OFS Capital Corporation (OFS) Q4 2019 Earnings Report, Transcript and Summary

Good day, and welcome to the OFS Capital Corporation Fourth Quarter and Full Year 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 Mr. Steve Altebrando. 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 fourth quarter and full year 2019 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 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 those 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 Chairman and Chief Executive Officer, Bilal Rashid.

Thank you, Steve. Good morning and welcome. Our net investment income per share was $0.34 for the third quarter, which is in line with our quarterly distribution. For the full year 2019, our net investment income was $1.43, which exceeded our annual regular distribution. We have now declared 29 straight quarterly distributions of $0.34 per share since our IPO in late 2012. We have declared $9.72 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 outearning it over the past five years, puts us in select company within the BDC sector. We attribute these results to being selective in our sourcing and underwriting as well as our ability to obtain favorable financing for the BDC. Turning to results from the fourth quarter, we continued to make progress in ramping up our senior loan subsidiary, which was established in the second quarter of 2019. We invested $52.5 million this quarter, of which $24.2 million was in the senior loan subsidiary. We established the senior loan subsidiary with the expectation that it would help improve the overall risk profile of the BDC, while increasing our ROE. Our reduced management fee on assets in the facility, along with incremental leverage permitted under the Small Business Credit Availability Act have enabled us to invest in higher quality loans to larger borrowers that previously did not meet our return targets. We believe that we have an advantage in this part of the market since our adviser has been investing in these types of loans for more than 25 years and currently has approximately $1.6 billion invested in these types of loans through other funds. As we have mentioned on previous calls, we continue to gravitate towards senior secured loans based on how we view the private loan market. As a percentage of fair value, approximately 90% of our loan portfolio were senior secured at the end of the fourth quarter compared to 76%, two years ago. Our net asset value per share at the end of the quarter was $12.46 compared to $12.74 in the prior quarter. The quarterly decline in NAV was largely due to unrealized losses related to fair values determined at the end of the quarter. Before turning the call over to Jeff, I would like to discuss the potential impact of COVID-19 on our portfolio. Recognizing that the impact of the outbreak is still evolving, we are monitoring the situation very closely and are in regular contact with our portfolio companies. Although it is hard to predict the overall impact of the outbreak on our portfolio, we have been positioning our portfolio defensively for some time now, given that we believe that we are in the late stages of the economic cycle. We have been concentrating on noncyclical sectors with minimal direct exposure to oil and gas, metals, mining, airlines or travel. 90% of our portfolio is senior secured based on fair value. We believe this seniority in the capital structure will provide greater downside protection. Lastly, we have always been thoughtful about how we finance the BDC so that we can increase the likelihood of withstanding periods of market dislocation. For example, our bonds are long-term and unsecured which affords us maximum operational flexibility. Our senior loan financing facility has no mark-to-market provisions and is nonrecourse to the BDC. And our corporate line of credit is highly flexible as well with no mark-to-market provisions. We have always put an emphasis on structure over pricing. 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. As Bilal mentioned, our net investment income was once again in line with our distribution, and we made significant progress ramping up our senior loan financing facility. We continue to believe the senior loan entity that we established in mid-2019 is attractive for our shareholders. By increasing our focus on first lien senior secured loans to larger borrowers, we believe we will further improve the quality of the portfolio and our ROE as we further execute on this portion of our strategy. As you may recall, in connection with this senior loan financing facility, the company's investment adviser 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 all assets held in the senior loan subsidiary. We deployed approximately $52.5 million in the fourth quarter, consisting of $7.1 million to existing portfolio companies and $45.4 million to 14 new companies. The new investments consisted of many floating rate senior secured loans to larger companies. Turning to the financials, starting with the income statement, total investment income for the quarter was approximately $13.4 million, a decrease of approximately $400,000 from the third quarter. This decrease was driven by lower interest income during the quarter due to one new nonaccrual and declining LIBOR rates. Total expenses of $8.9 million were largely unchanged from the prior quarter. Resulting net investment income per share of $0.34 for the quarter was in line with and covered our $0.34 distribution. Turning to our balance sheet, we had approximately $13.4 million of uninvested cash at the end of the quarter, $3.8 million of that cash was in our SBIC. Subsequent to the end of the quarter, we repaid approximately $16 million of SBA debentures, as part of our plan to focus on lower-yielding first lien senior secured loans to larger borrowers, which we believe will improve our overall risk profile. We intend to repay the outstanding SBA debentures over time as loans in that fund pay off. Our debt-to-equity ratio at the end of the quarter was about 1.2 times, excluding our SBIC debt and 2.1 times inclusive of our SBIC debt. As mentioned on prior calls, the SBIC debt does not count towards the leverage test. Our net asset value was $12.46 per share compared to $12.74 in the prior quarter. The decline was largely due to net unrealized depreciation related to fair values at the end of the quarter. We had one new nonaccrual this quarter with a portfolio of company called Constellis. This company provides security, operational and risk management support to government and commercial clients. We had already written a loan down substantially in the prior quarter, and it was further written down this quarter when it became clear that the company would not be making further interest payments in late December. At fair value, we currently have only 0.1% of the portfolio on nonaccrual. At cost, we currently have 4.3% of the portfolio on nonaccrual. This was the first new nonaccrual in the last six quarters. Looking at the overall health of the portfolio, we saw a majority of our borrowers exhibit a quarter-over-quarter increase in revenue as well as EBITDA. We continue to watch our portfolio closely. As Bilal mentioned, we are monitoring the impact of COVID-19 on our portfolio and are in constant contact with our borrowers. We do expect to see some impact from COVID-19, however, at this point, we are not sure how the length and depth of this virus will play out and how it will impact our borrowers. As far as our investments, at the end of the quarter, we had investments in 89 companies totaling approximately $517 million on a fair value basis. 93% of our loan investments were in floating rate loans. We have LIBOR floors on approximately 70% of our floating rate loan portfolio with an average LIBOR floor of 1.1%. As a percentage of cost, our investments were approximately: 78%, senior secured loans; 11%, subordinated debt; 4%, structured finance notes and 7%, equity, of which approximately 60% of our equity was in preferred equity securities. Our portfolio remains diversified with an average investment in each portfolio company of approximately $6.8 million or 1.3% of the portfolio's total fair value. The overall weighted average yield to cost on our performing debt and structured finance note investments was approximately 10.4% at December 31, compared to 10.8% at September 30. This decline was mostly driven by our focus on loans to larger companies, many of which are in the new senior loan subsidiary, which has a more attractive cost of financing. Before I turn the call back over to Bilal, we would like to highlight an investment from the quarter. We invested approximately $13.1 million in All-star Auto Lights through a floating rate senior secured term loan. All-Star Auto Lights is a distributor of new and refurbished automotive headlights to independent collision repair shops and multi-shop operators throughout the country. We believe the company is a leader in its industry and serves over 3,500 customers across more 5,500 locations. We expect this segment of the automotive aftermarket services sector to perform well during cyclical downturns. The five-year facility has a full covenant package, and the pricing is at LIBOR plus $750. 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. In 2019, we continue to meet our distribution and defensively positioned our portfolio, which we believe will serve us well through this period of uncertainty. We have been steadily increasing our allocation to senior secured loans. We are proud that since the beginning of 2011, OFS has invested approximately $1.3 billion, with accumulative net realized loss of principal of only $3.9 million or just 0.3%, while generating attractive yields on our portfolio. Our portfolio consists primarily of senior secured loans. We have attractive long-term financing in place which we believe gives us operational flexibility in the current market environment. Lastly, we benefit from the experience of our adviser, which manages a $2.1 billion corporate credit platform. Our adviser has gone through multiple credit cycles over the past 25 years and has a strong alignment of interest with all shareholders with more than 22% ownership of its shares. With that, operator, please open up the call for questions.

Thank you. We will now being the question-and-answer session. [Operator Instructions] And our first question will come from Mickey Schleien of Ladenburg. Please go ahead.

Yes, good morning everyone. And given all the volatility I have several questions. So please bear with me. I'll start by asking the following. I imagine that when you underwrite investments, you assume a recession in the downside case. In my view, if we're not already in a recession, we'll probably be one in very soon and perhaps it will last for a couple of quarters. So assuming I'm right and we have a conventional recession, but not a crisis, like in 2008 and 2009, then how much downside would you see to your average borrowers EBITDA? And how do you believe the portfolio will perform in terms of covenant compliance and defaults?

Hey Mickey, this is Jeff. Each company is stressed differently depending on the industry that it operates in, in the specific sector within that industry. But typically, I will say when we stress things on the downside, we stress them for more than a year. And usually, the shock occurs within the first couple of years of funding. And right now, based on the current environment, we've been shocking the companies generally in that first subsequent fiscal year post close. So we're hitting them on the front end, typically for more than a few quarters. And again, depending on the industry, each one varies. When you do have a full covenant package, our goal is to set the covenants relatively tight so that we can monitor stress. The borrower's goal is to set covenants as loose as possible. So it's a negotiation at closing. But so predicting how assets will perform vis-à-vis their covenants is very difficult at this point.

I understand Jeff. Couple of high-level questions just to get a better understanding of essentially what are two origination channels, could you compare the sourcing channels that you use in the underwriting processes for your lower versus your higher yielding investment buckets?

Sure, yes. So I think when you talk about lower-yielding investments, I mean, these are larger companies. And so we have a team of individuals who focus on those larger borrowers. And those investments are generally originated by other institutions, they tend to be larger banks. And so that sourcing really happens through those large institutions. And we’ve been in the market, as you know, for the last 25 years. And so we have very close relationships with really all the major financial institutions, which are – would be mostly banks. And so that team then once the deal comes in, then evaluates that transaction. And that team is really – is set up under industry lines. And so as soon as the transaction comes in, we take a look at it, if it meets our criteria in terms of the industry. So for example, one of the ways we think we hope to be protected against a recession or we mitigate the impacts of the recession would be avoiding certain industries. So if you look at our portfolio, historically, we’ve avoided oil and gas, metals and mining. If you look at our portfolio, we don’t have in our BDC, travel and leisure, et cetera. So we’ll look at that, look at the industry, if we like the industry, then we start doing the underwriting there, and these are generally transactions that are backed by large private equity sponsors, and we will underwrite the transaction by all the metrics that we would look at there from a leverage standpoint, we look at the pricing, obviously, look at any customer concentrations, barriers to entry. So all the usual evaluating factors that we would use to underwrite those transactions. So it’s a fairly extensive underwriting process that we accomplish. And that process can take anywhere from two to three weeks in that channel. As it relates to middle market companies, where we are originating those loans. There, we have a significant team of individuals who are sourcing those transactions for us as well. That’s our middle-market direct lending team. And both these teams work very, very closely with each other. And so that team – there are few sources. There’s traditional private equity sponsors that we have relationships with. In some cases, the deal flow comes in from banks, local banks will come to us and say, we have a client, and we can’t fulfill their needs. Would you come in and help us provide this financing. And then you have certain firms that are called fund-led sponsors, so these are our independent sponsors, and so those are institutions that don’t have a committed fund, but they actually bring in capital on a deal-by-deal basis. We have extensive relationships with them. And then in some cases, we have situations where we have direct relationships with the individual companies themselves. These are management owned or family-owned businesses as well. And so we have a database of now more than 15,000 market participants that we are maintaining and improving all the time. At any given time, we have two or three individuals who are on the road spending time in various different cities that – and meeting all these market participants and so that’s how the deal flow actually comes in. That allows us to be very, very selective, having this very broad way of sourcing transaction. We end up doing less than 3% of the deals that actually come in through that channel. And so when those deals come in, the underwriting process for those is a little more expensive. Those deals, it will take somewhere between six to 12 weeks to underwrite those transactions. We are doing really primary due diligence in those transactions. So we will be – in many ways, we’re doing the work that a private equity sponsor would be doing for private debt transactions. So it’s a fairly extensive process. We are doing, obviously, all the financial analysis, the company – the complete place in the industry, the competitive landscape, customer and supplier concentrations. We are doing background checks, we’re doing legal due diligence, we’re doing tax due reliance. So it’s a really very, very extensive process and once we underwrite the transaction, then it goes into portfolio management. And it’s the same team that does origination, underwriting and portfolio management. So there’s really great continuity and also alignment of interest. So anyone who sources a deal, has to also manage the deal. So they are bringing good deals that they want to manage over time. And so one other way that we are differentiated is that in a majority of the middle market deals that we are originating, we get either board seats or board observation rights. So that’s really important because I think there, it gives us live information. In many cases, it gives us the ability to overseas and affect any change in the company as well. So that’s how we are differentiated. And I think that’s really the reason why, as I would mention, as I mentioned in my prepared remarks that over the last almost now 10 years, we’ve invested more than $1.3 billion of capital and our cumulative realized net losses have been only 0.3%. And so over a 10-year period, almost, it’s a 0.03% annualized loss ratio. So it’s a fairly extensive process of sourcing, underwriting and portfolio management on both sides of how we invest in deals.

And Bilal, if I could just follow-up and to make sure I understand. Let’s call one strategy, sort of the lower middle market strategy and the other one is more of a middle market to maybe upper middle market strategy. How do the EBITDAs differ on average between those two strategies?

Yes. So, I think the larger middle market or the – some of the syndicated loans, I would say it’s somewhere in the $30-plus million EBITDA range. So the syndicated loans, obviously, are going to be $100 million or higher. But the upper middle market would be somewhere in the $30 million to $50 million range. So that’s one part of the market. And then the lower middle market part of the market is going to be how I would define it as about $5 million to $30 million EBITDA out of the market.

Okay. I understand. And given all the volatility that we’ve seen the last few weeks, Bilal, where are you seeing the most interesting risk-adjusted opportunities today?

Yes. It’s actually very interesting. I think the – obviously, to take advantage of the volatility in the market, we – you would have to look at the liquid part of the market because you can take advantage of it right away. And I think that in the first lien loans in the syndicated market, I think you’re seeing – beginning to see some attractive opportunities there because if you – as you have most likely followed. I mean, the loans, the syndicated loans are down 7% in just two weeks, which is a – it’s just incredible amount of decline. And I think we are certainly one – I mean, this is my own view, we want to stay away from oil and gas and some of the cyclical parts of the market, airlines, travel and leisure, et cetera, right now, but there are some really good, solid companies that are in good sectors, good performers, good sponsor backing that are trading at fairly attractive levels. So, I think that’s certainly one part of the market that would be – that is becoming attractive. I think the other part of the market that could be attractive, and clearly, that’s not our main focus in the BDC but we certainly have a lot of experience in it is when you’re seeing the CLO market, where there could be some interesting opportunities in the lower part of the CLO structure, especially I think the BBs, which have a really very good long-term track record. And if you can get double-digit yields there, that could be interesting as well. And as you know, we have a long-standing experience in investing in CLOs and managing CLOs. So that could be an interesting path as well. But I would caveat by saying that the main thrust of our strategy in the BDC is not investing in CLOs, but opportunistically, that could be an interesting place as well.

Yes. I would agree with that. Bilal, a couple of questions on the SBIC. You caught me off guard, frankly, because most BDCs are eager to employ SBIC financing, given its inherent advantages. And since you already have a team doing directly originated business with smaller companies that would normally – a good portion of that would fit into the SBA profile. So what aspect of that program has caused you, just to decide to wind it down?

Mickey, this is Jeff. I think it’s really – our focus is starting to go up market a bit. We have some very attractive financing in place with BNP that, quite frankly, the pricing is more attractive than the debentures. The debentures do have a maturity schedule that is starting to kick in, in the next few years. And we – to start to lock into new long-term five-year deals. So it’s a number of things, but I think it’s primarily related to our focus to start to move upmarket, first lien senior secured loans to larger borrowers to improve the risk profile of the BDC over time. So this is just – as deals pay off in that fund, we generally intend to delever that fund.

So Jeff, given the normal course of repayment activity, how long do you think it would take to wind down the SBIC?

Unfortunately, we’re not in normal course right now. But it’s a multiyear process.

Understand. And in your press release, you commented that winding down the SBIC will reduce your overall leverage on a consolidated basis. I’m not quite sure I understand what you’re referring to. Are you talking about portfolio leverage or your balance sheet leverage or some other metric of leverage? Can you define that a little bit more?

Yes. That really relates to our balance sheet leverage. And as you know, the SBA debentures are carved out of regulatory leverage. So we have higher leverage than some other BDCs because we get the benefit of not counting the SBA debentures in our regulatory test. So as those start to go away, our actual leverage, putting aside regulatory leverage for the moment is expected to decline.

So everything else equal, you expect your balance sheet to employ lower leverage – total leverage over the course of this unwinding?

That’s right.

Okay. And just a couple more questions, and I appreciate your time. What is the average LIBOR floor in the portfolio?

Yes. So the average LIBOR floor in a portfolio is about 1.1%. So it is – it’s protecting us today.

Okay. And how does the senior secured bucket breakdown between first and second liens?

About 22% of our senior secured’s are second liens.

Okay. And my last question, were there any one-time adjustments to interest income this quarter?

One-time adjustments, I mean, nothing that’s jumping out at me as anything immaterial now.

I’m referring to, in some cases, I’ve seen where something that’s being put on nonaccrual, there’s a reversal for previous income that may have been accrued or something like that?

I mean, we have Constellis, as we said, as a new nonaccrual, but nothing that I’m thinking of that’s unusual or immaterial, no.

Okay. And Constellis was on nonaccrual for the entire quarter?

Mickey, I’d have to get back to you on that.

Okay.

I think that might have a non calendar quarter interest payment cycle in – I think that we picked up, I think we did pick up two months of interest income on that, that was paid in cash.

Okay. Those are all my questions this morning. I very much appreciate your time. Thank you.

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. Please go ahead sir.

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.

The conference has now concluded. Thank you for attending today’s presentation. You may now disconnect.