Great Elm Capital Corp. (GECC) Q2 2017 Earnings Report, Transcript and Summary

Good day, ladies and gentlemen, and welcome to the Great Elm Capital Corp. Second Quarter 2017 Financial Results Conference Call. [Operator Instructions] [ I would now like to introduce your host for this conference call ], Ms. Meaghan Mahoney. You may begin, ma'am.

Thank you, Kevin, and good morning, everyone. Thank you all for joining us for Great Elm Capital Corp.'s Second Quarter 2017 Earnings Conference call. As a reminder, this webcast is being recorded on Friday, August 18, 2017. If you'd like to be added to our distribution list, you can either email investorrelations@greatelmcap.com or you can sign up for alerts directly on our website. The slide presentation accompanying this morning's conference call and webcast can be found on Great Elm Capital Corp's website under Financial Information Quarterly Results 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. Also, please note that nothing in today's call constitutes an offer to sell or solicitation of offers to purchase our securities. 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 Financial Information, SEC filings or by visiting 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 me; John Ehlinger; Adam Yates and Adam Kleinman; as well as Michael Sell, our Chief Financial Officer; and Meaghan Mahoney, our Head of Investor Relations. Last quarter, we started the call discussing a handful of realized investments from the quarter to provide tangible examples of our special situations investment approach. We will start this quarter's call in the same fashion, discussing 2 of the complete monetizations we had during Q2. 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, which is available on our website or through the webcast. Let's start this morning's call with a discussion of 310E53RD, LLC. Please turn to Slide 5 in the accompanying slide deck. This first lien loan was a component of the legacy Full Circle portfolio that comprised our day 1 portfolio post-merger and was contributed at a slight discount to par. This was a residential mortgage on a circa 4,000 square foot condo property in Manhattan with a first priority lien on said property, bearing interest at a rate of LIBOR plus 1,000 basis points with a LIBOR floor of 15 basis points. In addition to its first priority lien on the residence, the loan was also personally guaranteed by the borrower, whose net worth was far in excess of the value of the $6 million loan. Because of the steep interest rate and the estimated 78% loan-to-value on this investment, we expected that a near-term refinancing of this loan was our most likely liquidity event and we're not surprised to be refinanced at par in May 2017. This resulted in an IRR of 10.44% and a cash-on-cash return of 1.05x in approximately 6 months' time. The next investment we're going to discuss this morning as Tallage Adams, LLC. Please refer to Slide 6 in the presentation. The Tallage Adams senior secured loan was a MAST-contributed position that was contributed at a premium to par and carried with it a LIBOR plus 1,000 basis point interest rate with a LIBOR floor of 100 basis points. This position was a custom financing that embodied our team's style of opportunistic origination, low loan to assessed value, high interest rate, strong collateral package and a management team that we know and respect well. Tallage Adams was a Massachusetts-based limited liability company that purchased tax liens, typically at auction, from municipalities across the state of Massachusetts. Throughout the life of the loan, Tallage Adams stayed well within its covenant requirements. As this loan had a stated maturity of December 2017, we expect it to be refinanced within 6 to 12 months of the merger closing. We were ultimately refinanced in late June at par, resulting in an IRR of 17.04% and a cash-on-cash return of 1.06x in approximately 8 months. Now that we have covered 2 of the portfolio exits from the quarter, let's discuss Q2, our second full quarter managing the Great Elm Capital Corp. portfolio. I will turn the call over to Mike Sell, our Chief Financial Officer, to discuss the financial results from Q2.

Thanks, Peter. Please turn to Slide 8 for a snapshot of financial and portfolio highlights from the quarter. As of June 30, our net asset value was $153.7 million versus net assets of $170.4 million at the end of Q1. On a per share basis, this equates to a $13.29 NAV versus a $13.59 NAV at the end of Q1. This decrease in NAV per share was driven primarily by unrealized mark-to-market depreciation in our investment portfolio, partially offset by realized gains and accretion from our buyback and tender offer activity to date. As of the end of the second quarter, the fair value of our investments was $131.6 million versus $152.2 million at the end of Q1 and we have $58.9 million in cash and short-term investments. Now please turn to Slide 9 to walk through the quarterly financials. Total investment income for the quarter ended June 30 with $6.2 million against net expenses of $2.8 million, resulting in net investment income of $3.5 million or $0.29 per share. This compares to total investment income of $7.3 million for Q1 against net expenses of $3.2 million, which resulted in net investment income of $4.1 million and NII per share of $0.32 for the first quarter. Our Q2 distribution coverage was approximately 116% as we earned $0.29 per share of net investment income and paid $0.25 in the form of 3 monthly $0.083 distributions. Net realized gains in the portfolio were approximately $1.4 million, which equated to $0.11 per share versus $0.16 per share in Q1 on gains of approximately $2 million. Realized gains in the quarter were primarily driven by our investments in Chester Downs and repayments, which we discussed in our first quarter call, and Sonifi Solutions, for which we received a partial pay down at par. Net unrealized depreciation on investments during the quarter was $7.3 million, which equated to $0.60 per share versus unrealized depreciation of $0.21 per share in Q1 on net unrealized depreciation of $2.7 million. This was primarily driven by the mark to market on our investments in Avanti Communications Group plc and PE Facility Solutions. Now let me turn the call back to Peter to discuss portfolio highlights and activity.

Thanks, Mike. Let's now turn to Slide 11 to discuss some of the portfolio highlights and what we view as reflective of our total return, special situations investment approach. Today, despite the debtor-friendly state of the credit markets, we have constructed a portfolio comprised almost entirely of senior secured credit instruments with a weighted average current yield of 13.17%. That compares to a weighted average current yield of 12.63% as of the end of Q1. As of June 30, 99.7% of our invested capital was invested at the top of the capital structure in first lien and senior secured credit instruments. Our overall credit portfolio had a weighted average valuation of approximately $0.73 on the dollar, highlighting the potential for significant price appreciation in addition to the high current yield of 13.17%. That compares to an average price at the end of Q1 of $0.78 on the dollar, reflecting our exit of a handful of assets at a premium to par value. Echoing back to our previous comments about investing in a concentrated fashion as one of the key tenets of our investment philosophy, the top 5 positions in the portfolio represented 62.1% of the portfolio's NAV as of the end of the second quarter compared to 57.3% as of the end of the first quarter. Lastly, similar to the end of last quarter, approximately 65% 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 both the Full Circle, the MAST-contributed positions and some of the newer GECC positions since the merger closed in November. While we continue to make progress on working out and monetizing the Full Circle portfolio, we have also had a handful of the contributed and acquired positions that have had quicker realizations than we would have anticipated at what we consider to be very attractive IRRs. Turning to Slide 12. As of June 30, we had 20 debt investments across 17 companies that represent $131.2 million in fair market value and 7 equity investments representing $400,000 or 0.3% of invested capital. Turning to Slide 13 to walk through our quarterly portfolio activity. On the investment front, during the second quarter of 2017, we made one new investment and 3 add-on investments, deploying $21.4 million at a weighted average price of $0.99 on the dollar and a weighted average current yield of 11.05%. We'd like to note that, again, these capital deployments come at a lower average dollar price and a higher average current yield than our recent monetizations. Given our view of the current state of the credit markets with record covenant-lite issuance and other borrower friendly market trends, we have been cautious in deploying capital as we believe there will be a more compelling environment ahead. Given our keen focus on downside protection, we believe this cautious stance will be rewarded in the long run as we will have the dry powder to put to work in the inevitable credit market dislocations. Our new investment in the quarter was in the first lien senior secured loan of a company called Commercial Barge Line, which we acquired in the secondary market at a price of $0.88 on the dollar. Including our post-quarter end acquisitions in this name, we now have a position size of approximately $6.9 million at par value. On the monetization front, we monetized in part or in full 13 investments at a weighted average price of $1.02 on the dollar and a weighted average current yield of 10.19%, including the complete exit of one legacy Full Circle position at a slight gain. We continue to be quite pleased with the pace of both legacy and new investment realizations. Also important to note, all of the complete exits of Full Circle positions, MAST-contributed positions and positions that we have acquired subsequent to the merger closing have been at a gain. Slides 14 and 15 provides additional detail on the breakdown of the portfolio in terms of where our investments are located in their respective issuer's capital structures, floating versus fixed rate and industry breakdown. During the past quarter, we had a slight uptick in our exposure to floating rate instruments from 46.9% to 48.6% of the debt investments at fair value. Lastly, the weighted average yield on the fixed rate instruments in the portfolio is 10.09%, a significant margin above the current distribution rate of approximately 7.5% of June 30 NAV. With that, I will turn the call back over to Mike Sell to discuss recent capital structure activity.

Thanks, Peter. A couple of updates that we'd like to discuss with respect to capital activity. First, with respect to our distribution policy, let's turn to Slide 18. In May, our Board of Directors declared our distributions for Q3 of $0.083 per share per month. In our earnings release, we reported that we generated $0.29 per share in NII, which covers our currently declared distribution by approximately 1.16x. Earlier this week, we announced our distribution schedule and amount for Q4 2017 with a plan to continue to distribute the level from Q1, Q2 and Q3 of $0.083 per share per month or approximately 7.5% of our June 30 NAV. We intend to augment this base distribution with special distributions from investment company taxable income generated in excess of the declared distribution. To that end, we would currently expect to announce a special distribution by year-end and will update the market in due course. Next, with respect our stock buyback program, let's turn to Slide 19. During Q2, we purchased nearly 110,000 shares of our stock through our 10b5-1 program at an average discount to our June 30 NAV of 19%, utilizing $1.2 million of our $15 million 10b5-1 program. We also purchased an additional 869,000 shares through our tender offer at a price of $11.50 per share, gross of expenses representing a 13% discount to our June 30 NAV. From the commencement of the 10b5-1 stock buyback program in November 2016 through August 11, 2017, we have purchased an aggregate of approximately 513,000 shares at a weighted average price of $11.12 per share, resulting in approximately $5.7 million of cumulative cash paid to purchase shares in approximately 84% of June 30's NAV. Including the tender offer, we purchased an aggregate of nearly 1.4 million shares to date, spending approximately $15.7 million of share buyback and tender activity. For the first 6 months of 2017, our stock buyback program and tender offer activity has added approximately $0.20 of per share accretion to NAV. Lastly, on July 31, 2017, we filed a registration statement with the SEC for a baby bond offering. The intended use of proceeds for the offering is to repay the Full Circle 8.25% notes that were assumed in the merger and to make new investments consistent with our investment objectives. 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 this morning. 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. We're very comfortable with the ample amount of capital we have to deploy into future investments and we're excited about our current investment pipeline. We believe that 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 we look forward to growing both our NAV and distribution per share 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 Mickey Schleien of Ladenburg.

Peter, when we think about the economic backdrop for credit, it's pretty benign when we look at things like default rates below average and relatively stable economic growth. So I'm interested in understanding, within that environment, where are you seeing the best opportunities for your investment strategy in terms of industry or maybe secular trends?

Sure. Thanks, Mickey. As you've noted, economic conditions are pretty benign default rates, which we view as more of a trailing indicator than a leading indicator, remain low. Other indications of where we are in the credit markets, which we touched on in our comments in particular, the record percentage of the market in covenant-lite issuance, we think are signs that we ought to be cautious and extra selective in how we deploy capital, which has led to us deploying at a slower rate than we would have guessed about this time last year. That being said, we continue to find opportunities across industries. There are no particular industries that I would say that pop out as being extra rich with opportunities that we're pursuing at the moment. We've seen a couple of opportunities in the broader material space. None of those have made it into the portfolio yet. But generally speaking, the opportunity sets across industries.

Peter, certainly, I agree with you in terms of deal terms are very borrower friendly, but I'm trying to understand whether your selection of investments is taking some view on the economy or is it just -- is it more bottom-up and idiosyncratic?

Good question. It is much more bottom-up and idiosyncratic as we are working opportunities through our funnel. More and more of the opportunities at the top end of the funnel we're sending out or just missing or we need a better price given the increasing borrower-friendly nature of the debt markets today.

Our next question comes from Chris Kotowski with Oppenheimer.

I'm doing this remotely and working on a laptop with a small connection, so maybe I missed something. But if I look at Page 8 of the presentation, I see total investments of [ $131.6 million ]. But if I look at Page F2 of the Q, I see total investments of [ $205 million ]. Can you reconcile those 2?

Chris, this is Mike Sell. Yes, the reconciliation of those 2 is that we maintain investments in money market mutual funds and treasury securities as part of our cash management program. For a presentation to the market where people are trying to understand the economics of running this particular business, we exclude that from portfolio assets so that we make sure that you understand where our true investments hit versus our cash management activities.

Okay. All right. I'll circle back off-line and reconcile that.

Sure. And I think when you look at the MD&A, you can get to -- you'll see the numbers that come through in the presentations in the footnotes around those.

Okay. And then I wonder if you can give us an update on Avanti. You've said in the past that it's an outsized position and I mean I realized you're constrained in what you can say, but whatever kind of update you can give us and the timeline for the next couple of months ahead, what's there in terms of launch and by when should we have a clear resolution of it?

Sure. Thanks, Chris. So there are a couple of things that we should talk on -- talk about with respect to Avanti. The first one is towards the end of the second quarter, the company announced a new financing with HPS, which is a very sophisticated investor who provided new capital to the company. It's important for a couple of reasons. One, the capital that HPS is providing to Avanti is at a materially lower cost than the capital it was replacing. What I mean by that is all of the creditors in Avanti who are part of the financing which closed in January, which includes us, had an unfunded commitment to provide incremental capital to Avanti and part of the use of proceeds from this financing from HPS was to relieve us of that unfunded commitment. So while our exposure did not -- our direct exposure did not change as a result of that transaction, what it did do from the perspective, our position size, is that reduced the maximum potential position size that the position could have been. Our unfunded commitment was effectively at an initial interest rate of 15% and this money from HPS has come in at 7.5%. So it is a meaningfully lower cost of capital for the company, provides the company with incremental liquidity to fund the -- finish the build-out and launch of its fleet. So that's point one. Point two is post-quarter end, the company has announced that David Williams is leaving the company. He's the founder and the longtime CEO and is being replaced on an interim basis by Alan Harper, who is a nonexecutive director of the company. And we think that there are a lot of wonderful things that David Williams as a founder did in the creation of Avanti and getting it to this point, but now is a natural time for the company's leadership to change at the top and the rest of the senior management team is intact. So that announcement has happened relatively recently post-quarter end. Finally, you asked a question about the launch of the company's HYLAS 4 satellite. And while we don't have anything on this call that we can share, we do expect that as we get closer to the anticipated launch date of HYLAS 4, that the company will update the marketplace as far as when it expects that satellite to launch and ultimately when we should expect it to start generating revenue.

Okay. And do you have any remaining unfunded commitments to Avanti?

We have no remaining unfunded commitments to Avanti.

Okay. And there were also, I guess, significant adverse marks on 2 of the other, I think, they were both legacy Full Circle positions that were -- had unrealized marks in the quarter and can you give any color on that, either in terms of -- is this part of a resolution effort and what are your -- can you give any color on the efforts to resolve those situations?

Certainly. The first one and the bigger of the marks is PE Facility Solutions and our mark was approximately [ 1.6 million ] of unrealized depreciation during the quarter in the Secured Loan B. This position was independently valued by Lincoln Financial. The business was struggling earlier this year. We have since made some management changes, but the business' struggle earlier this year when that made its way into the financial results worked its way through the independent valuation and resulted in an unrealized depreciation. However, the management changes that we've made are showing good signs of bearing fruit and the trends in the business are quite positive, and we remain optimistic about both the investment and the near- and intermediate-term trends with respect to this investment. The second position is OPS Acquisitions, which was also an -- generated an unrealized loss, and there, the business trends are better than they were earlier in the year, which drove the markdown. This is also valued by Lincoln Financial, but that business is maybe not quite as far along as PFS is in its recovery.

[Operator Instructions] And I'm not showing any further questions at this time. I would like to turn the call back over to our host.

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

Ladies and gentlemen, this does conclude today's presentation. You may now disconnect and have a wonderful day.