OFS Capital Corporation (OFS) Q3 2019 Earnings Report, Transcript and Summary

Good day and welcome to the OFS Capital Corporation Third Quarter 2019 Earnings Conference Call and Webcast. [Operator Instructions] Please note this event is being recorded. I would now like to turn the conference over to Steve Altebrando, Investor Relations. Please go ahead.

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 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 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, and 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, Bilal Rashid.

Thank you, Steve. Good morning and welcome. Our net investment income per share was $0.36 for the third quarter again, above our $0.34 quarterly distribution. We have now declared 28 straight quarterly distributions of $0.34 per share since our IPO in late 2012. In addition, we have declared $9.38 per share in distributions over this time, including $0.37 per share of special dividends. And over the last five 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 made significant progress in the quarter ramping up our senior loan subsidiary. We invested 41.3 million in the quarter of which 22.7 million was in the senior loan subsidiary. Jeff will provide more specifics on our investment activities in this quarter later in the call. We believe the senior loan subsidiary will increase our ROE while further improving the overall risk profile of the BDC. The flexibility and incremental leverage permitted under the small business Credit Availability Act enables us to invest in loans that previously did not meet our return targets. We believe that we have an advantage in this part of the market since our advisor has been investing in these types of loans for 25 years, and currently has approximately 1.5 billion invested in these types of loans through other funds. We believe this new subsidiary is able to capitalize on one of the core competencies of our advisor. As we have mentioned on several of our previous calls, we have been gravitating toward more senior loans based on how we view the private loan market. And we expect that this subsidiary will accelerate that trend. Given the nature of the loans, we are investing in this subsidiary we continue to be comfortable with consolidated leverage exceeding 2.25 times debt to equity. Notably, the regulatory leverage is expected to be well below two times given that the SBIC debt does not count toward the leverage test. It is also important to reiterate that while the debt of the subsidiary is consolidated on our balance sheet for GAAP purposes. The debt in this facility is non-recourse to the rest of the BDC. This is similar to other non-consolidated facilities in the industry. Our net asset value per share at the end of the quarter was $12.74, compared to $12.95 in the prior quarter. The quarterly decline was largely due to unrealized losses related to fair values determined at the end of the quarter. For the fifth consecutive quarters, we had no new nonaccrual. Jeff will also provide more commentary on the performance of the portfolio. Turning to the broader lending environment. Over the last year, loan prices have been soft relative to their peaks in October 2018. We believe that this is related in large part to a supply demand imbalance. Over the last year, there have been 12 straight monthly outflows from retail funds aggregating approximately $50 billion. We believe that this imbalance in the broader market has begun to shift the balance in favor of the lenders. We believe that over the last quarter, lenders have become more discerning in the larger market, pushing back on loan structures, leverage and pricing. We have observed that in many cases, they have been disproportionately penalizing even slight underperformance which is reflected in lower prices. We believe that this dynamic has begun to create some interesting opportunities in the larger loan market. As such, we continue to be vigilant and cautious about our portfolio construction, 90% of our loan portfolio is senior secured as a percentage of fair value. This compares to 76% two years ago. We expect to continue to concentrate on senior secured loans and avoid highly cyclical industries. While we still believe that we are in the late stages of the current credit cycle, the U.S. economy remains in growth mode. Although a slow growth. In terms of deal flow, we continue to see attractive opportunities across the loan market. In the fourth quarter, we took advantage of the decline in interest rates by closing on an approximately $54 million seven years unsecured bond offering had 5.95%. This was a significant improvement in rates from a similar bond offerings that we executed a year ago at a rate of 6.5%. Proceeds from the bond offerings were primarily used to repay a revolving line of credit, further enhancing the strength of our balance sheet. At this point, I will 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. It was another strong quarter for our net investment income, which continued to exceed our distribution. As Bilal mentioned, we made significant progress ramping up our senior loan facility. We believe this entity is attractive for our shareholders by increasing our focus on lower yielding first lien senior secured loans to larger borrowers, which we believe will improve our ROE. In connection with this new financing facility, the company's investment advisor has agreed to waive a portion of its base management fee, it has agreed to reduce its base fee to 1% from 1.75% on assets held in the senior loan subsidiary when statutory leverage is above one times debt to equity. We deployed approximately $41.3 million in the third quarter, consisting of $13.4 million to existing portfolio companies and $27.9 million in five new companies. The new investments consistent mostly a floating rate senior secured loans to larger companies funded through our new financing facility and our SBIC. Turning to the financials, starting with the income statement, total investment income for the quarter was approximately $13.9 million approximately a $1 million increase over the second quarter. This increase was driven by a higher overall invested balance during the quarter partly offset it by declining LIBOR. Total expenses of $9 million increased $1 million compared to the prior quarter. This increase was driven by interest expense due to higher outstanding line of credit balances used to fund our investments and management fees due to more dollars invested during the quarter. Resulting net investment income per share of $0.36 remain stable again, this was above our $0.34 distribution. Net unrealized appreciation approximated only 0.6% of the overall cost of our investments. Turning to our balance sheet, we had approximately $8 million of un-invested cash at the end of the quarter, compared to $9 million last quarter. Of the $8 million of cash on our balance sheet, $4 million of that cash was in our SBIC. As Bilal mentioned, shortly after quarter end, we priced and closed a $50 million seven-year bond offering at 5.95%, which we use to paydown our PacWest line of credit. As of earlier this week, we have approximately $1.6 million of cash $100 million of undrawn commitment on our PacWest line of credit and $102.8 million of undrawn commitment on our new senior loan facility. Please note that cash and our loan facilities varies based on the asset mix and the amount of cash we deploy as equity. Our debt to equity ratio at the end of the quarter was about 1.2 times excluding our SBIC debt, and 2.1 times including the SBIC debt. As previously mentioned on this and prior calls, the SBIC does not count towards the leverage test. As also mentioned we would be comfortable increasing our leverage further in order to invest in senior secured loans of larger companies, which will primarily be done through our new senior loan subsidiary. Our net asset value was $12.74 per share compared to $12.95 in the prior quarter. The decline was largely due to net unrealized appreciation related to fair values determined at the end of the quarter. I would like to discuss in further detail the reason for the net unrealized depreciation fair value this quarter. A substantial portion of the unrealized depreciation related to Constellis a portfolio company that provides security, operational and risk management support to government and commercial clients. I want to note that the company is current on its payments and based on discussions with management they have stressed that they have adequate liquidity to fund operations. The company has a growing backlog and expects sequential performance improvement. The sponsor has substantial amount of cash invested in this business and we expect continued focus from the sponsor. As Bilal mentioned in this environment, we believe that certain loan prices have been disproportionately penalized even for slight underperformance which is reflected in lower loan bids and trades that negatively impact fair value. The broader lending environment has had softness and over the last year, loan prices have been soft relative to their peaks in October of 2018. We believe this is in large part related to supply demand imbalance resulting from 12 straight monthly outflows of cash from retail funds and invest in loans. More recently, we believe that this imbalance in a broader market has begun to shift the balance in favor of lenders who have more influence on loan structures. Turning back to our portfolio, as Bilal mentioned, we had no new nonaccrual this quarter at fair value we currently have only 0.1% of the portfolio on nonaccrual, at cost we currently have only 2.5% of the portfolio on nonaccrual. This is the fifth consecutive quarter with no new nonaccruals. Looking at the overall health of the portfolio, we saw the majority of our borrowers exhibit a quarter-over-quarter increase in revenue. We continue to watch our portfolio closely and we are not seeing any significant sector concerns in our portfolio. As far as our investments at the end of the quarter, we had investments in 73 companies totaling approximately $502 million on a fair value basis. As a percentage of cost, our investments were approximately 78% senior secured loans, 11% subordinated debt, 4% structured finance notes and 7% equity approximately two-thirds of which is in preferred equity securities. 90% of our loan investments were floating rate. Our portfolio remains diversified with an average investment in each portfolio company of approximately $6.8 million or 1.4% of the portfolio’s total fair value. The overall weighted average yield to cost on our performing debt investments was approximately 10.8% at September 30, compared to 11.4% at June 30. As expected, most of that decrease was driven by our focus on loans to larger companies, many of which are in the new senior loan subsidiary. Before I turn the call back to Bilal, we would like to highlight one of our investments from the quarter, New York Bariatric Group. We made a $10 million investment in a floating rate senior secure term loan, founded nearly 20 years ago, New York Bariatric Group is one of the largest providers of bariatric surgery and weight management solutions in the U.S. The five year facility has a full covenant package. The last dollar of debt leverage at closing was approximately 3.8 times and the pricing stands today at 7.1%. With that, I will turn the call back over to Bilal.

Thank you, Jeff. In closing, our net investment income once again covered our distribution in the quarter. While we continue to ramp up our senior loan subsidiary, we have been steadily increasing our allocation to first lien loans and remaining selective. We are proud that since the beginning of 2011, OFS has invested approximately $1.2 billion with a cumulative net realized loss of principal of only $900,000 or just 0.07 percent while generating attractive yields on our portfolio. Looking ahead, we remain confident in our earnings power. We have attractive long-term financing in place. We believe this financing will provide us the operational flexibility, we need to weather a potential economic downturn. In addition, we believe our portfolio consisting primarily of senior secured loans, positions as well for the current economic environment. In addition, by taking advantage of our higher leverage allowance, we believe that we can increase ROE of the BDC, while improving its overall risk profile by investing in senior secure loans of larger companies. With three rate cuts this year alone, and growing economic uncertainty, investors are increasingly focused on long-term capital preservation by relying on an experienced manager. Our advisor oversees a $2.2 billion corporate credit platform and its long standing investment platform has gone through multiple credit cycles over the last 25 years. We believe our loan loss track record demonstrates both our experience and alignment of interest. Since our advisor is the largest shareholder in the BDC with more than 22% ownership. With that operator, please open up the call for questions.

[Operator Instructions] And the first question comes from Mickey Schleien with Ladenburg.

Yes, good morning everyone. In your prepared remarks you mentioned the stress in the more liquid loan markets and clearly, as you said, some of that weakness is due to fund outflows due to declining LIBOR, but I think the markets also realizing that deal turns in some cases have been too aggressive, and fundamentals are deteriorating especially for companies whose business models may have been dislocated by the Internet or those that have been too acquisitive and maybe optimistic on their synergies. There's also increased bifurcation between good credits and those proceeds to be weak. So can you be a little more specific on what areas of the more liquid markets are most interesting to you? And, where do you think the market is mispricing those credits?

Thanks Mickey, I think that's a very good commentary, and good question. I think generally, you're seeing a lot of negative press in the market regarding the broader leverage loan market. And I think you're absolutely right, I think over the last few years, you have seen some deterioration in terms of structures, leverage, pricing has been compressing. And so, I think that that is - certainly has been a worry out there. I think where the opportunities arise, are situations where people are trying the baby with the bathwater, so to speak. Where there are certain sectors that are getting beaten up. For example, retail is one sector that has been, beaten up quite a bit. But there are some places within the retail sector certain companies that are actually doing well. Then on the healthcare side, within the pharma area you're seeing there as well, with some of the hangover from - the opioid crisis, certain companies are getting beaten up more and their share even though the performance, in fact, has been pretty good. So I think generally speaking, there's the overall negativity around the leverage - broader leverage loan market, which is creating some interesting opportunities, across different sectors, but I think within certain sectors, it's - the market has a negative view of the overall sector. And even though there are certain companies within those sectors - that could be interesting based on their performance. And so and then, as I was mentioning, and I think Jeff mentioned in his remarks, situations where, the company's long-term good performer - and has maybe one quarter of bad results. And suddenly, you're seeing because of the anxiety in the market, that the known price drops by five points three points, seven points on the day. And even though, that companies actually, is a good long-term performer - and is going to be in our opinion, fine in the long run. And I think that, those situations also create some interesting opportunities in the market. So I think, we're watching it, vigilantly and I think as those opportunities arise, we will take advantage of those. As we said earlier, we managed 2.2 billion of assets and about 1.5 billion are in some of those larger loans.

Mickey, I guess I would also add that the practical reality is that, CLOs are very large holder of loans in this sector. We have seen as we mentioned the retail fund outflows. But, as the Bilal mentioned, you see a fundamentally sound company that has one or two quarters of poor performance and the trading prices react very quickly, the managers of CLOs are reacting to collateral buckets and concentration limitations. So they're selling in some instances very quickly, which we think puts undue downward pressure on the price of these. So they’re managing through a vehicle which creates opportunities for others that have more flexibility.

Actually, Jeff I wanted to ask you about CLOs and even though we don't have the Q in front of us. I think you mentioned you're still holding some CLO investments. That market is practically frozen right now due to the fears of those CLOs tripping - their CCC buckets. So how do you feel about the outlook for cash flows to CLO equity and to the extent there is liquidity, which I know right now really limiting factor. How do you feel about increasing your CLO allocation at OFS Capital?

Yes, Mick I would say that right now that accounts for less than 5% of our investment portfolio. We expect it to remain a very small part of that portfolio. It is an asset class that we know very well. As you know we manage CLOs, we also invest in CLO equity and debt. And we don't expect meaningfully increase exposure to CLOs.

All right. And Jeff and Bilal given that you manage lot of money and you've been at this for a while in the more liquid markets, just at a 30,000 foot level, when you see a market like this where fear is impacting what you would consider generally good credits? Is that some sort of a signal of a bottom of the market or is it too early to tell?

Yes, I think it's too early to tell. Right now, I think there is a decent amount of uncertainty in the market with respect to what's happening with the trade war with China, and just overall global economic outlook softening, and then you have other political exogenous events like Brexit et cetera. So I think it's too early to tell at this point in my opinion.

Okay, I appreciate that information and your time this morning. That's it for me. Thank you.

Thank you. And at this time, I would like to return the floor to Bilal Rashid for any closing comments.

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. The conference call is now concluded. Thank you for attending today's presentation. You may now disconnect your lines.