OFS Capital Corporation (OFS) Q4 2018 Earnings Report, Transcript and Summary

Good morning, ladies and gentlemen, and welcome to the OFS Capital Corporation Fourth Quarter and Year-End 2018 Earnings Conference Call. All participants will be in listen-only mode. [Operator Instructions] Please note that this event is being recorded. At this time, I would like to turn the conference over to Steve Altebrando, Vice President of Equity Capital Markets. Please go ahead, sir.

Good morning, everyone, and thank you for joining us. With me today is Bilal Rashid, Chairman and Chief Executive Officer of OFS Capital; and Jeff Cerny, the company's Chief Financial Officer and Treasurer. Please note that we issued a press release this morning announcing our fourth 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 www.ofscapital.com. Before we begin, please note that the 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 by OFS Capital's management 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 Chairman and Chief Executive Officer, Bilal Rashid.

Thank you, Steve. Good morning, and welcome. We are pleased to report this morning that our net investment income per share was $0.40 for the fourth quarter. This was more than a 38% increase from last year and well above our $0.34 quarterly distribution. For the full year 2018, our net investment income was $1.38 per share and also exceeded our annual regular distribution. These strong results were driven by a significant, but disciplined deployment of capital in 2018, which was largely financed with attractively priced, fixed-rate, long-term debt. We have now declared 25 straight quarterly distributions of $0.34 per share since our IPO in late 2012. In addition, over the past four years, our total net investment income has exceeded our total regular distribution. We believe that maintaining our distribution and out earning it over this period of time puts us in select company within the BDC sector. We experienced a decline in our net asset value from $13.75 per share last quarter to $13.10 per share this quarter as a result of unrealized depreciation of the portfolio. This was in large part due to wider market spreads. We had no new non-accruals in the quarter, and we expect all of our performing loans to repay their original principal. Jeff will provide more details on the portfolio later in the call. In terms of originations, we deployed approximately $80 million in the fourth quarter of this year compared to approximately $28 million in the fourth quarter of last year. As discussed on prior calls, we remain committed to being highly selective, even with this healthy pace of deployment. Specifically, in 2018, we reviewed over 800 deals and executed on only a small fraction, concentrating on industries and management teams that we believe are well positioned to navigate the next downturn. As always, we remain focused on capital preservation, which we consider a key source of our long-term outperformance. OFS is generating a 10% distribution yield based on our net asset value and a more than 11% yield based on our latest available stock price. We believe that this is an attractive yield compared to the overall BDC sector. Since our IPO in late 2012, our total return, as measured by the change in net asset value per share plus cumulative distributions, is more than 10% above the industry average. In total, we have declared $8.70 per share in distributions over this period. Over a five year period, we have generated a solid ROE of approximately 8%. Since the beginning of 2011, OFS has invested approximately $1.1 billion. It is notable that we have achieved a cumulative net realized gain of principal while generating attractive yields on our portfolio. We believe our strong performance is a direct result of our sourcing, underwriting and portfolio management capabilities. We perform primary due diligence on the deals we agent, which can take several weeks or months to complete. Often, we received Board seats or Board observation rights for deals that we originate, which gives us a seat at the table to more proactively manage our investments. In essence, we think that we bring private equity discipline to private debt investing. Looking ahead, we believe that we are well positioned to continue to generate strong net investment income by adhering to our long-standing business plan of serving the growing financing needs of lower middle market companies. We believe that this will enable us to continue to deliver a consistent and attractive distribution, as we have, since our IPO. We are continuing to be vigilant and cautious about our portfolio construction. As you know, 87% of our loan portfolio is senior secured, as a percentage of fair value. We will continue to concentrate on senior secured loans and avoid highly cyclical industries. Although the U.S. economy is currently in good shape with a historically low unemployment rate, we believe that we are in the late stages of the current credit cycle. As it relates to deal flow for the year, we continue to see attractive opportunities within the lower middle market. After a volatile December, M&A activity has been picking up, and we are seeing more deal flow. So far this quarter, we have deployed $51.9 million of capital. As you know, last May, our board approved a reduction in the asset coverage ratio, which will permit increased leverage for our BDC this coming May. We are in advanced discussions with lenders that would enable us to dedicate a portion of our equity towards low yielding, senior secured loans to larger companies. We expect this to help increase our ROE. We believe the breadth and skill set of our $2.3 billion platform positions us well to benefit from this opportunity. At this point, I'll turn the call over to Jeff Cerny, our Chief Financial Officer, to give you more color and details for the quarter.

Thanks, and good morning, everyone. We are starting to see the benefits of our increased scale and our larger asset base, primarily resulting from $100 million in two, 7 year unsecured bond offerings this year. We believe this quarter was a good quarter with strong net investment income, but do note that unrealized depreciation was above our expectations. The majority of the unrealized depreciation was driven by market conditions, mostly widening credit spreads into a lesser extent, EBITDA multiple contractions due to declines in the broader equity markets. We believe that a material portion of the unrealized depreciation was due to market conditions late in the fourth quarter that has actually reversed in the first quarter. Starting with the income statement, we derived approximately $12.6 million in total investment income in the quarter, a $1.6 million increase over the third quarter. Net investment income increased to $0.40 per share compared to $0.35 in the prior quarter. This was driven by an increase in investment assets from strong deployment activity following our October 2018 bond offering, higher fee income and accelerations of original issue discounts. Total expenses of $7.2 million increased $900,000 compared to the prior quarter. This increase was driven by higher interest expense due to our October 2018 bond offering as well as increased incentive fees that resulted from higher outperformance above our contractual hurdle rate. Turning to the balance sheet, we had approximately $38 million of uninvested cash at the end of the quarter. $36 million of that cash was in our SBIC. This uninvested cash was in large part due to approximately $70 million of repayments, mostly in our SBIC, that occurred after our bond offering. We have deployed much of this cash in investment so far this quarter and our uninvested cash position today stands at $13 million. Regarding our ability to meet our clients' near-term needs, we currently have approximately $25 million in undrawn availability on our line of credit. We are in advanced discussions to upsize our current line of credit. Also as Bilal mentioned, we are currently evaluating financing alternatives to allow us to dedicate a larger portion of our portfolio to lower yielding, senior secured loans to larger companies. Our debt-to-equity ratio at the end of the quarter was about 1.46 times including our SBIC debt. As you know, this is well below our regulatory leverage requirements as the SBIC debt does not count towards the leverage test. We would be comfortable increasing our leverage further in order to invest in senior secured loans of larger companies, as I mentioned. We saw greater-than-expected unrealized depreciation this quarter, mostly driven by market conditions including widening spreads and EBITDA multiple contractions due to declines in the broader equity markets. We believe that a material portion of the unrealized depreciation was due to market conditions late in the fourth quarter, much of which has actually reversed itself in the first quarter. We also had nonmarket unrealized depreciation on a small number of performing loans and their related equity positions where we still anticipate being repaid in full. As a result, our net asset value at the end of the quarter was $13.10 per share compared to $13.75 in the prior quarter. At the end of the quarter, we had investments in 50 companies totaling approximately $397 million on a fair value basis. As a percentage of cost, our investments were approximately 79% senior secured loans, 14% subordinated debt and 7% equity, approximately two-third of which is in preferred securities. Our portfolio remains diversified with an average investment in each portfolio company of $7.9 million or 2% of the portfolio's total fair value. At fair value, we currently have 0.2% of the portfolio on nonaccrual compared to 0.4% last quarter. The overall weighted average yield to cost on our performing debt investments was 11.5% at December 31. This compares to our weighted average cost on our borrowings of just 4.8% at quarter's end. We deployed approximately $80 million in the fourth quarter across 20 investments. This consisted of $34 million in increases to several existing portfolio companies, and we also invested $45.6 million in nine new names. The new names consisted mostly of floating rate and senior secured loans with a weighted average yield on new debt investments of 10.1%. Importantly, our senior secured debt investments now makeup approximately 85% of our loan book as a percentage of cost, compared to 79% last quarter. One of the investments this quarter that I would like to highlight is a follow-on investment that we closed with JBR Clinical Research. This was a floating-rate, senior secured loan facility. JBR has a 30-plus year operating history as a site manager for pharmaceutical trials providing industry-leading study, design and management. The OFS team directly sourced and underwrote the deal leveraging both internal diligence efforts and third-party expert resources to underwrite and structure the deal. We ultimately closed the transaction with a full covenant package. The initial investment was made in the third quarter of 2018 and our relationship grew with the company as it completed strategic acquisitions. We funded a follow-on investment in November of 2018 and another follow-on investment in the first quarter. Today, the loan sits at about 3.75 times leverage with floating-rate pricing standing at about 10.6%. Follow-on investments are attractive, because we already know the company, its sponsor and its management team. We feel that our risk is mitigated knowing the capabilities of each party. This kind of investment helps reinforce our reputation in the market as a lender that can support role-up strategies in the agented transactions. Additionally, we believe our increased capital base continues to provide us with additional flexibility and capacity to support investments like JBR and make larger investments. Our bond offering in the fourth quarter enhanced our flexibility to do so. As Bilal mentioned, we are well positioned to benefit from an increase in BDC leverage limits given the breadth and expertise of OFS Capital management. We are in advanced discussions with several lenders to increase our borrowing capacity. We continue to believe in the share repurchase program previously authorized by our board, however, we were only able to repurchase a minimal amount of shares at the end of the fourth quarter. While we would've liked to buy more, the weakness in share price proved to be short-lived and taking advantage of the low stock price proved difficult given the timing and blackout periods. With that, I will turn the call back over to Bilal.

Thank you, Jeff. We are pleased with the increase in net investment income this quarter. We believe that our strong performance is due to the strength of our origination platform as well as our underwriting and portfolio management process. Looking ahead, we remain confident in our earnings power. We have a senior secured, floating-rate-focused portfolio and have locked in attractive fixed-rate, long-term financing. We are especially excited to take advantage of the higher leverage allowance for the BDC. We believe that we can increase the ROE of the BDC while investing in senior secured loans of larger companies. As you know, the adviser manages more than $2.3 billion in assets and has broad capabilities within the corporate credit sector. We expect to continue to benefit from our long-standing investment platform that has been in existence since 1994 and has gone through multiple credit cycles. We believe that this experience will help us navigate changing market conditions considering where we are in the current credit cycle. We continue to focus on capital preservation, as highlighted by our low-loss experience. In addition, we believe that our performance is further aided by the adviser having considerable skin in the game since it is the largest shareholder in the BDC. With that, operator, please open up the call for questions.

[Operator Instructions] And the first question this morning will be from Christopher Testa of National Securities Corporation.

First, more of a statement, just wanted to say, kudos to you guys for actually marking the book appropriately and being one of only a handful of BDCs to do it and not hiding behind "insulation." So thanks for marking your book concurrently. Just wondering, Jeff, could you give me a number in terms of how much prepayments fees and accelerated OID occurred during the quarter?

Sure, Chris. As I mentioned, we did have pretty substantial prepayments later in the quarter after the bond offering. It was about $1.4 million in total fees. So and note that -- with the -- with that acceleration and fees, we are obviously giving up interest income, because we sat on cash for a little bit of time, but we did redeploy a substantial portion in the first quarter. So we're feeling good about earnings.

Okay, great. Thank you. And just wondering too, obviously, you guys have a good amount of AUM aside from OFS. Could you give me an idea of how much of the AUM OFS Capital Corp routinely co-invest across?

So it's very limited. I mean, we -- from a middle market perspective, we have one other vehicle that is in its relatively infant stages right now, and there's a number of names that are invested across, but dollars not material.

Got it, and is this something you guys are looking to potentially increase, because it seems that scale is becoming more and more important and will help you with the granular portfolio. And you guys have a pretty good track record, and there's been guys with atrocious track records, who have raised a lot of money. So it just seems to me that this would be kind of low-hanging fruit for you guys to be able to raise more kind of private debt vehicles to augment your coinvest power?

Yes, I think -- this is Bilal. We are definitely looking at that and actually having advanced discussions on that front as well. So we -- And I think the main reason for that is to have that purchasing power, so to speak. I think it helps us compete better with our competitors. So that is something that we are looking into very seriously and have been engaged in some advanced discussions on that front.

Got it, okay. And I know you guys have alluded to the larger borrowers, which I think is a good idea. You had a previous total debt-to-equity target of 1.2 to 1.4, could you just elaborate on a couple of things. First, are you looking to potentially have a different credit facility for more kind of larger borrowers? And also, how would this change your total debt-to-equity target?

Okay. Good question, Chris. So yes, we are actually looking to do a separate facility for those larger borrowers. And our hope is that within the next few weeks, we will have that setup. And as it relates to the leverage target, it will certainly be above two times and that's not on a statutory basis, that's just on a regular basis. As you know, the SBIC doesn't count towards the leverage test. But I think when we set that entity up, which will be soon here, we'll give you a more definitive target of where we want to be. But at this time point, it will certainly be above two times.

Got it. And could you just give us an idea of what sort of EBITDA target companies you're looking at when you talk about larger borrowers?

Yes, so I think -- I would say, generally, EBITDA of anywhere from $25 million and above would be the norm for that facility.

And is there a certain cap like, for example, maybe you don't want to play in the $75 million range, but you'd be comfortable, may be going to $40 million or $50 million. Is that fair?

Yes, yes. I mean, I think that that's right.

And last one for me and I'll hop back in the queue. Just a couple of thoughts on fees. Just wondering if you guys have discussed potentially implementing a total return hurdle and now, especially with debt to equity going now seemingly towards two times. If you guys have given any thought to scaling fees on assets purchased with debt to equity over one times to just create a break point in fees so that shareholders benefit from this increased leverage?

Yes. Chris, that's a good question, I mean -- I think our focus as always is to do things that are accretive to the earnings of the BDC. So once we finalize the facility, we'll also announce the appropriate fee waivers related to that investment activity on larger senior secured loans, so that certainly in the cards, and we'll make that announcement as soon as we setup that vehicle.

[Operator Instructions] And I'm showing no additional questions. We will conclude the question-and-answer session. I would like to hand 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.

Thank you, sir. Ladies and gentlemen, the conference has now concluded. Thank you for attending today's presentation. You may now disconnect your lines.