OFS Capital Corporation 4.95% Notes due 2028 (OFSSH) Q3 2015 Earnings Report, Transcript and Summary

Good morning and welcome to the OFS Capital Third Quarter 2015 Earnings Conference Call. All participants will be in a 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’d now like to turn the conference over to Steve Altebrando, Vice President of Investor Relations. Please go ahead.

Thank you. Good morning, everyone and thank you for joining us. With me today is Bilal Rashid, our Chairman and Chief Executive Officer; and Jeff Cerny, our 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. We plan on filing our 10-Q this afternoon. Both documents as well as our most recent investor presentation can be obtained under the Investor Relations section of our website ofscapital.com Before we begin please note that the statements made on this call and webcast may constitute forward-looking statements within the meaning of the Securities Act of 1933 as amended. Such statements reflect various assumptions by OFS Capital 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 ways 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 to be inaccurate and, as a result, the forward-looking statements based on those assumptions could be – also 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. All forward-looking statements speak only as of the date of this call. Our comments may reference adjusted net investment income and non-GAAP measure. Please refer to our most recent investor presentation for a reconciliation. With that, I’ll turn the call over to our Chairman and Chief Executive Officer, Bilal Rashid.

Thank you, Steve. Good morning and welcome. We are happy to report that our third quarter results continue to show improving performance with net investment income of $0.38 per share. This more than covers our $0.34 distribution and is a significant improvement from $0.30 per share in the same period last year. Our year-to-date performance has been strong as well, we believe that these encouraging results are due to the vision and business plan we have in place at OFS Capital. Our strong performance relies on, one, maintaining our strict underwriting standards. This has resulted in low non-accruals and has ensured that we have no portfolio companies in the highly cyclical oil and gas sector. Two, being responsive to our borrowers needs, this has led to repeat business, a reputation as a reliable partner and good quality deal flow. And lastly, our ability to provide flexible capital solutions to a broad array of industries, particularly within the lower middle market. This is where we continue to find the best risk adjusted returns. We have enough capital to execute on our business plan, allowing us to continue to originate quality loans and sustain our distributions. We continue to find attractive risk adjusted returns in the lower middle market, especially in non-sponsored transactions. Our seasoned team has longstanding sourcing relationships allowing us to see a broad array of potential transactions and to be highly selective in making investments. OFS Capital’s credit intensive culture, thorough due diligence process and expertise in structuring transactions, positions us advantageously in this attractive market segment. The credit quality of our portfolio and our track record of underwriting quality loans continues to provide meaningful earnings growth and stability in the value of our portfolio. At the end of the third quarter, non-accruals represented less than 1% of the fair value of our total assets and 61% of the fair value of our portfolio was in senior secured loans. Our portfolio benefits from our external managers $1.7 billion credit platform, which has been in existence since 1994. Our manager has the size and breadth of expertise across all parts of the leverage loan market, which provides us with considerable economic and capital markets intelligence in addition to expertise across industries. Our portfolio also benefits from the experience of our investment team, which has a long history of working through multiple credit cycles. We placed a heavy emphasis on companies with strong management teams, high barriers to entry and strong free cash flow characteristics. In addition, we are very highly cyclical and commodity based industries. Our investment team takes a hands-on approach to managing the portfolio and working with our portfolio companies through the duration of our investment. Looking ahead, our portfolio has positioned to benefit from a meaningful increase in interest rates. A majority of our loan assets, our floating rate, while our debt is 100% fixed rate. At the end of September, we had $150 million in fixed rate SBA debentures, with a weighted average interest rate of 3.18%. We have no maturities until 2022. In the coming quarters, we will originate loans that meet our strict underwriting criteria. As of September 30, 2015 we had several potential sources of available capital. Number one, we had $42 million in cash. Number two, we had $24 million of equity invested in the senior club loan portfolio that can be redeployed in higher yielding investments. Number three, we have the ability to raise additional capital in the bank loan or the bond market. As a reminder, SBIC debt does not count towards the BDC leverage test, so we have not tapped any of our available statutory leverage. Lastly, our second SBIC license was submitted earlier this year, if approved we would have access to another $75 million in SBA debentures. While we have an ongoing dialogue with the SBA, we do not have an update regarding its timing and status. As you can appreciate, we have several financing options available to us, that we can access if and when needed so that we can continue to originate quality loans. OFS Capital had $32 million in originations in the third quarter and $155 million in originations over the past year. Our new loan pipeline is solid. Going forward, our primary focus remains the same, to grow our earnings, while being a conservative steward of our shareholders’ capital. As we have done so far, we will continue to finance the company in a thoughtful manner. We will only raise additional capital, if it is accretive. As a 30% owner of the company, the interests, of our external manager, are aligned with those of our shareholders. At this point, I’ll turn the call over to Chief Financial Officer, Jeff Cerny who will provide more details on the financials.

Thanks, Bilal. Turning to our results, we continue to be excited about the opportunity to enhance our yield and net investment income. We have 30% of our net asset value in cash, this gives us a lot of flexibility. We are continuing to focus on optimizing our capital base with higher yielding, lower middle market loans as we believe the relative value opportunity is strongest in this market. This strategy helped to drive our net investment income above our distribution for the quarter. This quarter we have 39 companies in our investment portfolio, totaling $247.2 million on a fair value basis equating to 100% of cost. As a percentage of fair value, our investments were comprised of approximately 61% in senior secured loans, 29% in subordinated debt and 10% in equity. Our average investment in each portfolio company was $6.5 million at fair value or 2.6% of the portfolio’s total fair value. The overall weighted average yield to fair value on our debt investments continues to move in a positive direction. It increased 32 basis points since the last quarter to 11.8%. This increase reflects the continued redeployment of capital into higher yielding loans. At the end of the quarter, floating rate loans comprised 56% of our loan portfolio. All of our floating rate loans contain LIBOR floors. We had one new non-accrual loan this quarter, Phoenix Brands, which has a $1.1 million fair value. We think there is a high likelihood we’ll collect par on this asset. Our only other non-accrual was Strata Pathology Services and it was resolved on October 2 when the company was sold. It had a fair value of only $84,000 and has been a non-accrual since the first quarter of 2013. Moving on to deal activity, during the third quarter, we closed six transactions with an aggregate principal amount of $31.9 million. This included $5 million of investments in two new portfolio companies and $26.9 million of investments to four existing portfolio companies. These investments included senior secured loans and subordinated loans. We derived approximately $7.7 million in total investment income in the third quarter, compared to $8.1 million last quarter. This quarter-over-quarter decline was largely due to the loss of income in the third quarter from investments that we sold in our senior loan fund during the second quarter, partially offset by a 32 basis point increase in the weighted average yield to fair value. Expenses totaled $4.1 million compared with $5.3 million for the prior quarter. The $1.2 million decrease in expenses was largely driven by a write-off of $1.2 million of unamortized, deferred financing closing costs in second quarter that was non-recurring. Net investment income for the third quarter was approximately $3.6 million or $0.38 per share, which exceeds our prior quarter net investment income of $0.28 per share, and our adjusted net investment income of $0.35 per share. As Bilal mentioned, we more than fully covered our distribution this quarter with net investment income. We still have the capacity to invest with approximately $42 million of cash, as well as $24 million in assets, remaining in the lower yielding senior loan fund. We have made good progress in deploying capital and optimizing our portfolio and we will continue to prudently generate liquidity on a timeline that allows us to maximize our interest income. Only selling lower yielding assets or otherwise raising capital when we believe we can timely redeploy the cash in higher yielding loans. With that I will turn the call back over to Bilal.

To summarize, we are pleased that our results this quarter have continued to improve, demonstrating the strength of our investment platform. We have a differentiated origination capability, that is currently focused on the lower middle market, especially on non-sponsored transactions. This is where we continue to see attractive risk adjusted returns. Our external manager’s extensive experience through multiple credit cycles, and the strength of our teams underwriting expertise and sourcing relationships has allowed us to construct a quality portfolio. We have attractive long-term fixed rate financing through the SBIC program, that positions us well for an expected increase in interest rates. Finally, in a sector that has seen other participants struggling to maintain growth, we have the capital available to continue our growth. OFS Capital remains committed to providing value to all our stakeholders, including both shareholders and borrowers. As part of an investment platform with a 30% stake in OFS Capital, shareholders can be reassured that our interests are strongly aligned. We remain focused on being responsive to the needs of our borrowers and providing them flexible capital solutions. With that operator please open the call for questions.

Thank you. We will now begin the question-and-answer sessions. [Operator Instructions] Our first question is from Terry Ma of Barclays. Please go ahead.

Hi, guys. I may have missed it, but all the $400,000 fee income you guys had this quarter and how should we think about that going forward?

How’re you doing Terry? Yes, this is Jeff. It is a combination of closing fees on new facilities, as well as some prepayments fees and we would expect that to be recurring plus or minus, and it just all depends on the size of the origination that we do. But typically with the closing fee, we take about half of that into income at closing amortized the rest of the [indiscernible].

And I think in addition to that you also have prepayment penalties. So I think part of – part and parcel of what we are doing is originating loans and then loans payoff. And so you have origination fees and you have prepayment penalties. So we beneath that will be a recurring item.

Okay. And how much of the $400,000 was prepayment penalties this quarter?

That was about, I think, a little bit less than half.

Okay. So can you guys just talk a little bit more about the investments you made this quarter? It looks like it was more skewed toward the existing portfolio companies?

Sure. You know, a peer portfolio companies in our portfolio that we like, our preference is that we continue to support those portfolio companies. That’s, to be honest, one of the best sources of new deal flow for us. And so, I think, that is continuing as we move forward. I think what we will try to do is as it relates to company that we like, we will continue to support them either in their growth or if there is a potential add-on facility with respect to an acquisition that we’re doing. So it’s slightly unusual from the last quarter, but we will try to be involved in the existing companies as much as we can.

Okay. In a sense was that committed capital already that they just drew on the quarter? Or was that they need an incremental, for whatever reason, you guys just added on? Can you just give a little more color?

Yes, I think most of it, – yes, most of it was really incremental capital, I mean, that’s – we’re investing in companies and luckily these companies are growing. And when they grow, they need more capital. And they had an option to refinance us out, but what we try to do is stay in the wheel because we’ve been involved in the transaction and we want to continue to support the business that we know and like. So I think that – a lot of that activity was related to companies growing and needing more capital.

Okay. And I think your percentage of subordinated debt last quarter was about 25%, and I think it’s close to 30% this quarter. So it’s ticking up a little bit. Do you have any long-term view on where that may shake out in a steady state?

Well, I think as we have migrated the portfolio from a senior secured kind of club portfolio out of the WM subsidiary, we naturally would expect that to tick up. I think that, as we look forward, we’re always trying to teed-up the balance sheet and get a first lien on the assets or a second lien on the assets. So I think that I wouldn’t expect it to differ materially from where it is today.

Okay, great. And can you may be just talk about what the actual yield differential between your senior secured portion in the portfolio versus the subordinated debt portion?

We don’t have that handy, right now, so it’s something we’d have to get back to you on.

Okay, great. That’s it from me. Thanks.

Our next question is from Christopher Testa of National Securities. Please go ahead.

Hi.

Hi, good morning. Thanks for taking my questions, guys. Just wondering kind of piggybacking off the previous question about those subordinated portion of the portfolio. Are you saying just generally more opportunities in the subordinated loans given kind of the backup in the high yield and second lien markets? Or was there anything to that kind of taking up the portfolio composition this quarter?

Yes, I think, as Jeff was saying earlier on, I mean, I think some of that is just related to us surely getting out of the – our low yielding senior secured portfolio that we had in the past. And one point of clarification here is that, you know, when we – we certainly have a large portion of our portfolio in senior secured loans, but even the subordinated debt, in many cases the subordinated debt that we have, the leverage that we have in those companies, it’s still at a very, very reasonable level. So in many of the cases, as we’re dealing with some of the lower middle market or traditional middle market companies, we may call it subordinated debt, but it’s behind a very low level of leverage. And so, it could be situations where we only have one third of leverage ahead of us and then we have – we’re all-in three terms of leverage. So although we are technically subordinated in that situation, we’re always monitoring the total leverage that we had in that company and also how much leverage we have ahead of us. So when you view the subordinated debt, you should also keep in mind that in most of those situations, we’re monitoring the leverage levels as well, and so it’s not in a very traditional manner, a standard sort of mezzanine type of leverage level that people see.

Right, that’s helpful. And do you buy any chance offhand have the weighted average attachment point leverage for the portfolio for the quarter?

Yes, I mean, I think in the past we’ve told people that it’s in the sort of mid-three’s right now and it continues to be in that range slightly above sort of mid-three’s.

Okay, great. And just on the non-accruals, I missed, what was the previous non-accrual that was resolved?

Company called a Strata Pathology.

And with that, was ever covered at par?

No, no, no, no. We have – I’ve spent on non-accrual for several years and it’s…

Okay.

It’s been carrying a fair value of well below par.

Okay, got it. And the other non-accrual that you mentioned of Phoenix Brands was that a new one for this quarter?

Correct.

Okay. And can you just give us some color on that, basically what the company does and why you’re expecting the high likelihood of par recovery on like how much capital is junior to you?

Sure, I guess, so we typically don’t comment too extensively on companies, but this is a company that is into consumer brands mostly in the laundry segment. So laundry detergents, fabric softeners, starch and things of that nature and it has brands. And we expect that the company is undergoing a sale process as we speak. So we make them indications, where we’re expecting that we will recover par.

And also I should mention here that it’s less than $1.2 million principle balance and it used to be slightly higher than that and over time it’s been paying off. So it’s a very small loan and as just that we expect to receive par on that.

Okay. And just, I know you guys are very, very much concentrated in non-sponsored, but are you starting to see more sponsor opportunities as kind of more and more people seems to be backing out of that market? Or is that something where the volume has just becomes so abysmal that non-sponsor is still going to be a major portion of the originations over the next quarter or so?

I would say that we’re focusing on the non-sponsored market because that’s the market where we find the best risk adjusted returns. We find the best pricing there. We get good covenants, good fee structures in terms of origination fees and prepayment penalties. So we will continue to focus on that sector, but from time-to-time and we find opportunities in the sponsored market which are attracted, we will certainly take advantage of those opportunities as well. So if you look at our portfolio, it does have sponsored transactions and so I don’t see us changing our tactics on that front and I think to the extent that we find opportunities in the sponsored market, as I said we will look at those certainly. But we focus – will certainly remain on the non-sponsored market because compared to the sponsored market we’re still finding better risk adjusted characteristics there.

Okay, great. And the $24 million of the lower yielding senior loan fund assets. Do you have a timeline for, when you think that will be totally runoff, are those liquid enough that you are actively, you are able to sell those or you just kind of wait for those to repay?

It’s going to be a combination, I think that – we have some cash as we indicated and we don’t want to sell those assets and give up the interest income because they’re good assets, too quickly. So we’re just kind of, we’ll sell those on a prudent timeline based on liquidity needs. But there are some, certain of those companies that are in the midst of a sale process. So we would expect to realize in some of those and sell others.

Great. And last one from me would just be – was there any portion of the interest income this quarter that was – I guess would you consider non-core and if the acceleration of interest income from a prepayment or anything?

Yes. There was because certain of our new originations were loans that had previously, run our books and they actually paid off and maybe the capital structure was redone. So the short answer is yes.

Okay. Do you have, do you have an idea of how much that accounted for this quarter, Jeff?

So you’re talking about, I know, acceleration of OID right?

Right. Yes.

I think it was less than $0.02.

Okay. Great. That’s all from me. Thanks for taking my question guys.

[Operator Instructions] Showing no additional questions at this time. This will conclude our question-and-answer session. I’d like to turn the conference back over to Bilal Rashid for any closing remarks.

Thank you all for joining our call today, and for your questions. We look forward to speaking with everyone again on our next call. Operator, you may end the call.