Gladstone Capital Corporation (GLAD) Q2 2018 Earnings Report, Transcript and Summary

Good day, ladies and gentlemen, and welcome to the Gladstone Capital Corporation Second Quarter Ended March 31, 2018, Earnings Call and Webcast. [Operator Instructions] And as a reminder, this conference is being recorded. I would now like to turn the call over to your host, David Gladstone. Sir, you may begin.

Amanda, thank you. That was a nice introduction, and hello, and good morning, everybody. This is David Gladstone, Chairman, and this is the quarterly earnings conference call for shareholders and analysts of Gladstone Capital for the quarter ending March 31, 2018. I want to thank you all for calling in. We are always happy to talk to our shareholders and analysts and welcome the opportunity to provide updates on the company and the investment portfolio that we have. And now we’ll hear from General Counsel and Sectary, Michael LiCalsi. He is the President of Gladstone Administration, which is the administrator to all of the funds, and he’ll make some comments with regard to forward-looking statements. Michael?

Thanks, Dave, and good morning. Today’s report may include forward-looking statements under the Securities Act of 1933 and Securities Exchange Act of 1934, including those regarding our future performance. These forward-looking statements involve certain risks and uncertainties and are based on our current plans, which we believe to be reasonable. Many factors may cause our actual results to be materially [Technical Difficulty] www specifically the [Technical Difficulty] And we undertake no obligation to publicly update or revise any of these forward-looking statements, whether as a result of new information, future events or otherwise, except as required by law. Now please take the opportunity to visit our website, once again, www.gladstonecapital.com and sign up for e-mail notification service, so that you can stay up to date on the company. Today’s call is simply an overview of our results, so we ask that you review our press release and Form 10-Q, both issued yesterday, for more detailed information. Again, those can be found on the Investor Relations page of our website. And now I’ll turn the presentation over to Gladstone Capital’s President, Bob Marcotte. Bob?

Good morning, all, and thank you for dialing in today. As a quick overview, I’ll focus my remarks on the results for the most recent quarter, our portfolio performance and capital position and conclude with some comments on the outlook for the balance of our fiscal 2018. The highlights for the quarter ended March 31 include: originations were $19.4 million on the quarter and net of repayments and syndicated loan sales of $14.2 million. Net originations were $5.2 million in the quarter. Investment income rose to $11.1 million as interest income increased 3.1% with the increase in average interest-bearing assets and fee income drops compared to the prior quarter. For the quarter, the overall portfolio yield declined to 11.5% due largely to an interest recovery in a legacy asset received the prior quarter and not in a fundamental portfolio shift. In March, late March, we amended our credit facility, which included a 2-year extension of the revolving credit period, a $20 million increase in the facility commitments and a 40 basis point reduction of the borrowing margin, which we should see positively impact our net interest margins beginning in the current quarter. Net interest income on the quarter was $5.6 million or $0.21 per share. The net assets from operations totaled $0.35 per share, up from $0.27 last – the prior quarter, largely as a result of the $3 million of net portfolio appreciation on the quarter, which lifted the return on equity for the quarter to 16.3% and 12.6% for the trailing 4 quarters. Net asset value also increased on the quarter by 1.7% or $0.14 a share to $8.62 a share, with a net portfolio appreciation on the quarter and a small lift in the revaluation of our bank credit facility. Regarding the portfolio, the asset mix on the quarter was largely unchanged, given the modest portfolio of movements as secured first lien assets continue to represent almost 50% of our investment portfolio and total secured debt represents 93% of our investments at fair value. You will note that our oil and gas exposure remained elevated at 14.8% of our portfolio at fair value. The performance of each of the underlying investments in this sector continues to improve. And with about 2/3 of our exposure and first lien investments at an average level of approximately 2.5 turns of EBITDA, we’re continuing to explore all options to sell down a portion of this exposure but not concerned of the overall exposure in the interim. Our non-accrual investments were unchanged on the quarter, representing a cost of $27.9 million and a fair value of $5.1 million or 1.3% of the portfolio at fair value. Since the end of the quarter, we’ve closed 1 small investment totaling $3 million. With respect to our capital position and outlook. As I mentioned earlier, the reset of our bank credit facility has provided some additional investment capacity, and we’ll improve our net interest margin going forward. Also, between $2.3 million of net proceeds under ATM program in Q2 and portfolio appreciation, our asset coverage ratio has improved slightly over the prior quarter. That said, we are continuing to monitor our investment activity closely and are anticipating several prepayments later in the quarter and are working to be in a position to recycle these proceeds to fund our near-term backlog, which includes several highly probable follow-on investments to our current portfolio. Regarding the outlook for the balance of 2018, we’re cautiously optimistic we should see net originations sufficient to maintain or slightly increase our current investment level, consistent with the growth of our net asset value and overall leverage limitations. While the lower middle market is not immune to competitive conditions from larger asset managers, there are certainly – there is – and there certainly has been some spread compression, it does appear that some of the rate compression has subsided, and we continue to believe we’re well positioned to better hit from the measured increase in LIBOR as well as a continued growth over our investment portfolio and net interest – net investment income. Speaking of future asset growth. As many of you noted, we’ve announced that the independent members of our board approved the reduction of our asset coverage of our debts from 200% to 150%, consistent with the revised legislation. This modification will not be effective until April 2019, and over the next year, we will be working with our current debt providers and our board to establish the framework under which we will utilize this additional capital flexibility. This increased flexibility is especially meaningful to GLAD as it levels the playing field with other BDCs that have used SBA debts, which have been excluded from regulatory leverage limitations, or which have allocated attractive investments to more highly leveraged JV entities to achieve their target returns. Let me assure you that we do not intend to alter our lower middle market secured investment focus as we consider this expansion of leverage and will establish a prudent debt service guidelines for the business with the intent of approving our ROE and driving additional distributions for the shareholders. And now I’ll attempt to pinch it for our CFO and provide some of the details on the fund’s financial results for the quarter. During the March quarter, as I mentioned, interest income increased by $300,000 or 3.1% over the prior quarter with the increase of weighted average principal balance of our portfolio, which increased from five – $353 million to $387 million on the quarter. That was partially offset by a drop of the weighted average yield of 50 basis points compared to the prior quarter, which includes the interest recovery I referenced earlier. Total expenses rose by $200,000 to $5.5 million as total financing expenses rose $382,000 on a 31% increase in average borrowings on our line of credit and a 32 basis point increase in LIBOR compared to the prior quarter. Net management and incentive fees fell $244,000 to $2 million as the gross fee increased with the higher assets and the drop in credits associated with fewer new deal originations but was more than offset by an increase in incentive fee waiver. Other expenses were slightly higher on onetime expenses associated with the amendment of the bank credit facility. And as I mentioned earlier, for the quarter, net investment income was $5.6 million or $0.21 per share and covered 100% of shareholder distributions. Moving over to the statement of assets and liabilities. On the balance sheet, as of March 31, we had approximately $412 million of total assets, consisting of $402 million of investments at fair value and $10 million in the cash and other assets. Liabilities were unchanged at approximately $118 million, consisting primarily of approximately $120 million of borrowings on our credit facility and about $52 million of Series 2020 Term Preferred Stock at liquidation value. Net assets increased by $6 million since the prior quarter due primarily to the $3.4 million of net appreciation and $2.3 million of common equity raised under our ATM program. For the quarter, we issued approximately 265,000 shares at a weighted average price of $8.89 per share. NAV per share increased by $0.14 to $8.62 as of March compared to $8.48 as of December 31, 2017. Looking forward, we continue to be well positioned to benefit from any upward movement in interest rates. As 90% of the portfolio is tied to floating rate investments, the weighted average floor on these investments is 1.3%. And with floating rate assets of $378 million of principal and only $128 million of floating rate debt, 100 basis point rise in LIBOR should generate an approximately 5% increase in net interest income. Inclusive of the net originations on the quarter, our leverage position declined slightly to approximately 78% as of March 31. And now I’ll turn it over to David who’ll conclude the presentation.

Investment income’s up, $11.1 million, increasing average interest rates, even though fee income was down compared to the prior quarter. Net investment income was $5.6 million, which covered 100% of our dividends. Always strive to do that, the quarter of $0.21 per share and net portfolio gains for the quarter, the increased net asset from operations is $9.3 million or about $0.35 per share. The results of $3 million of net portfolio appreciation for the quarter was good news, and the return on equity has continued to trend upward and stands at 12.6% for the last 4 quarters, which is near the top of the BDC peers, especially ones that just do loans. There are some that take some equity positions to get a little higher returns. Net asset value increased 1.7% or $0.14 per share to $8.62. The funds successfully amended its credit facility. In particular, I’m proud of Bob and his team for that. They got an extra 2 years, so we are good to go for 2 more years, and there’s some exit safety guards there, when – if something should happen. So we’ve got to increase in availability to $190 million and reduce the borrowing costs by 0.4%. And as Bob mentioned back then, this is a wonderful opportunity for people because we borrow at a variable rate and lend at a variable rate, so we are writing on the difference between the 2. So looking then at distributions, we’ve remained committed to paying shareholders cash dividends. And in April, our Board of Directors declared a monthly distribution of our common stockholders of $0.07 per common share per month for April, May and June. That’s an annual rate of $0.84 per share for the year. Looking forward, through this date of the call, we’ve made 183 sequential monthly or quarterly cash distributions to our common shareholders. That’s about $311 million and never missed a distribution. That’s about $11.56 per share for the shares outstanding at March 31. Current distribution rate of our common stock with a common stock price at $8.66 yesterday, distribution run rate now is about 9.7%. That’s a heck of a yield considering the idea that we have variable rate that we are investing in and variable rate that we’re borrowing in. So very nice to have that locked in, provides some degree of retention. Our monthly distribution is 6% for our preferred stock and then translates into $1.50 annually. The Term Preferred Stock trades under the ticker symbol of GLADN and closed yesterday at $25, which provides a terrific yield and very safe since it’s in a preferred stock position. In summary, the company sees improving position in the private business. We are lending to private businesses that are midsized with good management teams. Many of these are owned by middle-sized buyout funds that are looking for experienced partners like us that will lend money to their businesses that they’re investing in. This gives us a chance to make attractive interest rate loans, which support our ongoing commitment to pay cash distributions to our stockholders. We have a strong team here. We have a good capital base. And now I’ll have the operator come on and tell the callers how they can ask a question about the company.

[Operator Instructions] Our first question comes on the line of Mickey Schleien of Ladenburg. Your line is open.

Yes. Good morning David and Bob. I’d like to start by asking about the – your target leverage. I understand it’s early in the process, but clearly, the market would like to understand where leverage might go. So perhaps, conceptually, if your investment strategy weren’t going to change and everything else remained equal, do you have a sense of where your leverage could go, at least within some sort of range?

Thank you, Mickey. I think the start that we’re focused on right now, and as you’re aware, because we didn’t have some of the safety valves that I referenced in terms of SBIC debt or off-balance sheet vehicles, we’ve maintained a pretty significant cushion to our existing equity base. I think our initial feeling here is we will move in the first wave towards what would be a one to two. That may be – that may not be meaningful to you all, but it’s certainly meaningful to us. On a one to one basis, we can do that without changing anything in terms of our advance rates, our banks are very comfortable with our collateral position. That’s about $50 million of increase, and it essentially would mean about 0.5% increase in ROE. And remember that the vast majority of our assets in terms of leverage are averaged roughly three point – I believe it’s somewhere between 3.5 and 3.75 turns of leverage. So the first wave that we’re really thinking about is that. The second beyond that is – as long as marketing conditions are similar to where they are today, we can continue to maintain a secured asset position with the appropriate leverage that I’m referencing. I think there’s certainly a desire to potentially move up. I look at that first move that I suggested, and I think about it from a debt perspective based on where interest rates are today. That would put our interest coverage on our – all of our financing costs, including preferred stock and otherwise, of roughly three turns, which is pretty good for a finance company, I think, is very close to investment-grade levels. So beyond that, it’s really going to depend on market conditions. Today, those market conditions would allow us to put on additional investments at the leverage levels I’m referencing but really can’t put anything beyond what that first wave is. I think that’s meaningful to us. It’s meaning to our shareholders, and current market conditions, I think, are attractive for us to do that. But we’re talking about mid-next year, before that even becomes part of the process.

And Mickey, most people may not know, I’m sure you do, that we maintain a strong ability because we don’t ever want to be right at one to one, which this would now allow us. We are at 1 to 0.8 in order to leave enough room, in case something changes that we don’t flunk the test. So it would be nice, as Bob mentioned, to go to one to one. But after that, I’m not sure where we go. We’re going to work on that. We’re going to watch what others do and chat with our board, probably, maybe in September or December and try to get a fix on it because you’re exactly right, people do want to know where you’re going.

I appreciate that David. And just in terms of the process, if I understand it correctly, even getting to one to one would require a negotiation with your banks, and I guess, potentially refinancing the preferred shares. Is that correct?

The banks, as is typical, do have a specific reference to the asset coverage test of 200%. But it’s really – doesn’t have any bearing on their collateral coverage, the various concentration constraints that they have on the portfolio or the way they stress test the performance and clearing of their outstanding investments – their advances. So it’s in the document, but it frankly does not – I believe, from what they’ve told us to date, it doesn’t affect their credit and their investment decision. So I think that is something that we’re anticipating to be able to move on fairly easily. With respect to the balance of the capital structure, you are correct. The 200% test is in our most recently issued preferred stock in September of last year. It is not callable until September of 2019. Our intent would be to position ourselves to call that constructively in order to fully access any movement in our leverage. The exact timing of when that call might happen, the notice provided is really subject to continued refinement. But it definitely extends it beyond April date when the Board of Directors approval, it would be effective.

That’s helpful. And then just a couple of last questions, if I might. Looking at the valuation of Alloy Die, is it feasible for that company to go off of non-accrual in the next couple of quarters? And could you just repeat the breakdown of the originations that David referred to for the quarter?

Sure. I think we’ve commented on ADC in the past. It’s obviously a business that we are co-invested with GAIN in, so we have very good insights as to what’s going on. There has been a substantial management change, and there’s been a substantial buildup in liquidity of that business. We expect that business to move in the direction that you’ve alluded to, to become a performing asset, and that is something that we are expecting eminently. The final details have not yet been laid out, but the trajectory of that business is heading in that direction, and I don’t believe it will be too many quarters before we will be able to report that to you. With respect to the originations, David alluded to $8.1 million was a proprietary investment that we made on the quarter of the total investments of just over $19 million. The balance of them were either smaller investments or follow-on investments. With our focus on lower middle market growth-oriented investments, it’s not uncommon for us to have those businesses either acquire or expand. And so we have – we typically have follow-on investment activities, and that’s one of the references that I made earlier. We have a number of follow-on investment activities going on this quarter. So we’re mindful of that. It provides a nice hedge against going into the marketplace and in competing for some of the existing deals that are out there. We did have some repayments and a number of syndicated loan sales of $14.2 million in total in order to fund that and manage within our overall leverage. I think, as I’ve said before, we are more actively managing our investments and our liquidity profile, given the syndicated portfolio, given companies that are in our portfolio that are in a position to make prepayments of debt or pay down their debt, reduce their leverage. We are working that as part of our continued throttling or managing of our total leverage exposure. I expect that to continue for the near term.

[Operator Instructions] Our next question is from the line of Christopher Testa of National Securities. Your line is open.

Should we expect your ATM issuance to stop as you get towards next April, given your ability to expand leverage?

Interesting question. It’s far enough away that I’m not sure that we’ve necessarily thought about that. I think we’ve taken the view as long as we can accretively cover those distributions, we’ll probably continue to open it. I will say, with the move in NAV in this quarter and assuming that there are some adjustments in the price, the window may be a little tougher, given the overall valuations in the BDC marketplace to push on that ATM, but I would expect that we will continue to issue as long as we can accretively deploy. And I stated in the past, every one of our investments is priced to be accretive. So as long as we are putting on accretive assets, I think it makes sense for us to be growing that base. I think the other thing that we’re mindful of is as we think about the leverage increase in the future, we need to recognize that we will need broader capital markets participation to grow the balance sheet. It won’t all be bank lines. And so between equity and alternative capital markets – capital raises, we need to recognize that we’ll need to diversify the source of funds, and I think continuing to access the equity capital markets will be important part of that. We are still a relatively small BDC with our market capitalization and our total footprint. In order for us to access the capital markets, we will need to grow and continue to maintain a solid equity base and grow that access in liquidity for the future. So my long-winded answer is I think there’s still marketplace for the ATM.

Got it. No, that makes sense, Bob. I appreciate the answer. I mean, I guess, the way that I’m looking at it is, if you’re not accessing the ATM, given you have much more wiggle room towards next April on the leverage, why not just let the leverage ramp and improve your ROEs and earnings and potentially lead to another dividend increase? And so far, as you want to diversify the capital structure going to what Mickey said, you’re effectively looking to call the preferred issuance, so maybe kind of just kind of latter out the maturities with some small term notes.

That does make sense, but I think you also have to understand, we have a challenge as a small BDC. Our institutional holder base is very small. It’s probably amongst the smallest of the BDCs out there. And so we want the ability as we grow to allow stock to be accumulated and grow our institutional base. We also tend to have a share that is more volatile as a result of the limited institutional base. So it is a very difficult thing to manage, and one way to normalize and create some stability is make stock available when folks want to come in on it. And I think, thirdly, you have to recognize the ATM is small. $2.3 million in 1 quarter is not going to cover even a 10% of what we are expecting in originations. So I think in the normal course, our leverage would ramp, even if we continue to keep the ATM open. And I don’t believe it’s materially affecting our ability to see our ROE increase. Look where our ROE is today. We are certainly well up there, and I would expect us to continue to maintain that momentum. So we’ll take it under advisement, but at this point, the ATM is – continues to be the most effective way for us to raise equity capital, given the cost and given the limited discounts that are required to issue those shares. And I would be low to stop that and find myself in a position to have to do some kind of larger equity issuance, given the incremental cost and disruption that those issuances can have on our shares.

Okay. Now that’s great color, Bob. And in so far, as you’re able to grow, obviously, and use the increased leverage, do you think that there is going to be any more potential co-investments for you to make with GAIN?

With respect to GAIN, I think there is always a review of any opportunities as they are required to share those opportunities with us. In the past, probably, 2 years, there have not been very many opportunities, so the number on our balance sheet is winged. I think there has been somewhat of a natural – a divergence of focus and investments that we have pursued, which is slightly different than GAIN and given their financial framework and the model that they are pursuing. So it’s not likely, I think, that those 2 would converge to a point to see any significant increase in co-investments with GAIN, although we do review all of them. What I’m essentially saying is we tend to be investing in higher-growth businesses that are trading in much higher multiples that require much more equity to be invested, and we become, basically, the bridge between what the senior banks or more traditional senior lenders will provide and what a reasonable loan to value on those high-growth businesses might look like. And the result is that’s a nice position to be in. We’re essentially an equity alternative for some of these folks in good stable cash flowing growing businesses. Those kind of businesses was what – which is what our credit profile is based on, aren’t necessarily the same kind of businesses that GAIN, for example, can compete with given the capital structure and constraints that they operate in. So as long as our credit strategy and our focus on growth and – growth-oriented businesses is in place, I wouldn’t see a significant change in the co-investment activities with them. That said, we are always looking and trying to participate, as a co-investor, in the businesses that I’ve described. There are times when we are able to do, and there are times we are not. So it’s – equity has not left the portfolio, but it’s certainly been diminished, and we are very selective when we do make those investments.

Okay, great. And are you looking – obviously, you guys are lower middle market-focused, and Bob, you had mentioned doing more first lien senior secured debt. Is there also a potential, as the balance sheet leverage ramps, to do more kind of core middle market or even maybe potentially upper middle market loans that would kind of fit the bill and make the ROE map work for you, guys?

I wish I could say yes. In today’s environment, Chris, we can see deals in what we think is the middle market, I’m just using round numbers, $30 million to $40 million and unitranche-type paper. We can see that in various competitive processes be bid anywhere between L plus 4 to L plus 7. Four turns of leverage, L plus 4, for a business of that size is not going to work inside of the BDC. So I definitely think that the upper middle market, when you start getting over $25 million to $35 million facilities, competitive dynamics are pretty tough. So I think it’s unlikely in the current environment. Now will that change as interest rates go up? Will we see the benefit associated with higher LIBOR rates and make it more possible to participate? Yes. But I think everyone is appropriately concerned that as interest rates go up, the bogeys to some of those middle market investors that have lots of money to put to work is not necessarily going to result in an increasing spread. If you’ve raised $1 billion fund with a target return of 8% on it and LIBOR goes to 3%, you don’t necessarily need to hold out for that L plus 7 to make that work. So I think I am concerned that, while it theoretically could work, I’m concerned that there’ll be some spread compression as rates increases, given the nature of the largest players in the middle market today.

Got it. Now that definitely makes sense. And would you be looking to go beyond the one to one you had stipulated in the event that there is market dislocation and you can pick up syndicated loans at very cheap prices?

I think there’s really two catch – two drivers in the syndicated marketplace, and we do occasionally make syndicated investments, and we do occasionally sell syndicated investments. My concern is not necessarily the dislocations in pricing because I certainly think that, that has happened in the past, and we’ve taken advantage of it. Tends to happen in December when people want to clean up their balance sheets and get rid of some – getting rid of some of the riskier paper. The problem I have at this point is most of that stuff is extremely highly leveraged with significant synergies and add-backs and virtually no covenants. So it’s a fairly high hurdle. If you get into a measure of dislocation, we will look at those. But it’s certainly got to be at the right credit profile in order to make that work. And in today’s environment with the vast majority of paper being basically without covenant, it’s – the potential window of opportunities is appropriately narrow.

Got it. Okay. That’s very helpful. And the last one, if I may. Banks from what I have heard are assessing this on a one-off basis unlike the – our friends and the – at S&P who have kind of just made a blanket statement. But what I’ve heard is that banks have not traditionally put covenants or as many covenants on BDCs because they saw the one to one statutory leverage as being the covenants. So do you think that there is a likelihood that banks start to impose more of their own covenants seeing as they don’t have the one to one acting as a covenant for them?

I’m not sure that I see that, Chris. It obviously depends on the facilities. I think you have to divide the market. You have large scale businesses where they may be secured, but it’s not secured by a specific pool and, the advance rates and the parameters around the bank borrowings maybe somewhat looser. So the larger, more traditional capital stacks, I think the banks are going to have to deal with covenants. I think, when you look at – in our case, we have a special purpose borrowing entity. Everything is dropped in it. The advance rates are extremely precise, and I think the banks are much more comfortable regardless of what’s going on at the BDC entity that their collateral position is going to be sustained given the way it’s structured. You also have to recognize that even if the regulatory asset coverage is relaxed, their formulations in advance rates provide for a natural leverage limitation. In our particular case, roughly, our advance rates average, given its – depends on the individual asset and collateral performance, but currently average 54%. So they are looking at almost a two to one coverage of hard dollar performing fair market value of assets. Do you care what the leverage of the holding company is when you have a two to one coverage on fair value and it’s all got to be performing? I don’t think they’re as sensitive to it. So I don’t believe that we will see a tremendous pressure to relitigate the framework of the covenant structures when they already have that kind of inherent collateral protections.

Got it, that’s great color, and thank you for taking my questions.

Thank you. And at this time, there are no further questions. I’d like to turn the conference back over to Mr. David Gladstone for closing remarks.

All right. Thank you, all, for calling in and some good questions. We enjoyed it. See you next quarter. That’s the end of this call.

Ladies and gentlemen, thank you for participation in today’s conference. This does conclude the program. You may now disconnect. Everyone, have a great day.