OFS Capital Corporation (OFS) Q3 2017 Earnings Report, Transcript and Summary

Good morning, and welcome to the OFS Capital Corporation Third Quarter 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, this event is being recorded. I would now like to turn the conference over to Steve Altebrando, Vice President of Investor Relations. Please go ahead.

Good morning, and thank you for joining us. With me today is Bilal Rashid, Chairman and Chief Executive Officer of OFS Capital; and Jeff Cerny, our Chief Financial Officer and Treasurer. Please note that we issued a press release this morning, announcing our third quarter results. This press release was subsequently filed on Form 8-K with the SEC. Both documents can be obtained under the Investor Relations section of our website at ofscapital.com. Before we begin, please note that statements made on this call and webcast may constitute forward-looking statements as defined under applicable securities laws. Such statements reflect various assumptions, expectations and opinions of OFS Capital management’s, 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 way 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 inaccurate. And as a result, the forward-looking statements based on those assumptions also could be incorrect. You should not place undue reliance on these 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. With that, I’ll turn the call over to our Chairman and Chief Executive Officer,

Thank you, Steve. Good morning, and welcome. OFS Capital continues to be focused on generating net investment income that exceeds our distribution, just as we did in the eight quarters leading up to our recent equity offering. We intend to accomplish this objective by prudently deploying available cash and restoring our leverage to prior levels. We made good progress in the quarter towards achieving our goal. We deployed $42.4 million in six portfolio companies. These investments helped us generate net investment income of $0.33 per share. Despite a general tightening of spreads and looser structures in the broader leveraged loan market, we continue to see opportunities in the lower-middle market where we believe that capital is more constrained and one requires extensive sourcing, underwriting and portfolio management expertise. Since the inception of our investment platform in 1994, our reputation as a provider of flexible capital has grown. We believe that our role as a trusted partner has led to greater deal flow, allowing us to remain highly selective as we continue to adhere to our strict underwriting standards. As we have previously noted, our larger equity capital base enables us to make larger investments while maintaining concentration risks at acceptable levels. We believe that this has given us a strategic advantage in the lower-middle market as we are increasingly able to meet the full borrowing needs of our clients. This in turn, provides higher certainty of execution to our borrowers and allows us to win deals without sacrificing our underwriting standards. We are already seeing the benefits of this strategic advantage as we deployed $109 million over the last two quarters. Jeff will describe a transaction in the third quarter where we were able to underwrite, lead and hold a larger investment. We had $53.9 million of cash at the end of the third quarter. At September 30, 2017, our net asset value was $189 million, with just $17 million of debt from a regulatory standpoint. As you know, SBIC debentures do not count as regulatory leverage, and currently, the debt capital markets remain strong. Therefore, we believe that we have the ability to raise additional debt capital. Our net asset value per share at the end of the third quarter of 2017 was $14.15 compared to $14.40 at the end of the June quarter. This slightly lower net asset value in the current period resulted primarily from a decrease in value of certain investments. As of today, we have just one loan on non-accrual. Jeff will provide more specifics on that shortly. Our investment track record remains strong, generating attractive yields with a weighted average yield-to-cost on our debt investments of 11.5% at the end of the quarter. Since the beginning of 2011, we have invested $795 million. We have had accumulative net realized loss of just $1.4 million, which represents less than 0.2% net realized loss on accumulative basis. Looking forward, we believe that we are well positioned for an increase in interest rates, as approximately 73% of our loans are floating rate while 90% of our debt at the end of the quarter was fixed rate. We have already begun to experience the benefits of our balance sheet positioning as three-month LIBOR has increased from 0.3% to more than 1.3% over the past two years. Also, our attractive long-term financing includes $150 million in fixed-rate SBA debentures through the SBIC program, with a weighted average coupon of 3.18% with no maturities until 2022. This low, stable cost of debt has a meaningful positive impact on our return on equity. In terms of our investments, 76% of our loan portfolio is senior secured based on fair value. We continue to believe that our best opportunity to generate strong risk-adjusted returns is in the lower-middle market. We believe that OFS Capital has real competitive advantages in this underserved part of the market having cultivated long-standing relationships and having a team with deep underwriting experience in this segment. In our view, the lower-middle market has significant barriers to entry, particularly with respect to deal sourcing. In addition, it requires specific experience to underwrite and manage these investments. We also benefit from the broad expertise of OFS Capital’s external manager, which is an approximately $2 billion credit platform. The manager has successfully navigated multiple credit cycles since its inception more than two decades ago. We believe that our team has the size, relationships and breadth of experience across all segments of the leveraged loan market to provide us with both industry expertise and considerable capital markets intelligence. The OFS platform allows us to evaluate a broad array of potential transactions and to be highly selective in making investments. The manager continues to own nearly 3 million shares it has owned since the IPO of the company, providing strong alignment of interests between all stakeholders. These shares represent over 22% of the total shares outstanding, which is among the highest in the BDC peer group. We remain confident that our long-term focus and competitive advantages will continue to serve the company and its shareholders. We are dedicated to enhancing our reputation as a reliable financing partner and generating significant deal flow so that we can remain highly selective. At this point, I’ll turn the call over to Jeff Cerny, our Chief Financial Officer.

Thank you, and good morning, everyone. As Bilal described, we continue to prudently deploy capital with investments for the quarter totaling $42.4 million across six investments, primarily in senior secured loans. Currently, 76% of our debt portfolio are senior secured debt investors. Our recent equity capital raise, completed in the second quarter, provided us with additional flexibility and the capacity to make larger investments. For example, in the third quarter, OFS lead an investment for a franchisee of a well-known automotive aftermarket service brand. This was a non-sponsored lower-middle market company and the proceeds were used to refinance existing debt, provide incremental working capital and buyouts of inactive minority shareholders. OFS Capital funded approximately $24 million at close, approximately $5 million more than the upper end of our previous range. Our equity capital raise gave us comfort to speak for larger investments. More broadly, our deal pipeline has increased as a result, better positioning us with respect to existing and potential clients that seek larger and more flexible mandates, especially in a market where certainty of closing continues to be important. We believe that this expanded capital base also makes OFS Capital a more attractive partner to fund add-on investments for existing and potential clients. Originations through the first nine months of 2017 have been strong. OFS Capital has invested $115 million compared to $41 million over the same period in 2016. We believe that the year-to-date origination results confirm our business decision to expand our capital base and that this expansion will continue to contribute to the long-term growth of the company. Our goal remains, and has always been, to generate investment income above our distribution. Turning to our portfolio. At the end of the quarter, we had investments in 40 companies, totaling $296.6 million on a fair value basis. As a percentage of cost, our investments were approximately 65% senior secured loans; 23% subordinated debt; and 12% equity, of which 9% were preferred securities. Our portfolio remains diversified, with an average investment in each portfolio company of $7.4 million or 2.5% of the portfolio’s fair value. The overall weighted average yield to cost on our debt investments was relatively stable quarter-over-quarter, declining 16 basis points to 11.5%. At the end of the quarter, 73% of our debt portfolio had floating rate coupons, which we believe positions us well in this rising rate environment. We have been benefiting from rising rates for a few quarters now since one, three and six-month LIBOR rates are all above 1%, the typical LIBOR floor written into our loan agreements. Community Intervention Services, which was placed on non-accrual in the second quarter is our only current non-accrual. We took a further write-down of approximately $1.2 million on this investment, taking its fair value to approximately 27% of cost. This fair value reduction reflects our view on the continued disappointing performance of the company. Our net asset value at the end of the quarter was $14.15, which was a slight decline from $14.40 at the end of the June quarter. This decline was largely due to lower valuations for certain portfolio companies, including Community Intervention Services. We continue to actively manage these investments to maximize their value. As I previously mentioned, 73% of our loan portfolio had floating rate coupons while 90% of our debt is long-term fixed rate. Our SBA debentures have a weighted average coupon of only 3.18%. As a reminder, these debentures do not count towards our 200% asset coverage test. As such, we have significant capacity to grow our capital base and net investment income as we head into 2018. Turning to the income statement. We derived approximately $9.1 million in total investment income in the quarter, an increase of $1.1 million over the second quarter. The increase was due to a full quarter of interest from the senior secured loans invested in the second quarter, along with incremental interest and fees earned on investments made in the third quarter as well as income from repayments. Total expenses of $4.7 million increased compared to $3.7 million in the prior quarter. The increase was primarily driven by increased net investment income incentive fees due to improved performance in the third quarter and the reversal of a non-cash $283,000 accrual, which reduced incentive fees in the prior quarter. For the third quarter, net investment income was $4.4 million or $0.33 per share compared to $4.3 million in the second quarter. As far as liquidity, at quarter’s end we had approximately $54 million of cash, of which $52 million was in our SBIC. We also had $17.9 million available on our $35 million line of credit. We continue to believe that we have the liquidity, including the flexibility to access the capital markets, to enable us to meet our borrowers’ needs and increase our earnings per share. We have experienced unusually high prepayments during the past two quarters of $62.3 million compared to $12.7 million during the same period of last year, resulting in a higher-than-typical cash position at quarter’s end. As such, we expect to experience some earnings softness during the fourth quarter. However, we remain focused on prudently redeploying this capital and have a number of term sheets pending. While our cash on hand was unusually high, we remain confident in our long-term earnings potential. We believe that the strong historical performance of our portfolio has been driven by a commitment to rigorous credit analysis, prudent underwriting and creative structuring, a commitment that we intend to maintain. With that, I will turn the call back over to Bilal.

Thank you, Jeff. We remain focused on generating net investment income that will exceed our distribution, similar to the eight quarters leading up to our recent capital raise. Over the last two quarters, we have prudently deployed the capital we raised in April. We are optimistic about the earnings potential of our company, given our cash on hand and the ability to raise that capital. We believe that our long-standing underwriting process has produced a low-loss experience and will continue to guide us going forward. We believe that we are well positioned for rising interest rates, given our attractive long-term, fixed-rate financing through the SBIC program, with a weighted average coupon of 3.18%. Approximately 73% of our loan portfolio is floating rate. In addition, we believe that the manager is strongly aligned with our shareholders with 22% ownership of the BDC. Our investment platform has a long history and has weathered multiple credit cycles and changes in the economic environment since its inception in 1994. Our focus is to provide long-term value to all of our stakeholders, including both shareholders and borrowers. As a lender, we intend to continue to meet the needs of our borrowers by providing them flexible capital solutions. We intend to maintain our focus on delivering capital to the lower-middle market, which is where we continue to find attractive risk-adjusted returns. Given our experience and relationships, we believe that we are well positioned to build upon our success. With that, operator, please open up the call for questions.

We’ll now begin the question-and-answer session. [Operator Instructions] Our first question comes from Christopher Testa with National Securities Corporation. Please go ahead.

Hey, good morning guys. Thanks for taking my questions. Just curious, so we’ve had a couple of quarters of some NAV declines. Last quarter, there was no incentive fee, and then this quarter you guys seemed to earn the full incentive fee. I’m just curious how that happened.

Well I mean, the declines, Chris, in NAV are primarily driven by three credits that have been kind of previously identified as credits with some softness. On an overall portfolio basis, we haven’t seen any meaningful ratings migration quarter-over-quarter, and we feel good about our fair value marks. As you know, we have no new non-accruals. We have just one loan on non-accrual, CIS. And we did mention in the script that we took that down about $1.2 million in value.

Okay. So it’s more as long as there’s not a new non-accrual if the marks are still negative and takedown NAV. You guys still have the potential to earn the intensive fee in full?

Yes. So I mean, as you know, there are two components of the incentive fee. One is related to the income, and we generated a $0.33 per share net investment income. And the second component is related to capital gains and losses. And on that front, as Jeff mentioned, we had a slight decline on – based on unrealized depreciations on – mostly related to three credits. One of them is the Community Intervention Services, which is already a non-accrual. But as Jeff mentioned earlier on, the overall portfolio EBITDA and revenue trends are stable. One loan on non-accrual, vast majority of the portfolio is senior secured – of our loan portfolio is senior secured. And then as we mentioned, our track record over the last seven years, we’ve had less than 0.2% of realized losses on accumulative basis. And as you guys know, we – the manager owns 22% of the shares in the BDC. So we are very well aligned with respect to the quality of the portfolio.

Okay, that’s fair. And just looking, as you guys have continued to draw on the credit facility and increased some balance sheet leverage. Just a couple of questions on the left-hand side of the balance sheet. First one being, are you guys potentially looking to maybe upsize the current facility or possibly amend it to get a more favorable rate? And so far as you do anything with the facility, is that likely to be before or after a potential unsecured debt issuance?

Yes. I think we’re always considering those options with respect to the credit facility as well as any other capital market alternatives that we have out there. I think that we have talked a bit in the past about an unsecured bond offering. I think we continue to explore all alternatives there. I think we kind of view the PacWest facility as not only a working capital line but a warehouse line of sorts where we can build up assets. And if we do a public issuance, we can repay that debt and realize the benefits of that offering immediately.

Got it. Yes, I was just thinking, with the larger equity base and both you, Bilal and you Jeff, having a longer history of operating this public company that potentially you could get that rate down. It just seems high compared to peers, especially given your asset quality is pretty good.

Yes. Yes, I think that this facility that we have is actually, in our opinion, quite unusual in the sense that it doesn’t have all the bells and whistles that go with some of those other facilities where you have a very strict borrowing base and mark-to-market type of provisions. The potential for an event of default is higher in those. And the facility – and then there are several restrictions with respect to the type of assets we can put in there and concentration requirements, et cetera. So we do have access to those types of facilities if we chose to do that. We strongly believe that we can get access to those facilities. It’s just that there are tradeoffs between the rate versus all the other potential downside you can have with those types of mark-to-market type of provisions and covenants.

That’s good detail. Okay. And just sticking with kind of the theme of leverage, obviously, you guys are decently below NAV now. Has the board shown any inclinations to implement a repurchase program? I mean, I know the volume is low and it’s unlikely to move the needle that much, especially given the restrictions on windows and when you’re able to repurchase, but more as a capital management tool to help you guys get the balance sheet leverage up and increase ROEs.

Yes. I mean, I think our – as we’ve mentioned in the past, I mean, and I mentioned in the – my prepared remarks that we expect to increase net investment income here – from here onwards through deploying that capital we have but also restoring the leverage levels to prior levels. So I think that would be our focus. As we grow the business, we would look to increase the leverage here. And as you know, we have the ability to do that, given that the SBIC debentures don’t count towards the leverage test. So I think that’s what we are going to focus on going forward. And as you saw, our – the net investment income this quarter was $0.32 per share, and it’s very close to the $0.34 per share dividend. And so we feel good about the quarter. I think we’re making good progress towards the goal of increasing our NII over a long-term, above the distribution that we are making.

Got it. Okay, that’s all from me. Thank you guys for taking my question. I appreciate it.

Thanks, Chris.

[Operator Instructions] Our next question comes from David Miyazaki with Confluence Investment Management. Please go ahead.

Hi, good morning. So just a comment here, just to follow-up on the incentive fee conversation. As you guys are becoming larger and your audience will presumably become larger as well to include more institutional investors and a broader swathe of sell side analysts, one of the thing that’s been abused in the past in the BDC industry has been the collection of incentive fees by managers even though the mark-to-market has been negative because they’re not realized. And so I think a more robust structure that will be endorsed and appreciated by the institutional investment community would be one that would include those mark-to-markets. It just makes sure that we are properly aligned at all phases of where a particular set of loans is marked. So if there’s a negative trajectory, we’re not seeing income paid out to the manager as the marks decline. So I would encourage you and the board to look at some of the more robust incentive fee alignments to make them more appealing for a broader shareholder base. Moving on then, as you described where you are with a larger cash position and almost all of that is really in the SBIC, how does – what is the outlook right now for underwriting more loans that are going to be in the SBIC? Is that – if you had two companies, one that qualified and one that didn’t, is it – are the terms and yields going to be lower because it would qualify to fit into an SBIC?

No, no. Yes, so we are sitting on a little bit of cash, it is primarily in the SBIC. Prepayments, really, in the last few quarters have been significant. And it’s a double-edged sword there, obviously, because it shows the companies are performing and they’re repaying and we’re realizing gains, harvesting gains, but the downside is we need to do redeploy that. And right now, we have a really strong, robust pipeline with a significant number of term sheets out, and I would say the vast majority of those our SBIC-eligible. So we would expect to deploy that capital in the not too distant future.

So you are not seeing any kind of distortion in lending terms and yields because it’s SBIC-eligible. I was just wondering, there’s a lot of capital that’s available there, and I wasn’t sure the how competitive landscape is.

No, we are not seeing a difference between – I mean, I think it’s really been driven by prepayments more than anything.

Okay. And then also kind of thinking about your broader balance sheet. You really – the incremental loans that are going to be underwritten outside of the SBIC are at this point going to be – have to be funded entirely by debt capital, it looks like, right? Or just natural turnover within the portfolio. So if your incremental capital right now is debt, it does – it’s kind of put you in a limited position to buy back stock because I think that most people would probably be reticent to endorse a capital allocation strategy that’s going to use debt to buy back your stock. For a BDC, that can be a little hazardous. But kind of going along the lines of the incentive fee issue, if we look at what has happened to your stocks since the offering, it hasn’t been a very pleasant ride for shareholders. I – there’s obviously an adjustment period for when you’re going to be matching up your dividend and you income levels, but it has really created an overhang so that if you issued equity above NAV, and now you’re 12 points below, having a fully formed capital allocation philosophy, one that includes buying back stock below net asset value is something I think that would increase the appeal to a broader investor base. So I guess, I would just encourage you to think of that, be ahead of the plan. Right now, that’s not really something that you can do, but I think that it’s something that would be important to think about as you grow and become a larger company.

Yes, David. We definitely appreciate the comments and thoughts.

All right, thank you very much.

Thank you.

This concludes our question-and-answer session. I would like to turn the conference back over to Bilal Rashid for any closing remarks.

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