OFS Capital Corporation (OFS) Q2 2021 Earnings Report, Transcript and Summary

Good day. And welcome to the OFS Capital Second Quarter 2021 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 Capital Markets. 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 2021 results. This press release was subsequently filed on Form 8-K with the SEC. Both documents can be obtained under our 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'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, 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, everyone, and welcome. I hope that everyone and their families remain healthy and safe. We are pleased with the company's performance during the second quarter, as we continue to grow our earnings. Our net asset value has improved to $13.42 per share, which is approximately 8% above pre-pandemic levels at the end of 2019. There are some key takeaways from the quarter. Net investment income of $0.24 per share, up approximately 26% compared to the first quarter's net investment income. As a reminder, we had approximately $564,000 or $0.04 per share of duplicate interest costs in the first quarter related to our bond refinancing, an increase of approximately 12% in our NAV, which was $13.42 per share as of June 30. We increased our quarterly distribution by 9% compared to last quarter from $0.22 per share to $0.24 per share, marking our fourth consecutive quarterly distribution increase. Lastly, we had no new loans on non-accrual, which we believe demonstrates the continued improvement in the performance of our portfolio companies. The increase in our net investment income was largely driven by additional fee income and lower borrowing costs, resulting from our bond offering in the first quarter. We anticipate that there may be a future opportunity to further reduce the cost of borrowing on our existing debt, which in turn will help grow our earnings. The increase in our net asset value was largely driven by improvements in the performance in our debt investments and strong growth in our equity investments. One of these equity investments, Pfanstiehl, a global manufacturer of high-purity pharmaceutical ingredients, has performed especially well. While we primarily invest in senior secured loans, our investment strategy allows us to selectively make equity investments when we identify a strong opportunity. Since our IPO, we have invested approximately $39 million in the equity, as well as received warrants in more than 35 portfolio companies. To date, we have net realized gains of approximately $16 million on $14 million of invested capital. As of June 30, the remaining $25 million of capital still invested in our portfolio companies has a net unrealized gain of approximately $44 million. We believe that our asset selection before and during the pandemic, along with the strength of our balance sheet has enabled us once again to successfully weather an unprecedented crisis. Our adviser has navigated through multiple credit cycles and global economic disruptions over the past 25 years, and we relied upon this experience to help us successfully navigate the COVID crisis thus far. We also believe the resilience of our portfolio through the pandemic is a testament to our long-standing underwriting process. Our fundamental priority is to remain focused on preserving capital, while thoughtfully growing our earnings. We continue to originate loans to new companies, as well as increasing the size of our loans to existing portfolio companies as they grow organically or through acquisitions. Our portfolio remains defensively positioned both in terms of seniority in the capital structure and industry selection. As a percentage of fair value, approximately 95% of our loan portfolio was senior secured at the end of the second quarter. Our portfolio is diversified across multiple industries with our highest exposures in health care, technology, business services and manufacturing. In addition, we continue to avoid highly cyclical industries such as oil and gas, metals and mining. Our loans are largely floating rate and our financing is primarily fixed rate. Therefore, we view our portfolio as being well positioned to benefit from an eventual increase in interest rates. Looking forward, we expect that the broader economy will continue to improve over time due to the fiscal and monetary policies enacted over the past 18 months. This has incentivized overall M&A activity and the need for debt capital to finance this level of deal making activity. We have been actively reviewing potential investments from new borrowers, as well as existing borrowers for whom we are a trusted capital provider. While always selective, we see the current conditions as a solid backdrop to deploy capital, which we anticipate will lead to an increase in our net investment income in the long term. Our financing continues to provide us operational flexibility. As of the quarter's end, more than 90% of our debt matures in 2024 or later and nearly two thirds of our debt is unsecured. In addition, our senior loan facility matures in 2024 and is non-recourse to the BDC. Our corporate line of credit is flexible with no mark-to-market provisions. OFS Capital continues to benefit from the expertise and scale of its advisers. With more than $2.5 billion in assets under management, the BDC adviser has experience investing across the loan and structured credit markets, which helps us to identify relative value credit opportunities across multiple asset classes. Our team of investment professionals has extensive experience in credit underwriting and restructuring across industry verticals. In addition, we believe that shareholders benefit from our alignment of interest with the adviser owning 22% of the outstanding shares of the BDC. You can be assured that we are working diligently every day to protect our investments and drive the business forward for the benefit of all shareholders. At this point, I'll turn the call over to Jeff Cerny, our Chief Financial Officer, to give you more details and color for the quarter.

Thanks, Bilal. Good morning, everyone. As Bilal just discussed, we continue to be encouraged by the overall performance of our portfolio companies and the increase in the fair value of our debt and equity investments, driving a 12.2% increase in our net asset value over the prior quarter. Turning to our financial results. Starting with our balance sheet, we had $35.2 million of cash at the end of the quarter, of which $15.5 million of that cash was in our SBIC. At quarter's end, we had $95.5 million left in outstanding SBA debentures. As Bilal mentioned, 90% of our debt matures in 2024 or later and 63% of our outstanding debt at quarter end was unsecured. We feel good about the composition of our liabilities. It should be noted that $78.4 million of the unsecured debt is callable later this year, adding to our flexibility to manage our liabilities and potentially reduce the cost of our borrowings. Excluding our SBIC debt, our debt-to-equity ratio improved to approximately 1.3 times at the end of the quarter compared to 1.4 times at the end of last quarter. Our net asset value continues to show a strong recovery since the onset of the pandemic. Net asset value per share of $13.42 at the end of the second quarter exceeds our pre-pandemic net asset value per share of $12.46 at fiscal year end 2019. Also, our net asset value per share at the end of the quarter was 12.2% higher than the prior quarter. The increase was primarily driven by higher fair value marks on our investments, especially as Bilal discussed, the increase in our unrealized gain on our equity investment in Pfanstiehl. OFS Capital has a long standing track record of making accretive equity investments. Since the BDC's inception, we have invested approximately $39 million in the equity and also received warrants in more than 35 portfolio companies. To date, we have net realized gains of approximately $16 million on $14 million of invested capital. The remaining $25 million that is still invested in various portfolio companies as a net unrealized gain of approximately $44 million at June 30. While we primarily invest in senior secured loans, our investment strategy allows us to make equity investments when we see a strong opportunity. As Bilal mentioned, we had no new non-accruals this quarter. We have not had a new non-accrual since the second quarter of 2020. We currently have 2.6% of the loan portfolio on non-accrual at fair value. Turning to the income statement. Total investment income for the quarter increased approximately $900,000 to $11.4 million. This was primarily due to an increase in interest income, common dividends and other fees. Total expenses of $8.2 million were marginally up over the prior quarter. This small increase was due to incentive and professional fees. This was largely offset by decreases in interest expense due to our bond refinancing in the first quarter and the reduction in administrative fees. Net investment income of $0.24 per share was up approximately 26% compared to the first quarter's net investment income. As you may recall, we had approximately $564,000 or $0.04 per share of duplicate interest costs in the first quarter related to our bond refinancing. As Bilal discussed, earlier this morning, we announced the distribution for the third quarter of $0.24, an approximate 9% increase in the quarterly rate. The Board approved this higher distribution based on our increased earnings, driven in part by our bond offering in the first quarter, which we believe will continue to improve our overall earnings and optimize our capital structure. As always, we remain focused on our liquidity and maintaining a healthy balance sheet. Turning to our investments. We are pleased that our portfolio companies have continued to perform and believe that our underwriting selectivity will continue to positively impact how the portfolio performs in the future. Several of our portfolio companies continue to identify opportunities for growth for which we are evaluating incremental funding. The overwhelming majority of our investments are in loans. 95% of the fair value of our loans were senior secured, 97% of which were floating rate. We had LIBOR floors on approximately 89% of our floating rate loan portfolio with a weighted average LIBOR floor of 1.1%. In the current interest rate environment, this LIBOR floor is a strong contributor to our earnings, as it favorably compares to the three month LIBOR of just 15 basis points at June 30. Our overall investment portfolio as a percentage of cost includes approximately 71% senior secured loans, 8% subordinated debt, 15% structured finance notes and 6% equity, of which approximately half of our equity was in preferred securities. Our portfolio remains diversified. At the end of the quarter, the portfolio had investments in 91 companies totaling approximately $484 million on a fair value basis with an average investment in each portfolio company of $5.3 million or 1.1% of the portfolio's total fair value. The overall weighted average yield to cost on our performing debt and structured finance note investments is 9.77%, down by 27 basis points quarter-over-quarter, primarily as a result of our continued focus on first lien debt to larger companies. With that, I will turn the call back over to Bilal.

Thank you, Jeff. In closing, we are pleased with our performance in the second quarter. Our net asset value has continued to improve, reaching above pre-pandemic levels and driven by the performance of both our debt and equity investments. Once again, we increased our distribution, reflecting both the improved performance and our expected outlook for the quarters ahead. We maintained a solid liquidity position, which we believe will help us in this current economic environment, as we seek to take advantage of potential new investment opportunities and support our existing portfolio companies. We continue to remain focused on capital preservation. Since the beginning of 2011, OFS has invested approximately $1.6 billion with a cumulative net realized loss of principal of only $24.7 million or an annualized loss percentage of approximately 0.15%, while generating attractive yields on our portfolio. Over time, we have been steadily increasing our allocation to senior secured loans, which now constitute the majority of our loan portfolio as we continue to increase our exposure to larger borrowers. Our financing is primarily long term with 90% of our debt maturing in 2024 and beyond. We believe that this gives us operational flexibility to execute on our business plan. Lastly, we believe the size, experience and reputation of our adviser has continued to benefit our business. With a $2.5 billion corporate credit platform within a $30 billion asset management group, our adviser has broad resources including long-standing banking and capital market relationships. It has gone through multiple credit cycles over the past 25 years, and it has a strong alignment of interest with all shareholders with a 22% ownership interest in the BDC. Finally, I want to thank our employees for their continued dedication. While the impact of this pandemic continues to evolve, we believe our hard work and diligence has helped us successfully navigate a challenging time thus far. With that, operator, please open up the call for questions.

Thank you. [Operator Instructions] And the first question will come from Mickey Schleien with Ladenburg. Please go ahead.

Yes. Good morning, everyone. Hope, everyone is well. I'd like to ask about your outlook for the loan market. Considering both the private debt and private equity markets have a lot of dry powder and spreads are tightening, which we all know can result in higher repayments. But the economy is growing sharply and M&A is very active, and I'm getting the sense that borrowers seem to be gravitating more and more and more to private debt solutions. So I realize repayments can be a function of vintage and call protection. But broadly speaking, how would you characterize the outlook for organic growth in the leveraged loan market versus re-financings? And what are your expectations for OFS' originations versus repayments for the rest of the year?

Thanks, Mickey. That's a very good question. So I think that you're right. I think there is a decent amount of capital in the private debt market right now. And it - a lot of it actually has been raised for the upper part of the middle market, in the sponsored space. The part of the market that we play in, the lower middle market, is somewhat insulated, but not completely insulated, obviously. So I think that as it relates to repayments, I think that we will likely see that repayment activity does continue. But then I think at the same time, there's a lot of M&A activity that is also happening in this space, which will require a decent amount of capital to finance that M&A activity. I think in the past, when you saw a lot of refinancing activity, maybe a couple of years ago, you weren't seeing a lot of new capital that was required. The M&A activity was not as strong. I think with a strong backdrop in the economy, we are seeing the M&A activity picking up as well. So although repayment activity, I believe, will continue, but at the same time, the demand for capital will also continue. And so we think that the - our origination book and the new origination activities would, I believe, would grow over time. And our expectation is that the new originations would outpace, in my opinion, the prepayments. I would also mention that in addition to making new loans, we, excuse me, we also can look at other parts of the credit market. So as you know, we have expertise not just in the middle market loan origination, we also have expertise in the structured credit market as well, looking at CLO equity and CLO debt as well. So given that we have a broad platform, if market gets frothy in one part of that market, we can certainly look at the other parts of that market as well. So as you've seen, we have a fairly diversified portfolio across those different sub asset classes within the credit and structured credit space.

Thank you for that explanation, Bilal. I appreciate the - your insight. Just one follow-up, sort of housekeeping question since we haven't seen the 10-Q. Could you just describe what drove the realized - the net realized loss this quarter?

Yes. So I think - and Jeff, please chime in. I think that was - those were loans that were already marked down to, I believe, close to zero. And it was just a reversal of them from going from unrealized to realized. Is that correct?

That's correct. That makes up the predominant portion of it, yes.

All right. That’s it from me this morning. I appreciate your time. I hope everyone has a good weekend. Thank you.

Thanks, Mickey. Thank you.

The next question will come from David Grusky with Parika [ph]

First, gentlemen, I just want to congratulate you on a fantastic quarter and doing a fantastic job for the shareholders through this crisis. Just want to ask you about the equity investment in Pfanstiehl and what your thoughts are in terms of liquidity?

Yeah. David, thank you very much, first of all, and this is Jeff. We are primarily a platform that invests in senior secured loans, but we do make selective equity investments when we find a private company. And Pfanstiehl is a good example of that. That was an investment that we made many years back. It's about a $400,000 basis. And the fair value is around $49 million right now. So we continue to see a lot of growth trajectory for this company. And while we think there is liquidity, we think it's too early to tell. We still think there's some strong appreciation here, and we believe there's some tailwinds in this industry. So - and the company is largely unlevered. So they have a lot of flexibility to work through any issues. So we feel real good about that investment.

That’s great. Thank you.

This concludes our question-and-answer session. I would like to turn the conference back over to Mr. 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.