 million at a premium to book value as of March 31, including a mix of institutional and retail investors joining that [ph] -- capital rates. We have the liquidity to equip our pipeline. We're pleased with our strong quarterly results that continue to cover our dividend. These results were enhanced by notable returns at 2 of our equity holdings that drove the special dividend of $0.08 per share. I would now like to open the line for questions, operator.

[Operator Instructions] Our first question comes from Troy Ward with KBW. Troy L. Ward - Keefe, Bruyette, & Woods, Inc., Research Division: Gentlemen, Jim, quickly on Slide 14. I think it's pretty interesting as you just look at the different yields there. The compression, not only in the quarter, but in the overall portfolio was more than we expected in the quarter for sure. So how should we be thinking about kind of as a 2 part question, not only the potential yields, but as you look at the -- on Slide 14 towards the bottom, the second lien and the first lien, basically came in at the same yield. So almost all the product you put on this quarter, is called 10.5% yield and then on the bottom right, the mix of the portfolio was still 30% first lien and still 36% subordinated debt. Should we continue to see a mix towards the first lien? And if that's the case, where do the yields ultimately end up here?

Yes. A couple of things. I think we think that Q3 will probably look like the origination in Q2, but we are hearing of a little bit of -- as banks are coming back, but now with banks having received the rules under Dodd-Frank as we understand it, are drawing their credit line as a stand [ph] at a point that could occasion more deployment of mezzanine. We'd like to think that we're logically consistent between the risk-adjusted return, first lien, second lien and subordinated debt. You did -- you made an observation about the chart on the lower left of Page 14, and that the yields being somewhat comfortable between or quite comfortable between first and second lien debt. But the second lien debt companies would be larger, more -- probably 1 click more durable credit than would be the case in the first lien debt. Additionally, I would say that companies that we feel are more cyclical, it is typical that we would only consider those investments with a first lien or a unitranche structure. So that -- I think, there is internal consistency relative to how we underwrite those. I think the -- I think -- Terry ran through the numbers that we have upsized the proportion and certainly, as a trend since our IPO 3.5 years ago, in the current market, we're trending to more senior and more unitranche investments because that's where we think we've gotten the most attractive attachment point in those investments. Troy L. Ward - Keefe, Bruyette, & Woods, Inc., Research Division: Is there a point when you look at the overall yields though where there needs to be a bottom, where you need to say, "yes, this is a good company and we think a 9% yield is a good deal, but based on the structure we're in here in the BDC, we really need to be offering shareholders x amount of yield or x amount of ROE on the portfolio?" Just kind of a bigger picture. How do you think about that as you start to approach the market?

Exactly what you said. There is a point where it is -- we are not the efficient balance sheet. I think in general, I think there are efficient holders for a variety of assets. And given banks high leverage, it makes sense, perhaps for them to be ABL lenders, that's the other end of the spectrum from us. And I would say, a very durable credit in that 8% or 9% range starts to raise questions about if at a maximum 1:1 leveraged balance sheet if we're the efficient holder for it. Troy L. Ward - Keefe, Bruyette, & Woods, Inc., Research Division: Okay. And then just one quick question kind of on the portfolio and then I'll hop back in the queue. Can you just provide us a little bit of color on the CK market investment? It looks like the yield ratcheted up there this quarter slightly, is there something negatively impacting operations there?

One thing that -- Troy, we want to be very transparent to our constituencies. At the same point, we want to maintain our policy of not commenting on specific investments in that, that could compromise a relationship with a borrower. It could compromise management of a credit for maximum success. So without digging into any particular credit, I think that it's appropriate to look at the broad credit scoring to judge the health of the portfolio.

[Operator Instructions] Our next question comes from Christopher York with JMP Securities.

This is Kevin Chen for Chris York. Your investments in the business services sector have increased meaningfully over the last 6 months and is now about 29% of your portfolio. And you kind of touched on this earlier in Troy's question, but could you talk a bit more about how you think about underwriting these credits given the cyclicality in the revenues?

I'm going to ask Chris Flynn to address that. I think as an overarching point, business services is a very highly diversified group of credits. Within that group of credits, we really look for reoccurring revenue enterprises. So Chris, do you want to talk about how you screen and ultimately make those investments?

Sure. With any opportunity, we spend a lot of time not only underwriting the existing cash flows that we're being asked to size and leverage off of -- but we go back and look historically on how the businesses have performed in the downturn and putting those 2 together, we'd come back with what we feel is an appropriate capital structure to make sure from a principal protection standpoint. We have -- the company has sufficient liquidity and sufficient enterprise value to cover our notes. So when you look at a business services opportunity, as Jim alluded, it's, what's the consistency of the cash flow, what's the recurring nature of it. Are there certain customer concentrations that we need to be aware of and then how is the business performed and what's the free cash flow generation? The nice thing about those businesses is traditionally, there's not significant amounts of CapEx that's tied up. Uses of cash of the companies traditionally are able to generate sufficient cash flow not only to cover our interest expense, but also delever through actual free cash flow generation.

And I just add as well that there's quite a bit of variability even within the business services category in terms of the nature of the businesses. Business services is pretty broad. And I would see, as you take a look at our schedule of investment, much of it is focused on the software area. But I would say, even within the software area, again, diversified amongst industries and types of services as well. So those provide a risk mitigant as you think about the size of the bucket, it is pretty broad.

Our next question comes from Jonathan Bock with Wells Fargo Securities.

Maybe some broad brush strokes on the originations themselves this quarter. Not diving into specific transactions, but again more generalities. Chris, would you be able to tell me the percentage recap of the current originations that you did -- ballpark?

Just so I follow -- you're asking what is the percentage of new deals that were done --

Dividend recap. Yes.

I am flipping pages.

I can move on.

Yes. It's going to take a little bit of math.

No problem. So then, maybe another question. Chris, just of the deals that were done, maybe give us a sense of the amount of -- I'll call it proprietary where you were the sole kind of originator of the credit yourself then perhaps syndicated versus the percentage of which you participated as part of a club or maybe more of buying let's say off of a loan debt -- loan desk whether Jefferies, JPMorgan, Crédit Suisse, et cetera. Maybe do have that kind of breakout?

Well, with respect to leading investments in -- as you know that's our style. Clearly, the majority we were the investment leader.

Okay. And then maybe kind of understanding spread relative to leverage and this hits on Mr. Ward's, I'd say kind of use of lowering portfolio spread or return in what is -- some consider as a somewhat heightened credit risk environment just given the flush liquidity. Can you give us a sense? I mean, going in excess of 5x to 5.5x EBITDA whether it's second lien or subordinated, is that something that -- are there issues once you start getting into the nosebleed sections of leverage? Again, all else being equal, I understand every industry has its specifics. But maybe give us your sense of comfort around leverage? Jim, I know you mentioned 4x attachment point. But maybe give us the book end as to how high one might be willing to go in terms of leverage at the current spread?

Embedded in that 4x is a strong belief over the course of our underwriting those investments that they are durable, diversified revenues. So that there is not a huge range really in the leverage factors. I think the -- it is a narrower band then you might expect because of its lower leverage and it's a good credit, it's logical that it would be done exclusively with bank debt. And if the leverage exceeds what we think is serviceable in a downside scenario, which is really our most important single test is coverage in that downside scenario. It would be very -- in the 5x leverage range at the size companies we find the attractive risk-adjusted return would be a very unusually high level of reoccurring revenue to be comfortable at that. What you call the nosebleed, of course, you could add 2 turns to that nosebleed in the larger cap space, which is why Chris's description of the importance of our being very regionally focused in our origination, being able to source smaller credits where we avoid getting out into the bleachers.

Appreciate that, Jim. Again, in terms of nosebleed leverage rather, I guess that's really not a very technical term. But just one question that people bring up. And Jim, you made an important point about BSL and larger more liquid transactions. I also noticed you mentioned that also focusing on those kind of larger companies that do have a little bit more stability, I would assume those would be the same types of transactions banks would be interested as well, right? The bigger the deal, the more ability for them to take on senior secured debt, which then perhaps you might consider coming behind in a junior capacity. So where is the cutoff in terms of EBITDA, in terms of what's attractive to you? As you start to move up, you're dealing with a bit more leverage levels. But you're also dealing with, shall we say, better borrowers?

I would -- our average EBITDA in the 30s, I think that's really how we define our fairway. There are situations because of depth of relationship or industry expertise, we have some special seat at the table we've invested in larger companies. YP being one of those and that relates to relations, the very strong relationships Chris Flynn had. There will be those instances and when we have those in the portfolio, we've in the past said, our average attachment point in EBITDA is x excluding 1 or 2 larger companies. So we try and keep -- make it possible for you to analyze what really is the appropriate composite nature of the portfolio. I will say that when you get into those, the broadly syndicated world, that's where typically junior capital is public debt, high-yield debt rather than typically the type of private junior capital that's one of the arrows in our quiver.

Appreciate that, Jim. And just a question as it relates to second lien and Moody's and a few others obviously have done several great pieces on second lien returns or what we'll call it recovery rates. And they were only marginally better than your traditional mezzanine bonds. Does it mean that that's what's going to happen in the future, but it's the best data point that one has looking at the past. And so moving into second lien, obviously second lien pricing is much tighter than what one could get on the sub-debt market. At what point do you believe that second lien risk is likely not going to be I'd say palpable relative to the yield that you're getting to date? Or would you disagree that losses on second lien are the same as mez?

Right. I think from our perspective, not all second liens are created equal. When you look at the larger market and where you participated, I think one of the key differentiators between the second lien and the mezzanine is just your contractual subordination to your payment stream. And so that's important to note in the sense of as you build the second lien portfolio, there's not that subordination provisions and the rights of blocking those payments. But -- and that's an important factor to take into setting that price. The second comment I would make is as you look at where we're executing in the second lien market, it's a smaller -- it's usually a less levered balance sheet and we're grabbing that lien to manage more control on the process as we look through and a potential downside scenario, how we have a seat at the table to effectively manage the workout scenario to protect our principal.

Appreciate that. Then last question, just as it relates to CLO, the CLO portfolio. Obviously, looking at a few of the CLO investments on balance sheet today, Adirondack, Sheridan or even Octagon, I think in terms of whether notes or residual interest. The tight spread environment continues to pressure CLO equity and CLO mezzanine returns. And so is it possible going forward that, one, you see this environment as less attractive than you did in December and perhaps the earlier part of the year and, if that is the case, how should we look at, at the income and potential marks on those investments given that overall asset spreads are tighter and the liability structure in the CLO is effectively fixed?

The -- I would characterize this as opportunistic in those investments with the great skill set that Mike Herzig and Bob Hickey, specifically have in that area who live in the broadly syndicated world. They manage, independent of us, CLOs very skillfully. And the -- our specific economics there we thought we had a very attractive entry point and we feel good about the durable returns. BSL spreads are still historically very attractive. So I would characterize the arbitrage at today's rates as being very attractive relative to our specific entry point into those investments. But you've seen us make someone we felt they were attractive with the manager we knew, we respected and we importantly knew, and understood their portfolio at inception and we haven't made some for a period of time. So we look at those with the same lens as every other investment. It's all about the risk adjusted return under a variety of scenarios.

And John, it's Terry. I'll just add to the second part of your question, really getting that yields, as you know it's really -- you're really recognizing income in expected return, which is driven not only by those spread differentials you're referring to but several elements that have a significant impact, which are the fall out rates and prepayment, prepayment rate in a portfolio. And on a quarterly basis, we take a pretty good dive into all of those assumptions and modeling out the projected cash flows, thinking about all the market dynamics not only from income recognition standpoint but relatedly from a valuation standpoint. These portfolios are still relatively new and we think that the yields in the 14% range we're accruing to -- At the end of the day -- today, quite frankly probably you have a hint of conservatism in them. So we feel good about where we are today relative to several factors that will impact those flows, one of which you referred to.

I'm showing no further questions at this time. I will turn the call back over to Jim Hunt for closing remarks.

Well thank you, everyone, for joining us today. We look forward to seeing you in the fall and have a safe and happy end of the summer. Take care.