OFS Capital Corporation (OFS) Q1 2015 Earnings Report, Transcript and Summary

Good morning and welcome to OFS Capital First Quarter 2015 Earnings Conference Call. All participants will be in listen-only mode. [Operator Instructions]. After today's presentation there will be an opportunity to ask questions. [Operator Instructions]. Please note that this conference is being recorded. I would now like to turn the conference over to Steve Altebrando. Please go ahead.

Thank you. Good morning, everyone and thank you for joining us. With me today is Bilal Rashid, our Chairman and Chief Executive Officer; and Jeff Cerny, our Chief Financial Officer and Treasurer. We issued a press release and Form 8-K with the SEC this morning announcing our first quarter results. Both documents can be obtained under the Investor Relations section of our website at ofscapital.com. We plan on filing our 10-Q this afternoon. Before we begin please note that the statements made on this call and webcast may constitute forward-looking statements within the meaning of the Securities Act of 1933 as amended. Such statements reflect various assumptions by OFS Capital concerning anticipated results are not guarantees of future performance, and are subject to known and unknown risks, uncertainties and other factors that could cause actual results to differ materially from such statements. The uncertainties and other factors are in some ways beyond management’s control including the risk factors described from time-to-time in our filings with the SEC. Although we believe these assumptions are reasonable, any of those assumptions could prove to be inaccurate and, as a result, the forward-looking statements based on those assumptions also could be incorrect. You should not place undue reliance on those forward-looking statements. OFS Capital undertakes no duty to update any forward-looking statements made herein. All forward-looking statements speak only as of the date of this call. A replay of this call will be available until May 18, 2015 beginning approximately two hours after we conclude this morning. Alternatively the webcast will be available for the next 30 days. To access either replay please visit our website at ofscapital.com. With that, I will turn the call over to our Chairman and Chief Executive Officer, Bilal Rashid.

Thank you, Steve. Good morning and welcome. As you probably saw, we issued a press release earlier this morning detailing our performance in the first quarter 2015. We are pleased with our performance which was a result of our focus on originating quality loans to middle market borrowers with the goal of increasing distributions to our shareholders. We continue to meet the growing need for capital within the capital constrained lower middle market. This is where we continue to see significant opportunity for investing in high yielding assets while maintaining our underwriting standards. We believe that the lower middle market provides us better pricing and stronger covenants that will generate attractive risk adjusted returns. OFS Capital's credit intensive culture, its thorough due diligence process and its expertise in structuring transactions give us an advantage in this important and underserved market segment. We expect to continue to originate attractively priced loans in the lower middle market with a focus on non-sponsored transactions. Our net investment income for the first quarter was $0.28 per share compared to $0.15 per share in the first quarter of last year. Our adjusted net investment income per share for the quarter, a non-GAAP measure, was $0.29 per share. This adjustment was driven by a non-cash charge related to our voluntary reduction of our senior loan credit facility as we continue to reduce the size of that pool. The growth in our net investment income was largely a result of an increase in the weighted average yield of our portfolio. While industry-wide spreads have tightened since the beginning of the year the weighted average yield of our portfolio improved to 10.24% in the first quarter of 2015 compared to 9.56% in the fourth quarter of last year. This noteworthy improvement was due to a steady growth in the higher yielding direct lending portfolio in our SBIC and a decrease in the lower yielding senior club loan portfolio. As we mentioned on our last earnings call, we expect to reduce our exposure to lower yielding senior club loans and redeploy that capital in high yielding direct loans. We expect to monetize the remaining pool of senior club loans as and when we need additional capital to originate our higher yielding loans. We feel good about the credit quality of our portfolio. At the end of the first quarter, we had just one loan on non-accrual representing less than 1% of the fair value of our total assets. We had virtually no exposure to the oil and gas sector. Approximately 73% of the fair value of our portfolio was senior secured and approximately 70% was floating rate. We believe that OFS Capital's credit intensive culture and its expertise and structuring transitions has serves us well so far. We have a highly experienced investment team with a hands-on approach to managing the portfolio and working with our borrowers. We continue to put an emphasis on companies with strong management teams, high barriers to entry and strong free cash flow characteristics. We focus on avoiding highly cyclical and commodity based industries. Our strong origination capabilities enable us to be more selective. The OFS Capital brand continues to be recognized in the marketplace for our ability to provide flexible capital and being responsive to the needs of our borrowers. Our sourcing capabilities demonstrate the strength of our platform and our investment team’s extensive expense and relationships in the middle market. We continue to receive positive feedback from market participants which has led to repeat business. Going forward, our primary focus remains the same, to grow our earnings while being a conservative steward of our shareholders' capital. As a 30% shareholder of the company the external manager is incentivized to do so. We believe that we have a winning combination of attractively priced assets, matched with attractive long term financing through our SBIC. Our outstanding pooled SBIC debentures which totaled $127.3 million, as of March 31, 2015, have a fixed weighted average interest rate of 3.18% with no maturities until 2022. In the coming quarters, we will continue to originate loans that meet our strict underwriting criteria and we have access to sufficient resources to meet our annual origination targets. As of March 31, 2015, we had several potential sources of capital available to us. Number one, $23 million of capital available within our existing SBIC; number two, $47 million of equity capital invested in our senior club loan portfolio that can be redeployed in higher yielding investments. Number three, we have the ability to raise capital in the bank loan or the bond market, and we have an active dialogue with bankers and lenders in this regard. Lastly, our second SBIC license is under review and we have been in dialogue with the SBA regarding our application. However, at this point we do not have any update on the timing. As you can see, we have several financing options available to us and we are working diligently on each of those options to continue to execute our business plan of originating quality loans. As we have done so far, we will continue to finance the company in a thoughtful manner. We will only raise additional capital if it is accretive to our shareholders. As a 30% shareholder of the company, the external manager’s interests are aligned with those of our shareholders. To summarize, I'm encouraged by OFS Capital’s result in the first quarter of this year, but I'm even more excited about the opportunities ahead. At this point, I’ll turn the call over to our Chief Financial Officer, Jeff Cerny, who will provide more details on the financials. Upon the completion of Jeff’s comments, I will follow up with some concluding remarks, and then we will open up the line for questions.

Thanks, Bilal. Turning to our first quarter results, our investment portfolio totaled $316.2 million on a fair value basis as of March 31, equating to 99.7% of cost. Looking at where the portfolio stood at March 31, the portfolio is comprised of 60 companies including 26 in the SBIC fund. As a percentage of fair value at quarter-end, our investments were comprised of approximately 73% in senior secured loans, 20% in subordinated debt, and 7% in equity. At March 31, the 60 companies in our portfolio were diversified across 19 industries. Our largest portfolio company accounted for 4.6% of the aggregate fair value of our portfolio. Our five largest investments accounted for approximately 22% of the portfolio’s total fair value. Our average investment in each portfolio company was $5.3 million at fair value or 1.67% of the portfolio’s total fair value. The weighted average yield to fair value was 6.8% on debt investments in our senior loan fund and 12.1% on debt investments in our SBIC fund. The overall weighted average yield to fair value on our debt investments continues to move in a positive direction. It increased 68 basis points since last quarter from 9.56% to 10.24%. The 68 basis point pickup in weighted average yield to fair value quarter-over-quarter reflects the continued ramp up in our SBIC fund and pay downs in our senior loan fund. On a fair value basis at March 31, the debt investments in the SBIC fund now represent approximately 64% of the overall debt portfolio versus 60% last quarter. As Bilal mentioned, our intention is to continue to fully ramp up our SBIC fund and redeploy capital from our senior loan fund into higher yielding assets. Our one non-accrual investment was omitted from the weighted average yield to fair value calculation. At the end of the first quarter, floating rate loans comprised 70% of our loan portfolio. This is down from 73% last quarter largely driven by the growth in our SBIC portfolio. The SBIC portfolio, include certain unit tranche and subordinated debt investments that tend to be structured with fixed rates. All of our floating rate loans contain LIBOR floors. As I noted earlier, we had one non-accrual at March 31, Strata Pathology Services. It had a fair value of $713,000 and has been on non-accrual since the first quarter of 2013. Moving on to deal activity, during the first quarter, we closed five transactions with portfolio companies in an aggregate principal amount of $24.8 million. This included $18 million of investments in three new portfolio companies and $6.8 million of follow-on investments in two portfolio companies. These investments included senior secured loans, subordinated loans and preferred stock with approximately 92% constituting loan investments. We derived approximately $7.6 million in total investment income in the first quarter, compared to $6.9 million in the fourth quarter. This 10% improvement quarter-over-quarter was largely due to achieving a full quarter of interest income from investments closed during the fourth quarter, as well as the new first quarter investments, and a 68 basis point increase in the weighted average yield to fair value quarter-over-quarter, reflecting our stated goal of shifting away from the senior loan fund. Approximately $1.9 million of the first quarter's total investment income was derived from our senior loan fund and $5.7 million came from our SBIC fund. The percentage of total investment income derived from the SBIC fund was 75% versus 67% in the prior quarter. Again, these highlights our efforts to optimize our portfolio into higher yielding investments. Expenses totaled $4.9 million for the first quarter, compared to $4.2 million for the prior quarter. The $700,000 increase in expenses was largely driven by our management fees returning to contractual level, plus a seasonal increase in our administrative feeder in the first quarter. It is important to know that there is a $430,000 non-cash right-off of deferred financing closing cost related to our voluntary commitment reduction of our senior loan fund debt facility versus $665,000 last quarter. This reduction was initiated to eliminate fees on the unused portion of our line of credit that was not needed as we shrink the senior loan fund portfolio. Net investment income for the first quarter was approximately $2.7 million or $0.28 per share, which was unchanged from the prior quarter. Our adjusted net investment income was $2.8 million or $0.29 per share, excluding the non-cash write-off of $430,000 but adding back $336,000 in additional incentive fees we would have paid in the absence of the write-off. We believe this adjusted net investment income of $0.29 per share, which is a non-GAAP measure, provides greater transparency and insight into our ongoing operations. We expect to continue presenting this non-GAAP adjusted net investment income amount in the future as we are likely to incur additional non-cash charges related to further reductions of our senior loan fund debt facility. The facility reductions will be determined as we continue our efforts to shift our capital towards reporting higher yielding investments. As of March 31, we had $1.3 million of deferred financing closing cost related to the senior loan fund debt facility on our books. The unamortized portion of the $1.3 million that remains upon the full repayment and cancellation of our senior loan fund debt facility will be written off. For the first quarter, we had a net increase in net assets resulting from operations of $3.2 million or $0.33 per share compared with $3.5 million or $0.36 per share for the fourth quarter. Turning to our capacity to make additional investments, as of March 31, our existing SBIC fund had approximately $23 million in liquidity, which included $9 million in incremental SBA debenture borrowing capacity. As Bilal just described, we have several other liquidity options, including the redeployment of capital from out senior loan fund. Our goal is to prudently generate liquidity on a timeline that allows us to maximize our interest income, only selling lower yielding assets or otherwise generating capital when we believe we can timely redeploy the cash. With that, I will turn the call back over the Bilal.

Thank you, Jeff. To summarize, we continue to focus on growing the earnings of the company. We will do so by originating quality assets while financing those assets in a manner that is accretive to our shareholders. We will continue to focus on mitigating downside risk by adhering to our underwriting standards and by our continued focus on portfolio management. I would like to reiterate that our core values remain the same, which are to put the interest of our shareholders first. As the largest shareholder of the company, the external manager's interests are well-aligned with those of our shareholders. The outlook for OFS Capital is exciting. The earnings of the company have almost doubled over the last year and we believe that we have a lot more runway to grow our earnings. Given our third balance sheet resources and access to additional capital, we have the dry power to do so by originating quality, higher yielding assets. Our team has been working efficiently, and our reputation as a flexible capital provider to middle market companies is growing. Overall, I am pleased with the performance over the last year. But I'm even more excited about the future of our company, its growing market presence, the strength of our team and the continued success of our time tested underwriting process. With that, operator, please open up the call for questions.

[Operator Instructions]. Our first question today comes from Terry Ma from Barclays. Please go ahead.

Hey, guys. Can you maybe just characterize the level of competition you guys are seeing in your SBIC loans when you go out to originate? And maybe talk about order or not you've seen other BDCs or other lenders?

Yes. So with respect to the lower little market and especially the non-sponsored market, we're not seeing any more competition than we have seen in the past. I think this segment of the market, we believe, is relatively insulated from the frothiness of the larger market and certainly the traditional middle market. And with respect to competition from other BDCs, we see some competition from other BDCs, but I would say not from a vast majority of the BDCs. I think we see other competition from independent SBIC from time to time, but one of the reasons why we think this sector is so attractive and we’ve been focusing on this sector is that it is a fairly underserved sector. There is relatively less completion in it and because of that we’re able to get quite attractive returns. As you can see, the average yield on that SBIC portfolio is almost close to about 12%, and we’re getting more covenants, stronger structures and leverage levels are almost the same as you would get on the larger middle market. And in that sector with those leverage levels, you’re getting returns that are several basis points lesser than what we’re getting in the lower middle market, which is broadly represented in our SBIC portfolio.

And what’s the debt to EBITDA and interest coverage of your SBIC portfolio on weighted average basis?

On a weighted average basis, we’re running in the mid 3x to 3.4x or so. And interest coverage on a weighted average basis well over 2x, but I don’t have that number handy.

I know we touched on this last quarter, but I guess you guys are moving more towards higher yielding loans and SBA loans. At any point could this be a portfolio that entirely consists of SBA loans and you get rid to that senior loan bucket? How are you guys thinking about that longer term?

Yes, I mean, I think that certainly our expertise is in both the lower middle market directly originated loans, which are probably represented in the SBIC and the senior club loans as we call them. I think at this point, we’re seeing very attractive opportunities in the lower middle market. I think we will continue to originate, focus our origination efforts on the lower middle market, especially the non-sponsored part of the market and deemphasize the senior club loan portfolio. So the mix is definitely growing in the direction of more lower-middle market and less sort of traditional middle market, senior club loans, and maybe possible that a predominant majority or essentially a very large part of the portfolio is lower middle market focused, but it would depend on how things are going in both those markets. Right now, as I mentioned, we’re seeing very attractive opportunities in the lower middle market, and that plays to our strength here, because we have a comparative advantage in that part of the market; we’ve got long-term relationships there. It’s harder to source those types of transactions. It’s also harder to underwrite those types of transaction. So we’ve got the expertise to do that and so we want to continue to play on that strength. And I think if you look at the combination of these higher yielding assets combined with long-term fixed rate financing, as I mentioned on the SBIC, the pool debentures, the average cost is 3.2%, fixed rate and these are very long-term financing. I think that’s a very powerful combination and we’ll continue to play to that strength.

And I guess how do you manage them? I guess, you think about the risk of the portfolio given these loans are to smaller companies. I think GDP was negative the first quarter and how do you think about the risk at a high level when the economy -- or if and when the economy turns?

Yes, I mean, I would say that really the lower-middle market companies -- we don’t have any data that would suggest that the lower-middle market companies are necessarily more risky than the traditional middle market or the larger market companies, but I would say, a majority of the differential between the spread in the lower middle market portfolio and the traditional middle market portfolio is really because it’s a much more underserved sector of the market. You have less completion here. It’s harder to originate these types of transactions. You need a full origination team, and thankfully we have that. And if you look at the overall risk, as I mentioned, in the lower middle market, you’re getting -- at least, our experience has been that you’re getting better covenants. The leverage is actually the same overall, if not better than the larger middle market, and so the structures are more lender-friendly. So I think it’s a sector where you need to have that expertise and not just have that expertise in this environment, but actually through several credit cycles. And we certainly, as a manager, have that expertise and we’ve seen these companies perform over several credit cycle. So we feel pretty good about the risk going forward on this. And I think suddenly if we didn’t feel comfortable with it, we won’t be going into it. We own, obviously, as a manager more than 30% of the shares of the company. So our interests are certainly aligned with the shareholders here.

[Operator Instructions]. Okay, that looks like this concludes our questions and answer session. I can turn the conference back over to Bilal for any closing remarks.

Thank you all for joining our call today and for your questions. We look forward to speaking with everyone again on our next call. Operator, you may end the call now. Thank you.