OFS Capital Corporation (OFS) Q2 2020 Earnings Report, Transcript and Summary

Good day and welcome to the OFS Capital Corporation Second Quarter 2020 Conference Call. All participants will be in listen-only mode. [Operator Instructions] After today's presentation, there will be an opportunity to ask questions. Please note that this event is being recorded. I would now like to turn the conference over to Steve Altebrando. Please, go ahead, sir.

Good morning, everyone, and thank you for joining us. Also on the call 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 second 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 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 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 Chairman and Chief Executive Officer, Bilal Rashid.

Thank you, Steve. Good morning and welcome. We hope that you and your families continue to be safe and healthy. Given the challenging economic and public health impact of the ongoing COVID-19 pandemic, we are pleased that during the quarter our portfolio companies performed above our expectations. In the second quarter we had only one loan placed on non-accrual out of a portfolio of 73 investments. In fact, we are encouraged that in this environment some of our portfolio companies have identified opportunities for growth, both organically and through acquisitions. We are prepared to support these companies as they pursue these opportunities. Our NAV per share increased in the second quarter, approximately 4% from the prior quarter to $10.10. The quarterly increase in NAV per share was largely due to unrealized gains related to fair values determined at the end of the quarter. Our net investment income of $0.19 per share was greater than our distribution of $0.17 per share. As you would expect, we continue to maintain close contact with our portfolio companies and remain focused on working with our borrowers to get through what is clearly a challenging and uncertain period. As mentioned, we have been positioning our loan portfolio more defensively in terms of both industry selection and seniority in the capital structure. As a percentage of fair value, approximately 87% of our loan portfolio was senior secured at the end of the second quarter compared to 77% two years ago. We have been concentrating on non-cyclical sectors with minimal direct exposure to oil and gas, metals, mining, restaurants and airlines. We have also been prudent in our approach in limiting the number and amount of revolving known facilities offered to our borrowers. We had just $9 million in revolving debt commitments, $4.3 million of which were undrawn at the end of the quarter. It has been our long-standing practice to keep our revolving debt exposure to a minimum, which we believe has once again helped us with our current liquidity position. Turning to net investment income, we generated $0.19 per share for the second quarter. The decline in net investment income was related to various factors. First, we paused our origination activities during the second quarter due to uncertainty related to the COVID-19 pandemic and the slowdown in M&A activity. In addition, we decided to hold a large cash position throughout the quarter, which we believe was a prudent approach, despite its impact on earnings. Jeff will provide more details on other contributing factors later in the call. We anticipate that as we begin to deploy capital into add-on and new investments and optimize our portfolio, our investment income will grow. This morning we declared a $0.17 per share distribution for the second quarter, same as we did last quarter. Given the significant uncertainty related to the COVID-19 situation, we continue to take a cautious approach to our distribution. We believe that this decision will enhance our liquidity and strengthen our balance sheet. Going forward, we believe that our liquidity position will allow us to support our portfolio companies and use our capital opportunistically, as the broader economic picture becomes more clear. With regard to our balance sheet, we believe that we have ample capital on hand with approximately $31.8 million in cash and additional capacity to draw on our credit facilities. Turning to our liabilities. Our flexible financing improves our ability to withstand market dislocation. As of June 30, over 90% of our debt had stated maturities in 2024 or later. Our long-term unsecured debt makes up 45% of our debt outstanding as of June 30. Our senior loan facility matures in 2024 and is non-recourse to the BDC. And our corporate line of credit is flexible as well with no mark-to-market provisions. We expect that this will provide us with operational flexibility in the current environment. We believe that the BDC's adviser has the expertise and scale to invest across the loan and structured credit markets with more than $2.1 billion in assets under management. In an unprecedented environment like this, we believe that we are able to identify relative-value credit opportunities across multiple markets. The BDC adviser has a team of investment professionals with long-standing experience in credit underwriting and restructuring across industry verticals. Our adviser's credit platform has been in existence since 1994 and has gone through multiple credit cycles, navigating recessionary environments to maximize potential recoveries. As you know, the adviser owns 22% of the outstanding shares of the BDC. In our view this key alignment of interests is always important but in this environment, we believe even more critical. You can be assured that we are working hard every day to protect our investments and drive the business forward for the benefit of all our shareholders. 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. Like Bilal said, we've recognized it continues to be a trying time and we are grateful for the health of our families and employees. We appreciate you joining us today and hope you are doing well and staying safe and healthy. Turning to our financial results. Starting with our balance sheet, we had approximately $31.8 million of cash at the end of the quarter. $22.7 million of that cash was in our SBIC, which may be used in part to support our existing portfolio companies. Our debt-to-equity ratio at the end of the quarter, excluding our SBIC debt was approximately 1.5 times. At the end of the quarter, our regulatory asset coverage ratio was 166%. As you may recall the SBIC leverage does not count towards the regulatory asset coverage ratio. Our net asset value per share at the end of the quarter was $10.1 compared to $9.71 in the prior quarter. This approximately 4% increase was primarily driven by higher fair value marks on our investments. Of the 73 investments in our portfolio, we added just one new non-accrual in the quarter, 3rd Rock Gaming is a first lien senior secured investment. We have rescheduled 3rd Rock Gaming's June 30th principal on interest payment. The impact of COVID on its customers which include gaming venues has been substantial due to social distancing needs. The delays in reopening the venues and the timing associated with the return of significant customer traffic is unknown. The fair value as a percentage of cost was taken down to 61.5% this quarter from 81.4% last quarter. We currently have 4.9% of the portfolio on non-accrual at fair value. Turning to the income statement, Total investment income for the quarter was approximately $11 million, a decrease from $12.9 million in the first quarter. This decrease was primarily driven by three factors; lower interest income during the quarter due to declining LIBOR rates; the new non-accrual I just mentioned; and the decision to hold a large cash balance during the quarter due to the uncertainty in the current environment. We have since used some of that cash to repay a portion of our PacWest line of credit. Total expenses of $8.4 million were down approximately $500,000 due to lower management and incentive fees as well as lower professional fees. Resulting net investment income per share was $0.19 for the quarter. As Bilal discussed, we declared a distribution of $0.17 earlier this morning. We believe that this rate will enhance our liquidity and strengthen our balance sheet, so that we can continue to support our borrowers and capitalize on potential new opportunities. Turning to the portfolio, we continue to actively work with our portfolio companies to help them get through the challenges associated with COVID-19. We are working through liquidity solutions and other actions that will allow our portfolio companies to maximize value. At this point, we are still not sure how the length and depth of this virus will play out and how it will fully impact our borrowers. We believe that our highly selective investment process and focus on capital preservation may positively impact how our portfolio performs. As far as our investments at the end of the quarter, we had investments in 73 companies, totaling approximately $438.4 million on a fair value basis. 90% of the fair value of our loan investments were in senior secured loans, 87% of our loan investments were floating rate loans. We had LIBOR floors on approximately 89% of our floating rate loan portfolio with an average LIBOR floor of 1.16%. This compares to three-month LIBOR at June 30th of approximately 30 basis points. As a percentage of cost, our investments were approximately 74% senior secured loans, 12% subordinated debt, 7% structured finance notes, and 7% equity of which approximately 54% of our equity was in preferred equity securities. Our portfolio remains diversified with an average investment in each portfolio company of approximately $6 million or 1.4% of the portfolio's total fair value. The overall weighted average yield to cost on our performing debt and structured finance note investments remained consistent quarter-over-quarter at approximately 10.1%. With that, I'll turn the call back over to Bilal.

Thank you, Jeff. In closing, we believe that our solid liquidity position will help us to weather the current economic situation, take advantage of potential investment opportunities, and support our existing portfolio companies. Currently, we are evaluating both new investments as well as add-ons for a couple of our borrowers that are pursuing growth and acquisition opportunities. We remain focused on strengthening our balance sheet. We continue to proactively manage our portfolio and help our borrowers to navigate this difficult and uncertain economic environment. Since the beginning of 2011, OFS has invested $1.4 billion with a cumulative net realized loss of principal of only $14 million or just 1% while generating attractive yields on our portfolio. We have been steadily increasing our allocation to senior secured loans and our portfolio consists primarily of such loans. We have also been increasing our exposure to larger borrowers. Our financing is primarily long-term. As of June 30, 90% of our debt matures in 2024 and beyond. We believe that this 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 is part of an asset management group with over $30 billion in assets with broad resources including long-standing banking relationships. Our adviser has gone through multiple credit cycles over the past 25 years and we believe it has a strong alignment of interest with all shareholders with a 22% ownership interest in the BDC. We also believe that we have a strong team of investment professionals with industry expertise and restructuring experience to help us through this period. Finally, I want to thank our employees who have done an incredible job over these last several months. We remain committed to their safety and well-being. OFS continues to work diligently to respond to the continuing situation especially by supporting our portfolio companies. With that, operator, please open up the call for questions.

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

Yes, good morning everyone. I hope everyone is safe and healthy. I have a handful of high-level questions and one housekeeping question. So let me start out by asking you about your investment thesis on the loan market, because prior to the pandemic most market participants were in general agreement that we were in late stages of the cycle, but the pandemic effectively accelerated the process. What is your view on the possibility that we are now in the early stages of a new cycle effectively?

Sure. Thanks a lot Mickey. That's a very good question. I think that, certainly I think we are in the beginning of a new cycle. It's obviously different than the prior cycles just because of the uncertainties around this time around. I think we are -- have some significant uncertainties around the health care situation still. And so I think the thesis going forward at least in the short run for us as it relates to investments is focusing our attention on what we believe at least in the near-term on what we call COVID-defensive sectors and staying away from sectors that have some exposure or significant exposure to the health care situation. And I think the other piece of our thesis is to focus at least initially on portfolio companies, in which we already have existing exposure. So I think -- from that standpoint I think there -- the big benefit is that these are companies that we are very familiar with and these are companies that are actually doing well during this environment, and need money for expansion or are looking for capital to acquire some potential competitors. So the thesis again to summarize is to, even though it's early stage in this new credit cycle, it is to focus initially on add-on investments and then focus at least in the short run here on sectors that we believe are COVID-defensive.

Yeah. Mickey and this is Jeff. I would also note that, we've been in the process of this over the last two years, but continuing to focus on moving up the capital structure focusing on first lien senior secured borrowers and slightly larger companies. So this is a process that we began as part of the last cycle. I think it proved well as part of this recent downturn, and I think we're going to continue to focus on moving up the capital structure and more senior secured loans.

Yeah. I understand Jeff. I'm just -- I'm curious, I mean, the leverage – the broad – broadly speaking the leveraged loan market has had a very strong recovery from the lows in March and spreads are tightening but I sort of agree with you that the next few quarters seem to have a great deal of uncertainty at least in my mind. So there seems – I mean, do you think there's a disconnect between prices in the leveraged loan market and risk? And is – apart from follow-on deals in companies that you know well that are COVID-defensive do you think the risk reward ratio in the market is interesting today?

Yeah. I think beyond those – the two types of investments that I spoke about earlier, I think I agree with you on that front. I think that it is possible that at least the broadly syndicated loan market may have gotten a little bit ahead of itself, because I think in many of those situations we still haven't received the Q2 financials yet. And so I think that that's the reason why our initial focus is going to be on add-ons and sectors that are fairly COVID-defensive. And I think – and because I think there still remained quite a bit of remains quite a bit of uncertainty going forward not just on the health care front obviously we are still – t here's uncertainty related to a vaccine and other treatments, but I think just the impact of almost 35% decrease in GDP in the last quarter, I think those impacts still are unfolding.

Yeah. I definitely agree. And in terms of the effect of the pandemic Bilal, how is that playing out in terms of competition amongst direct lenders like you in the middle market? We did see a dislocation of deal terms seem to be improving maybe not so much in terms of spreads but structures seem to be certainly better today than pre-COVID. Is that attracting actually more competition into the market and making it more difficult for you?

Actually, what I would say is that, in the middle market space, I mean, the deal flow has not been that great so far. And then I think that I – from what I hear from others is that others are also focusing on companies that they are very familiar with. And so the investing in a new company where potentially, it's hard to do the due diligence because just practically speaking it's hard to travel and meet the borrowers and visit the plant et cetera. So I think, because of some of those restrictions, there hasn't been a lot of activity in new issue transactions within the middle market. So it's hard to gauge how much competition we'll have, once the deal flow starts becoming normalized. But I think that, at this point, I would say, there's just not enough information to opine on that.

I understand. And my last question, sort of, a housekeeping question, but Jeff you mentioned climbing the capital stack. Could you break down your senior secured loan bucket between first lien and second lien please?

Sure, Mickey. About 23% of our overall senior secured loans are second lien and those do tend to be to some of the larger borrowers. And so, they have some liquidity in the market and they are tradable if we want to create liquidity with those loans. But, yes, less than one-fourth are second lien.

That's 23% of senior secured or 23% of the total portfolio?

23% of the senior secured.

Okay. That's helpful. Maybe one last question that just came to mind. Given the fact that you have a broad platform and you invest across the space. Do you have a sense that the ratings agencies are sort of waiting to see how second quarter results develop before they make decisions on potential additional downgrades or not?

I would say that there was a significant wave of downgrades in early April following year-end numbers, but they did begin to bring in more forward-looking expectations into that process and take action on those. And sometimes the ratings actions by the agencies tend to be clustered around payment dates. So I guess the short answer is, I'm not sure, but I think that the downgrades have been fairly significant. They slowed in May and June. I don't know how they're viewing the future, quite frankly. I don't know, Bilal, do you have anything you want to add or?

Yes. I mean, I would say that, since the initial onslaught of ratings downgrades, right after the pandemic hit. I mean, they've been relatively silent. And, I think, it is possible, Mickey as you're mentioning that they are looking wait -- towards the Q2 numbers that come out in early August, generally for these companies, to decide whether they want to take further action or not. I think they took action in many of the situations based on the expectations. And my guess is that, if the numbers actually come out worse than the expectations, then there could be potentially more downgrades. So I think we're probably a week or two weeks away.

I understand. That’s very helpful color, Bilal. Those are all my questions this morning. I appreciate your time. Thank you.

Thank you, Mickey.

[Operator Instructions] 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.