Oaktree Specialty Lending Corporation (OCSL) Q4 2014 Earnings Report, Transcript and Summary

Good day, ladies and gentlemen, and welcome to the Q4 2014 Fifth Street Finance Corporation Earnings Conference Call. My name is Joyce and I will be your operator for today. At this time, all participants are in listen-only mode. Later we will conduct a question-and-answer session. [Operator Instructions] As a reminder, this conference is being recorded for replay purposes. I would now like to turn the conference over to your host for today, Robyn Friedman, Vice President of Investor Relations. Please proceed.

Thank you, Joyce. Good morning and welcome to Fifth Street Finance Corp's fourth quarter and fiscal year-end 2014 earnings call. I'm joined this morning by Leonard Tannenbaum, Chief Executive Officer; Todd Owens, President; and Richard Petrocelli, Chief Financial Officer. Before we begin, I would like to note that this call is being recorded. Replay information is included in our November 5, 2014, press release and is posted on the Investor Relations section of Fifth Street Finance Corp's website, which can be found at fsc.fifthstreetfinance.com. Please note that this call is the property of Fifth Street Finance Corp. Any unauthorized rebroadcast of this call in any form is strictly prohibited. Today's conference call may include forward-looking statements and projections. We ask that you refer to our most recent filings with the SEC for important factors that could cause actual results to differ materially from these forward-looking statements and projections. We do not undertake to update our forward-looking statements unless required by law. To obtain copies of our latest SEC filings, please visit our website or call Investor Relations at 203-681-3720. The format for today's call is as follows. Len will provide introductory remarks. Todd will provide an overview of our results and outlook, and Rich will summarize the financials. Then we will open the line for Q&A. I will now turn the call over to our Chief Executive Officer, Len Tannenbaum.

Thank you, Robyn. Before we begin, I'd like to introduce our investors and analysts to Todd Owens, our new President and member of the Board of Directors. Todd is a 24-year veteran and former partner at Goldman Sachs & Company, in which he held various roles during his tenure, including Head of the West Coast Financial Institutions Group, Head of the Specialty Finance Group, and was also a senior member of its bank group. He brings with him a breadth of experience in a number of financial services sectors including commercial finance, asset management, alternative asset management, commercial banking and business development companies. Todd's relationship with Fifth Street dates back to 2007 when he was Goldman Sachs' lead banker on FSC's initial public offering in June 2008. Adding Todd strengthens FSC's senior management and is another step in continuing to build the team that fits the needs of established and growing company. We're excited to have an industry veteran of Todd's caliber join the team and look forward to introducing him to our analysts and investors in the coming months. At the end of October, Fifth Street Asset Management, FSAM for short, an affiliate of FSC, completed its initial public offering. We view FSAM's initial public offering as favorable for FSC shareholders because of the additional transparency and public capitalization at the asset manager level. In conversations with our rating agencies, we also believe they view being a part of a larger platform with a publicly traded asset manager is a positive due to enhanced ability to provide support for FSC and other products. For the quarter ended September 30, 2014, FSC generated $0.25 of net investment income per share, which was driven by gross originations of $394 million and the continued funding of SLF JV I, our joint venture with a subsidiary of Kemper Corporation. We ended the September quarter operating at a leverage ratio of 0.63, which is below end of our targeted range of 0.6 to 0.8. I'll now turn the call over to our new President, Todd Owens, to provide additional details about the quarter.

Thank you, Len. I'm very excited to be a part of Fifth Street as a member of the management team after having worked closely with senior management over the last several years while I was at Goldman Sachs. The team has built an impressive business with a strong brand and solid foundation, which I look forward to helping expand upon as we continue to grow and diversify. Since closing SLF JV I in May, we have made significant progress in both funding and expanding the joint venture. The JV provides multiple benefits. It expands FSC's investment capacity to originate and underwrite middle market loans and provides an efficient way to finance assets that enhance returns for our shareholders. As described on our last earnings call in July, the JV initially invested $157 million in a diversified portfolio of senior secured loans. Based on the timely ramp and initial success of the joint venture in October, we announced that FSC and Kemper doubled the equity commitment to the joint venture from $100 million to $200 million. Under a 2-to-1 leverage assumption, this will provide capacity for investments up to $600 million. As of September 30, 2014, the JV had $186 million of assets, including investments in a range of one stock and senior secured loans to 18 portfolio companies. The joint venture generated a 17% weighted average annualized return on investment during the September quarter, which was accretive relative to our consolidated portfolio yield of 11.1%. We have ample capacity to grow SLF JV I and other similar joint ventures since only 12.9% of our assets were non-qualifying at the end of the September quarter versus the regulatory cap of 30%. What happened in this JV and other similar potential JVs represent an important driver of our future earnings. We are pleased to announce that during the quarter, we and certain of our affiliates received an exempted order from the SEC to co-invest with other funds managed by our investment advisor. The sharing of deal flow should allow us to deploy capital effectively and efficiently, while enhancing portfolio diversification and optimizing individual investment sizes. We can now hold up to $250 million per transaction across the platform, which is a key differentiating factor in the middle market. In the September quarter, we closed our first co-investment transaction, providing a $195 million one-stop financing facility at the equity co-investment to support Veritas Capital's acquisition of BeyondTrust Inc. Another initiative intended to improve net investment income per share is growing First Star Aviation, our aviation leasing portfolio company. As a reminder, First Star was formed in June 2013 and continues to invest in a well-diversified fleet of widely used commercial jets with a globally diversified lessee base of major international airlines. During the September quarter, First Star sold two aircraft, which delivered a high-teen unlevered return. These two aircraft were on lease to United Airlines and sold to a fund investor with expertise in used commercial passenger aircraft. Subsequent to the end of the quarter, First Star announced the acquisition of two mid-life aircraft, which are on long-term leases to SriLankan Airlines and Vueling Airlines S.A. First Star currently owns eight aircraft on lease to seven different carriers of additional deals in the pipeline. Our venture lending platform continues to build momentum in the venture debt space with mid to late-stage technology companies. We now have six portfolio of companies with a total value of $89 million in the venture loan portfolio. During the September quarter, we exited a $6.5 million debt investment in one of our venture portfolio companies, SugarSync, which provided a return in excess of 20%. As a reminder, the venture loans in our portfolio generally have higher yields than our existing portfolio average, which should be accretive to NII. Additionally, most of our venture debt investments include warrants, which may be accretive to net asset value per share and generate future capital gains. Through our direct origination efforts and disciplined investment process, we have constructed a diversified portfolio with varied and long-term sources of financing. The investments in our portfolio are spread across 40 industries and we have minimal exposure to the energy sector. The underlying business trends in credit quality in the portfolio remained strong during the quarter with only one investment continuing on non-accrual. Additionally during the September quarter, we increased the capacity on FSC's balance sheet to fund loans with attractive risk-adjusted returns, raising $130 million in July through an equity offering and $8 million through our ATM program. We believe we are well positioned to take advantage of attractive investment opportunities and look forward to providing updates as we make further progress on our multiple initiatives to improve net investment income. Many of our recent initiatives, including SLF JV I as well as entering aircraft leasing and venture lending, would not be possible without the significant investment we have made in the Fifth Street platform and the size of FSC's balance sheet. We believe the continued success in these business lines should further differentiate us from our peers. I would now like to turn the call over to our Chief Financial Officer, Rich Petrocelli, to discuss our financials in more detail.

Thank you, Todd. We ended the fourth quarter of fiscal 2014 with total assets to $2.7 billion, an increase of $595.9 million from 2013 fiscal year-end. Portfolio investments were $2.5 billion at fair value, and we had available cash on hand of $109 million. Net asset value per share was $9.64 at fiscal year-end. For the three months ended September 30, 2014, total investment income was $76.2 million. Net PIK accruals recorded in excess of PIK payments received, which is a key indicator of earnings quality, was low at $5.2 million for the quarter or 6.9% of total investment income. Net investment income was $37.5 million for the quarter, a 30.5% increase when compared to $28.7 million in the prior year. During the September quarter, we received $285.1 million in connection with the full repayments on 11 of our debt investments, of which all except one that we sold at a discount of 1% were exited at or above par and at prices consistent with our fair value marks. We also received an additional $123.6 million in connection with syndications of debt investments and sales of debt investments in the open market. The credit profile of the investment portfolio continues to be strong as 99.7% of the portfolio at fair value was ranked in the highest one and two categories. During the quarter ended September 30, 2014, we had one investment in the portfolio in which we had stopped accruing income. This investment has a remaining fair value of approximately $6.4 million or 0.25% of the total portfolio. The weighted average yield on our debt investments has improved quarter-over-quarter to 11.1% with a cash component of yield making up 9.9%. The average size of a portfolio of debt investment was $24.2 million at September 30, 2014, an increase from $22.1 million at the prior year-end. We had gross originations of $394.4 million in nine new and five existing portfolio companies, bringing the total companies in our portfolio to 124 at September 30, 2014. We believe we are conservatively positioned relative to our peers with over 94% of the portfolio by fair value consisting of debt investments, 79.0% of the portfolio invested in senior secured loans, 70% of the debt portfolio consisting of floating rate securities and no CLO equity at quarter-end. The investment portfolio continues to be very well diversified by industry sponsor and individual company. Our largest single industry exposure remains healthcare, including pharmaceuticals at 20.2% of the total portfolio. Our investment in HFG, our Healthcare Finance Portfolio Company, was our second largest single exposure at only 4.8% of total assets. And HFG itself holds a diversified portfolio of loans backed by healthcare receivables. Our top 10 portfolio company investments represent 30.4% of total assets. As of September 30, 2014, the JV had $186 million of assets, including investments in 18 portfolio companies, and has a strong pipeline of attractive investment opportunities. In connection with the recent upsizing of the equity commitment of the JV from $100 million to $200 million, we are now working to increase the Deutsche Bank credit facility in the first quarter of 2015. As recently announced, our Board of Directors declared a monthly dividend of $0.0917 per share through January 2015. Our dividend represents $1.10 annualized run rate and over 12% yield on the current stock price. I will now turn it back over to Robyn.

Thank you for joining us on today's call. Joyce, please open the lines for questions.

[Operator Instructions] Our first question comes from the line of [indiscernible].

The SLF leverage, was it 10-to-1? Was that the number that you guys were talking about or what?

Wow, 10-to-1, that's a big number.

I thought I heard that, so I thought that was wrong. So that's why I'm asking.

It's 2-to-1.

And, Rich, the decline in the total investment assets in FSC for the quarter, what was the driver of that? It wasn't quite clear to me reading the documentation.

We sold over $100 million of securities, some of which to the JV and some to third-parties.

The decline in the oil prices, how does that affect the value of the aircraft in this aircraft leasing subsidiary?

The good news is the aircraft that we have are 15-year-old-plus aircraft. And what happens is they're not as fuel efficient as new aircraft. So it obviously would increase the value of a less fuel-efficient aircraft. It's difficult to quantify though, because each one of these aircraft is different and it can be used for different routes. So in general, an older aircraft appreciates in value if oil prices decrease, but it's a very in general comment.

So it's not going to be a material number on any level?

No.

Our next question comes from the line of Doug Mewhirter [SunTrust Robinson Humphrey]. Please proceed.

I just had two questions. The first is maybe for Richard, just a very simple reporting question. Where will I see the dividend or interest income from your JV, your SLF reported? Would that be dividend income from control investments or is it --?

About $1.3 million dividend and then the interest on the sub-notes for the quarter was about $1.1 million.

And second, I know you definitely don't have a large exposure to energy relative to a lot of your peers. But could you describe sort of, I guess, how protected or hedged those companies are either directly or indirectly to the changes in oil prices?

Some are the individual assets, I think we would just analyze this, given the massive price decline that we saw on Friday. The reason we're not in energy, by the way, or not very heavily in energy is not because we didn't see a lot of energy deals. We just thought the energy deals that we saw, because it was such a hot sector, we're very stretched and over-levered, so good news is our credit team led by Ivelin really stayed out of those deals. But I'll let Ivelin join me in answering some of the exposures.

Ivelin Dimitrov. I think on the energy side, a few of the exposures that we had, we'll try to focus on the services side, we don't have a lot of investments in companies that have direct exposure. We measure our exposure to different shale plays and try to figure out what the right breakeven price for the different shale plays is and we try to ascertain while we have breakage points from that perspective. And the review that we view as part of our portfolio management process, which seemed to be in a fairly good shape, of the investment that we have in the portfolio right now, I think there is three of them that have a more direct exposure and two of them are in the process of being sold for a fairly substantial multiple, so we seem to be in decent shape there.

The next question comes from the line of Troy Ward [Keefe, Bruyette & Woods].

Len, one of the things that you've never done in FSC is asked for permission to sell below book value. Is that something that you intend to do in the near term or potentially ever? Just asked for information, I'm not asking you whether or not you will issue below. Just are you going to ask for permission to sell below?

This ever comment, I'm not going to answer. You'll see the proxy come out at the annual meeting and FSC does not intend to ask for permission to sell below book versus I would say 90% of our peers do.

As I think about kind of the size of the 30% bucket as you look at whether it's aircraft leasing or the JV, I don't think venture fits in there. So if we assume that the balance sheet will stay static for a period of time, I'm not saying forever, but for a period of time, do you have a preference on how to use the remainder of that 30% bucket?

I guess really what we're focused on is the JV structure, and we're going to be looking to continue to grow either the size of the JV or additional JVs into that 30% bucket. There's a little bit of flexibility within there if we see the right opportunities in aircraft leasing to increase the size of that portfolio. But that should be really incremental to what we have in that space today. It's really what we're focused on using the JV structure.

I think you gave the percentage of what you are currently in the 30% bucket. You still have quite a bit of room left, is that right?

Yeah, we do. Currently we're at just under 13% in the 30% bucket. So we have a lot of room.

And then, Len, I know healthcare has been a focus for your teams including the large controlled investment. How did you view the elections with the Republicans coming in? Just overall how do you view that with respect to your healthcare exposure?

How does the Republican Congress and Senate change the idea of Obamacare, because it's a tax could be repealed and potentially increased -- look whether or not that happens, we're always overweight healthcare. We like being overweight healthcare. We understand it. We have deep industry expertise there. So we felt very comfortable. We continue to feel like that's a very nice defensive sector that we'll do well in and we'll continue to overweight.

We've always focused on businesses that save people money, and maybe a lot easier in the healthcare space. From that perspective, the companies we're invested in should do well irrespective of the change and iteration. There's always dollars available for our cost savings businesses, one sector that we think healthcare -- because we're very granular the way we think about it, one sector that we're fairly excited about is our exposure to medical devices. We have a few contract manufacturers in the portfolio and we are hearing rumblings that device tax might get changed in some shape or form, which will be beneficial to our exposure. We're not counting on it, but if that happens, to answer your question, that will be one direct consequence of the election change.

And then just one quick follow-up. You talked about the securities that were sold in the quarter. I think you said $100 million. Some of those went to the JV. Does it detail in the 10-K how much or which ones went to the JV or can you provide that information?

The majority of the initial portfolio, the $157 million, that was largely what went to the JV, and then a few other possessions as well later on in the quarter, so over 90% of what's in the JV today.

The next question comes from the line of Douglas Harter [Credit Suisse].

Can you remind us the economics to you when you syndicate loans and the beneficial impact of that?

The economics typically on a syndication can be 50 basis points to 100 basis points of extra income, but it really depends on the loan. Fortunately when you take down the entire piece, you take additional risk, and so we're able to capture some of that when we syndicate down. That's been one of our initiatives is the capital markets, that's what we're really pleased about, the increased volume from our capital markets desk. So it generates some income. It'll continue to grow and continue to be a larger contributor.

In the near term with the stock below NAV, how much could that be scaled in order to sort of keep the origination levels consistent without having access to capital in the short run?

Well, not only do we syndicate down, the other thing is we paid on it quite a bit. So just putting that money back to work using the SLF structure and of course we're at the low end of range. Leveraging the balance sheet a little bit more, we actually have plenty of room to churn and monitor assets. That's why we're not seeing to sell below book and nor do we really have to. I was asked over the years many times what is the sort of critical mass for FSC that it can be self-sustaining. And the answer of the size that's out by $1.5 billion of equity was consistent. So if you guys look back over five years that I've been CEO, I'm sort of saying, okay, when does FSC get to critical mass. So the good news is we're of the self-sustaining size. We have access to the credit market. We have access of institutional markets. And we can just earn money by managing the portfolio.

The next question comes from the line of Robert Dodd [Raymond James].

On kind of that liquidity question, obviously the SLF initially stopped with assets from the prior portfolio. Do you have a view on how much more of the FSC asset book would be appropriate to go into the SLF and whether you've got essentially a stocked book to ramp that up some more, or if it's more of a question of direct originations from this point forward?

The good news is that the SLF has plenty of opportunities should it go into it. As not good news is the limiting constraint with that. You just saw the announcement that Kemper doubled in size. The limiting constraint is it's not really finding new partners. We have plenty of partners interested in partnering with us there. The limiting constraint is leverage. So what will slow the SLF growth or constrain it to a degree is the fact of finding leverage partners to lever each new vehicle. And as you know, we're huge borrowers from the market, both there and throughout the business. The real challenge is that, not finding new equity partners and not finding new deals for the SLF. Unlike many of our peers, our origination pipeline is huge and it's full of first lien one stock, first lien stretched senior, first lien, which are all very good components of an SLF structure. So the deals are not the problem. The constraint is leverage. So that's what I would watch for.

And then just looking at the disclosures in the K in terms of the blended yield on the portfolio, about 8.1, which is pretty healthy. And then if I back out or attempt to back out the direct interest income, et cetera, the $3.7 million in revenue, are you willing to give us any color on how much of that was fee income in the quarter tied to obviously a relatively high level of originations, which were sales into, but was any of that revenue in the quarter a disproportionate fee contribution?

The overwhelming majority of that revenue was interest income from the portfolio.

The next question comes from the line of Jonathan Bock [Wells Fargo].

Rich, just a question as it relates to dividend income, I want to make sure I heard something correctly, because I do think there was an increase in controlled dividends paid to Fifth Street from roughly $190,000 to now $3.8 million. One, do those numbers fit? And two, what is the primary contributor now to controlled dividends paid?

Well, there are two significant dividends in the quarter. Todd mentioned the aircraft gains. So those drove a $2 million dividend. And in addition to that, we have the $1.2 million dividend from the JV.

And Len, HFG is a unique asset, and obviously it would be beneficial to hear about the growth opportunities and kind of the tie-in, because you mentioned healthcare is kind of a core vertical for Fifth Street. Can you give us an update on that asset's potential for growth now as we are roughly almost, I believe, a year, maybe a little longer, as a part of the FSC platform?

On HFG, the first year of our ownership, we really ended up in making sure that we're optimizing the business. We looked at the credit lines, spent time with those partners. We looked at the management team. We looked at the operations there. Now that we're on solid footing, we started really supporting ways to grow the business. And for the first year, there had been a number of transactions that we've looked at and partnered with the HFG team and we reported yields back and forth. It was one of the core synergies we're expecting to get from their platform and also from our origination efforts. So that's one way to grow. And the other way is to expand their products and expand their access to capital, which we're working on. There's a number of interesting opportunities on the leasing side. There's interesting opportunities on more institutional asset-backed side. And overall, there's a number of ways we can capitalize on the fairly unique assets that we had there in HFG. So that's something that hopefully you'll hear from us in the coming months, ways we can expand that business.

As a finance company how are you able to have this as a qualified asset on the books?

That's because it is a finance company. It's not an investment company.

You had a buyback in place roughly $100 million, which you extended, which is obviously appreciated. First question was, and maybe I missed this, there any stock bought back near the end of the quarter at around 0.95% or a little bit below is the first question? And to date have you repurchased any stock to date as the stock has hovered at around 0.9%?

We did use the buyback at one point, but we haven't used the buyback yet.

If one's goal is to leverage and also generate higher shareholder ROE, is the share buyback at this level an appropriate tool that we could expect to see utilized over the next three months?

I'm not answering the question. I don't think it's appropriate to forecast to use the buyback or not. But I think in the past we've said it's certainly not to trade. We issue stock and we buy back stock. And if it's traded at a substantial discount, we will use it. We did use it about a year ago. We had used it in the past unlike some people. But it has to trade at a substantial discount for us to feel like it's a good idea.

Investors just have the question, they wonder if 0.9% and a 10%-plus yield is a substantial discount that's accretive. I guess it's in the eye of beholder. The last question would be, Len, Todd FSFR's decision to raise capital at a discount to NAV did create a significant amount of investor questions as it related to the entirety of the platform, or FSC, et cetera. I am just curious if you had the chance to do it all over again, would you raise capital at a discount to book value in that entity again?

It's the FSC's call here. It's really probably not the right forum to address that question. We prefer to do that with you either on the next call. But away from this as you heard earlier, within FSC, we have no intention today of issuing below NAV.

The next question comes from the line of Terry Ma [Barclays Capital].

Can you maybe just talk more broadly about where you are seeing the best risk-adjusted return opportunities across your new initiatives, whether it's aircraft leasing, venture lending or the senior loan fund?

Across the platform, being a traditional middle market originator, bringing our balance sheet a certainly close to deals in the middle market, the best risk-adjusted returns right now we're seeing in the one-stop product for us is a way for us to be [indiscernible] out to controlling our destiny is to get the yield premium for the people that are direct originators. Alongside that, we're actively looking at opportunities in aircraft leasing and also in our technology business. But as you know, those are smaller parts of our overall platform. Most of the effort is on the middle market lending side. And we're looking into December call, which we saw has been a good quarter for us.

Can you just remind me how big the senior loan fund can get as a percentage of the portfolio? I may have missed this, but is it safe to assume that you used the remainder of your non-qualified bucket for that?

It can get much bigger. Again, the constraint is leverage. It's not partners and it's not deals. So as we find additional leverage partners for the senior loan fund, we think it can expand a lot over the next year or two.

Thank you for joining the call. Hope you have a great day.