Great Elm Capital Corp. (GECC) Q1 2017 Earnings Report, Transcript and Summary

Good day, ladies and gentlemen, and welcome to the Great Elm Capital Corp First Quarter 2017 Financial Results Conference Call. [Operator Instructions] As a reminder, this conference call is being recorded. I would now like to introduce your host for today's conference, Ms. Meaghan Mahoney. Ma'am, you may begin.

Thank you, Kaylee, and good morning, everyone. Thank you for joining us for Great Elm Capital Corp's First Quarter 2017 Earnings Conference Call. As a reminder, this webcast is being recorded on Monday, May 15, 2017. If you'd like to be added to our distribution list, please e-mail investorrelations@greatelmcap.com. The slide presentation accompanying this morning's conference call and webcast can be found on Great Elm Capital Corp.'s website under the Investor Relations link at www.greatelmcc.com as well as a copy of our earnings release and Form 10-Q. A link to the webcast is also available on the Great Elm Capital Corp. website. I'd like to call your attention to the customary Safe Harbor statement regarding forward-looking information. Today's conference call includes forward-looking statements and projections and we ask that you refer to Great Elm Capital Corp's filings with the SEC for important factors that could cause actual results to differ materially from these projections. Great Elm Capital Corp does not undertake to update its forward-looking statements unless required by law. To obtain copies of the SEC filings, please visit Great Elm Capital Corp's website under the Investor Relations tab or the SEC's website. Hosting the call this morning is Peter Reed, Great Elm Capital Corp's President and Chief Executive Officer. I will now turn the call over to Peter.

Thank you, Meaghan. Good morning, and thank you, everyone, for joining us today. I'm joined this morning by our investment committee comprised of myself, John Ehlinger, Adam Yates and Adam Kleinman as well as our Chief Financial Officer, Michael Sell; and Meaghan Mahoney, our Head of Investor Relations. Last quarter, we spent a significant portion of the call discussing our differentiated investment approach and strategy. In order to help illustrate our investment approach, each quarter going forward, we will start the call discussing a handful of investments from the quarter to provide tangible examples of our special situations investment approach. Following the investment examples, we will go through a review of the quarterly financials, portfolio highlights and investment activity as well as an update on our capital structure activity. Lastly, we will open up the line to Q&A. Where relevant in our prepared remarks, we will point you to the corresponding slide number in the deck that Meaghan referenced that is available on our website or through the webcast. Let's start this morning's call with the discussion of Optima Specialty Steel. Please refer to Slide 5 in your presentation. We view this example as representative of our catalyst-driven special situations investment approach and how we can capitalize on a company's bankruptcy filing or restructuring. As noted in the presentation, this position was a component of the initial contributed GECC portfolio with approximately $15 million of face value of bonds contributed at a price of $0.91. This senior secured bond carried a 12.5% coupon and had a December 15, 2016, maturity date, approximately 6 weeks subsequent to the closing of the Full Circle merger. We viewed this looming maturity as a catalyst for a potential restructuring. On the maturity date of December 15, the company filed for Chapter 11 bankruptcy protection, at which point, the interest rate on the bonds increased by 200 basis points in the form of default interest, paying 14.5% until the bonds were ultimately refinanced. Approximately 2.5 months post filing for bankruptcy in late February of 2017, our notes were ultimately paid off at par plus accrued and unpaid interest, including default interest, by a debtor in possession facility that we also invested in. Recently, the equity owners filed a planned support agreement with the bankruptcy court, which, if approved, will pay off the current DIP facility that we hold in cash in full. In this example, the looming maturity and the company's bankruptcy filing were ultimately the catalyst for our profitable exit. Another event-driven example that we would like to discuss this morning is the bonds of Everi Holdings. Please refer to Slide 6 at this time. Another of the initial GECC positions in the portfolio, the senior unsecured notes of Everi were contributed to the portfolio at a price of approximately $0.9425 on the dollar with a 10% coupon and a maturity in January of 2022. What we believe was misunderstood about Everi's business was the resilience of the underlying cash flows with a market-leading payments business with sticky, long-term cash flows and the growth potential of its slot manufacturing business. In March of 2017, the company reported earnings that beat expectations and demonstrated improvement in both of these operating segments. Additionally, management forecast growth in revenue, EBITDA and free cash flow. Subsequent to its earning announcement, the company took advantage of the debtor-friendly credit markets and launched a refinancing process for secured debt, which would have the potential impact of saving the company over $8 million per annum in interest expense. After these catalysts, the bonds rallied in the trading market and GECC exited all of its position between Q1 and Q2 at a realized gain of approximately $600,000. Our sector-focused research team enables us to conduct bottom-up fundamental research to identify missed price and misunderstood credit investments such as Everi payments. Now that we've covered a couple of investments, let's discuss Q1, our first full quarter managing the combined Great Elm Capital Corp portfolio. I will turn the call over to Mike Sell, our Chief Financial Officer, to discuss the financial results from Q1.

Thanks, Peter. Please turn to Slide 11 for a snapshot of the financial and portfolio highlights from the quarter. As of March 31, our net asset value was $170.4 million versus year-end net assets of $173 million. On a per-share basis, this equates to a $13.59 NAV versus a $13.52 NAV at year-end. This increase in NAV per share was driven predominantly by our net investment income of $0.32 per share exceeding our declared distribution of $0.25 per share for the quarter. As of the end of the first quarter, the fair value of our investments was $152.2 million versus $154.7 million at year-end, and we had $66.8 million in cash and cash equivalents, a similar level to year-end. We view this as a significant amount of liquidity to deploy into new and follow-on investment opportunities as they present themselves. Now turning to Slide 12 to walk you through the quarterly financials. Total investment income for the quarter ended March 31 was $7.3 million against net expenses of $3.2 million, resulting in net investment income of $4.1 million or $0.32 per share. This compares to total investment income of $5.8 million for the partial Q4 period against net expenses of approximately the same amount, resulting in de minimis NII during the partial quarter ended December 31, 2016. Adjusted NII was $0.28 per share after deducting onetime formation and merger-related professional fees of $3.5 million for the partial quarter ended December 31, 2016. Our Q1 distribution coverage was approximately 130% as we had $0.32 per share of net investment income and paid $0.25 in the form of monthly $0.083 distributions. Lastly, net realized gains in the portfolio were approximately $2 million, which equated to $0.16 per share versus $0.02 per share in Q4 on gains of approximately $300,000. Net unrealized depreciation on investments during the period was $2.7 million, which equated to $0.21 per share versus unrealized depreciation of $1.05 per share in Q4 on net unrealized appreciation of $13.5 million. Now let me turn the call back to Peter to discuss portfolio highlights and activity.

Thanks, Mike. Let's now turn to Slide 14 to talk about some of the portfolio highlights and what we view is reflective of our investment approach. Today, despite the debtor-friendly state of the credit markets, we have constructed a portfolio with a weighted average current yield of 12.63% that is comprised almost entirely of senior secured credit instruments. That compares to a weighted average current yield of 12.76% as of year-end. As of March 31, 94% of our invested capital was in senior secured credit instruments. Despite our focus on top of the capital structure opportunities, our overall credit portfolio had a weighted average valuation of approximately $0.78 on the dollar, highlighting the potential for significant price appreciation in addition to the high current yield of 12.63%. Echoing back to our prior comments about investing in a concentrated fashion is one of the key tenets of our investment philosophy. The top 5 positions in the portfolio represented 57.3% of the portfolio's NAV as of the end of the first quarter. Lastly, 2/3 of the portfolio was in investment ideas that are representative of the way in which we intend to invest going forward after having exited in whole or in part a number of the initial GECC positions as the merger closed in November. While we continue to make progress on monetizing the Full Circle portfolio, we had a handful of the contributed positions that have had quicker realizations than we would have anticipated at very attractive IRRs. Turning to Slide 15. As of March 31, we had 23 debt investments across 20 companies that represent $149.6 million in fair market value and 7 equity investments representing $2.6 million. Turning to Slide 16 to walk through our quarterly portfolio activity. On the investment front, during the first quarter of 2017, we made 2 new investments and 6 add-on investments, deploying $75.9 million at a weighted average price of $0.98 on the dollar and a weighted average current yield of 12.29%. A higher dollar price but a slightly higher current yield than during the fourth quarter. On the monetization front, we monetized in part or in full 17 investments at a weighted average price of $0.99 on the dollar and a weighted average current yield of 13.34%, including the complete exit at a net gain of one legacy Full Circle position. We believe this portfolio activity indicates that we are continuing to rotate the portfolio into attractive risk-adjusted total return opportunities with high current yields while maintaining our keen focus on down side protection through investing predominantly in senior secured instruments. Slides 17 and 18 provide additional detail on the breakdown of the portfolio in terms of where we are on the capital structure, floating versus fixed rate and industry breakdown. During the past quarter, we had a pretty significant uptake in our exposure to floating rate instruments from 38.4% to 46.9% of the debt investments at fair value. Lastly, the weighted average yield on the fixed rate instruments in the portfolio is 10.11%, a significant margin above the current distributions rate. With that, I will turn the call back over to Mike Sell to discuss recent capital activity.

Thanks, Peter. There's a couple of updates that we would like to discuss with respect to capital activity. First, with respect to our distribution policy, let's turn to Slide 21. In March, our Board of Directors declared our distributions for Q2 of $0.083 per share per month. In our earnings release, we reported that we generated $0.32 per share in NII, which covers our distribution by approximately 1.3x. Last Friday, we announced our distribution for Q3, continuing to distribute at the level from Q1 and Q2 of $0.083 per share per month or approximately 7.3% of our March 31 NAV. We intend to augment this base distribution with special distributions from NII generated in excess of the declared distribution and as catalyst-driven investments are realized over time. Next, with respect to our stock buyback program, let's turn to Slide 22. During Q1, we purchased nearly 246,000 shares of our stock through our 10b5-1 program at an average discount to our March 31 NAV of 16%, utilizing the $2.8 million of our $15 million 10b5-1 program. Rolling that forward, to Q2 to date through May 10, 2017, we have purchased over 378,000 shares cumulatively at a weighted average discount to our March 31 NAV of 18%. In aggregate, we have used approximately $4.2 million of cash to date under our 10b5-1 program, where we have systematically bought shares in the open market as they traded below 90% of NAV. The discounted purchases to date represent expected accretion to NAV of approximately $0.09 per share since the inception of the program. In addition to the authorized $15 million 10b5-1 program, our Board of Directors authorized $35 million in share repurchase capacity, which we view as further evidence of our intense focus on alignment of interest with our stockholders. Lastly, with respect a stock buyback activity, our $10 million self-tender offer expired on May 5 and we announced the final results last week. In the tender, we purchased nearly 870,000 shares, representing approximately 6.9% of our outstanding shares at a price of $11.50 per share on a pro rata basis for a total cost of approximately $10 million before fees and expenses. This purchase price represented approximately 85% of our March 31 NAV and adds an expected $0.14 per share of potential NAV accretion. With that capital activity update, let me turn the call back over to Peter for closing remarks and then Q&A.

Thank you all for joining us today. We had quite a bit to cover. This was our first full quarter as a publicly traded company, and we're happy to report that we have a number of realized investments to discuss. We continue to be excited about the current portfolio, the investments we have made to date and the rate at which we have been able to rotate out of the legacy Full Circle portfolio and into new investments as well as the realized returns that we have generated already on both the contributed positions and one of our more recent investments. We have created a significant alignment of interest with you, our stockholders. We hope to have displayed this through our share repurchase and stock tender activity and look forward to growing our NAV per share and distribution together going forward. Thank you again for the support and confidence that you have placed in us. With that, we will turn it over to the operator to open the call for questions.

[Operator Instructions] Our first question comes from the line of Mickey Schleien with Ladenburg.

Peter, a question for you. The market's relatively difficult at the moment. We've seen spreads tightening with that process continuing, looser covenants, slow GDP growth in the first quarter, but the Fed looking to raise rates and the administration sort of struggling to enact its pro-growth strategy. So it's tough to see any trends in all of that. I'm curious, what are you and the investment committee's fundamental thesis in that environment in terms of selecting new investments?

Mickey, thanks for your question. And we are definitely in agreement with you on the state of the credit market. It's made it more difficult in which to deploy capital that meet our risk and return criteria. So set against that backdrop, we continue to find compelling opportunities, but they're not as plentiful as in a more favorable market environment.

And does that imply that you don't expect to grow your balance sheet very meaningfully over the next few quarters?

No, I don't think that it does because market conditions change all the time. And further, even in difficult markets, we continue to find opportunities. So I think it's much more a focus of the opportunities that we uncover and take advantage of than it is of the current market backdrop.

Okay, my last question. Peter, are there any industries or sectors that you're more interested in and those that you're looking to avoid?

I'd say that we're relatively agnostic about industries. There are probably some. I don't expect to see a lot of real estate in the portfolio in the near term, for example. But this team has -- on the other hand, the team has a pretty significant expertise and skill set in the broader TMT sector so that I would expect to see that to continue to be a meaningful part of the portfolio going forward. But we're pretty agnostic as to where the opportunities come from.

And does that include cyclical sectors like energy or metals and mining?

It could. We don't have a lot of extractive industries in the portfolio today and I can't think of any reason why that's going to change in the near future. But you never know where opportunities will come from.

[Operator Instructions] Our next question comes from the line of Jim Roumell with Roumell Asset Management.

A couple of questions. First, could you give just a little bit of color in terms of the relationship with GEC and the management contract there? What are the terms there in terms of the straight fee and any kind of participation? Just a little bit of color there. I'm' new to the story. Secondly, I was curious you didn't discuss Avanti. And although you note that your top 5 holdings are 57%, that's a 27% of the portfolio. And so I'd like some color on that particular security. And then third, in terms of total operating expenses as a percentage of assets, where do you -- where do you see that going? What are you aiming for in terms of cost structure?

Sure, thanks, Jim. I'll take the first 2, and Mike Sell may be able to provide some commentary on the third. First question is we believe we have a shareholder-friendly IMA. With respect to fees, we charge 1.5% management fee on assets, but that excludes cash. And then there's a two-part incentive fee, part one and part two. Part one is a 20% incentive fee in excess of a 7% hurdle rate, and part two is a 20% fee on capital gains net of losses. With respect to the third...

Just quickly in terms of the second issue there. How does that affect -- is that done on a quarterly basis?

That is calculated quarterly.

So what happens in terms of -- you have net realized gains this quarter, but in 2 quarters, losses overwhelmed gains. Is there any type of clawback provisions? Or is it just kind of done quarterly?

There's a couple ways to address that question. First, the -- it's cumulative realized gains against cumulative unrealized losses. So prior losses will impact your ability to collect fees on current period gains. And then secondly, there's a total return feature related to the payout of the part one incentive fees, where to the degree you're not generating a total return sufficient to have 20% of your total return paid out in fees, you can't take your pre-incentive fee net investment income fee, which is the part one fee. There's no high watermark per se like you would see in some other products. That's typically not seen in the BDC space. But these total return look-back features, we view it as best-in-class in terms of the technology available to us.

Okay.

And then since I've got the floor, I'll go ahead and address the operating expense question. So we're running at about 2.5% operating expenses that's exclusive of fees and interest currently. We would expect that number to be lower over time. We do have some higher-than-expected operating expenses as we carried over the administrator for Full Circle to make sure that we had a proper transition of the roles and responsibilities as we completed the merger process and went into our stand-alone vehicle. That will fall away. And then you would expect over time as the balance sheet grows that you can gain some operating leverage from the predominantly fixed cost nature of our cost structure.

So all-in, in terms of -- the portfolio stood still and you took the management fee [ plus ] the operating expenses, you're kind of looking at 3.5%, 4%?

Yes, it's pretty much where we are right now for the quarter.

Okay. And then I guess lastly, the issue on Avanti, an update there. And also, what do you -- I'd be interested in the carrying value of Avanti and the NAV.

Sure. Jim, its Pete. On our last call, one of the things that we discussed is Avanti is a -- if you've identified a significant position in the portfolio that is not representative of how we intend to manage the portfolio going forward but rather is an outcome of the deal dynamic in connection with the formation of this merger. I think everyone in connection with the merger at the time, or we and the investment banker for Full Circle, believe that scale was important and there were only a certain number of investments that we had to contribute to the portfolio. So we realized that the position is bigger than we would like for any position to be going forward. We think that that's a temporal issue and we'll adjust that over time. With respect to Avanti itself as an investment, we continue to believe that Avanti has a very valuable collateral package. We are working very closely with the company to maximize the company's value and therefore the value of our investment. And as for the NAV, Mike, can you chime in?

Yes, Avanti currently comprises approximately 28% of our NAV in aggregate.

Okay, so we can kind of back-in of how that's being valued on -- how the bond is being valued, that roughly $0.90 or something?

Yes, I think if you look at -- there's a schedule of investments in the financials that lays out all of our holdings and the valuations. The 2 credit instruments we hold our valued at approximately $0.90 and $0.40 based on IDC and trades data.

Got it. And then just in terms of Avanti coming down, it's a percentage of the portfolio that it's larger than you want. Is that a result of expected capital raises and it coming down that way? Or the expectation that you look to monetize it one way or another?

Potentially all of them. But irrespective of any future capital raises, we want to get that position to a smaller position size over time if we can do that without harming value.

Got it. And my last question. On a Avanti, the company notes that currently, the utilization of their satellite platform is roughly about 1/3. And I'm just curious if you can give any color of why the system is so underutilized. Is it that there is just a ton of capacity? Or is it that they brought our new capacity recently that just hasn't been sold yet? And do you have any color as to where you see their capacity going to?

I don't think, at this point in time, we can share our views on where capacity goes. I think that with any satellite operator, it's important to understand that capacity is not a monolithic thing. Avanti, like -- net capacity is distributed over a -- from distinct, what are called spot beams over a broad geographic area. So it's sort of like people say about real estate: All real estate is local. In this sense, all capacity for Avanti is local, and the utilization from market-to-market can vary widely for very different reasons. So it's a nuanced and -- it's a nuance issue to understand, for sure.

Got it. Well, okay. So given Avanti's particular piece of real estate, do you have any comments or color on where you see the utilization being able to go to over the next couple years?

We don't have a forecast that we're prepared share on a public call. And further, we -- I can emphasize that we like Avanti's real estate. We believe that it's valuable and will prove to be valuable over time.

Thank you, and I'm showing no further questions at this time, I'd like to turn the call back to Ms. Mahoney for any closing remarks.

Thank you again, all, for joining us this morning. We look forward to our continued dialogue. And please do let us know if we could be helpful with anything in follow-up. Have a great day.

Ladies and gentlemen, thank you for participating in today's conference. This does conclude the program and you may all disconnect. Everyone have a wonderful day.