OFS Capital Corporation 4.95% Notes due 2028 (OFSSH) Q2 2017 Earnings Report, Transcript and Summary

Good day, everyone. And welcome to the OFS Capital Corporation Second Quarter 2017 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. Please note that the event is being recorded. I would now like to turn the conference over to Steve Altebrando. 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 second quarter 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 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 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. All forward-looking statements speak only as of the date of this call. Also during this call, management will be referring to a non-GAAP financial measure, adjusted net investment income. This measure is not prepared in accordance with U.S. generally accepted accounting principles. You can find a reconciliation of this non-GAAP financial measure to the most directly comparable GAAP measures and other related information in OFS Capital’s second quarter 2017 earnings release and in the Investor Relations section of our website at ofscapital.com, under the heading Tax and Non-GAAP Information. With that, I’ll turn the call over to our Chairman and Chief Executive Officer, Bilal Rashid.

Thank you, Steve. Good morning and welcome. The second quarter of 2017 was an important period for us. We believe that the $53.7 million equity capital raise in the quarter improved our competitive position. It gives us the ability to better meet the financing needs of our borrowers, while reducing the concentration risk in our portfolio. Overtime, we believe this will further improve the quality of our deal flow and lead to increased shareholder value. We remain focused on consistently generating the net investment income that will exceed our distribution similar to the prior eight quarters. We intend to accomplish this objective by prudently deploying capital from cash on hand and restoring financial leverage to prior levels. As you know, the debt capital markets for BDC remain strong. In the second quarter, we took steps to accomplish these goals. Since the close of the follow-on equity offering, we have deployed approximately $77 million. At June 30, 2017 our net asset value was $192 million with just $6 million of debt from a regulatory standpoint. As previously described on these calls, our SBIC debt does not count towards the BDC asset coverage test. So we have significant capacity to raise additional debt. Now turning to our quarterly results. Our second quarter net investment income was $0.33 per share compared to $0.36 per share in the first quarter. Our adjusted net investment income, a non-GAAP measure was $0.31 per share compared to $0.37 per share in the first quarter. As frequently occurs, when new equity capital is raised by a BDC, we experience a temporary drag on earnings, while deploying that capital. Our net asset value per share at the end of the second quarter of 2017 was $14.40 compared to $14.82 at the end of 2016. The lower net asset value in the current period resulted primarily from a decrease in the value of two loans as well as lower unrealized gains on certain equity securities. As of today, we have just one loan on non-accrual. Our underwriting track record remains strong, while generating double digit yields on our loan portfolio. Since the beginning of 2011 we have invested $753 million, we have had a cumulative net realized gain of $200,000 and a cumulative unrealized loss of just $3.8 million. This represents just one-half of 1% net loss on a cumulative basis. Since our IPO in late 2012, our total return as measured by distributions plus the change in our net asset value has been approximately 36%. The key drivers of this performance are our time tested underwriting standards and our hands on portfolio management approach. Looking forward, we believe that we are well positioned for a rising interest rate environment as approximately 76% of our loans are floating rate, while 100% of our debt is fixed rate. This compares to 67% of our loan portfolio being floating rate at the end of the first quarter. Also, our attractive long-term financing includes $150 million in fixed rate SBA debentures through the SBIC program with a weighted average coupon of 3.18% and no maturities until 2022. This low cost of debt continues to have a meaningful positive impact on our return on equity. In terms of our investments, 78% of our loan portfolio is senior secured based on fair value. As we move into the second half of 2017, our focus remains on the lower middle market. Over the years, we believe that we have been able to establish a competitive advantage in this underserved part of the market cultivated long standing relationships and having a team with deep underwriting experience in this segment. In our view the lower middle market has significant barriers to entry and requires specific experience to underwrite and manage investments. We continue to believe that our best opportunity to generate strong risk adjusted returns in this part of the middle market. As you know, we also utilize the broad expertise of OFS Capital’s experienced external manager, which is an approximately $1.7 billion credit platform. We believe that OFS Capital is well positioned to continue its growth and navigate any potential changes in the market environment. The manager has successfully navigated multiple credit cycles since it’s inception in 1994. Our team has the size, relationships and breadth of expertise across all parts of the leveraged loan market to provide us with both industry expertise and considerable capital markets intelligence. The OFS platform allows us to evaluate a broad array of potential transactions and to be highly selective in making investments. The manager continues to own to nearly 3 million shares that it has owned since the company’s IPO, providing strong alignment of interests between all stakeholders. These shares represent over 22% of the total shares outstanding, which is among the highest in our BDC peer group. We are confident that our long-term focus will continue to serve us well. We expect to maintain a reputation as a reliable financing partner and continue to receive good quality deal flow. At this point I will turn the call over to Jeff Cerny, our Chief Financial Officer.

Thank you. This quarter our platform continues to perform, Bilal just described the benefits of our $53.7 million equity raise. Throughout the quarter, we prudently deploy the proceeds primarily into senior secured investments with originations for the quarter totaling $66.1 million. On the liability side, the vast majority of our debt continues to be long-term fixed rate SBA debentures with a weighted average coupon of 3.18%. As a reminder, these debentures do not count towards our asset coverage ratio and as such gives us flexibility to grow our capital base and the net investment income. We believe our minimal regulatory leverage is a competitive advantage relative to many of our peers. Turning to our portfolio. At the end of the quarter, we had investments in 42 companies totaling $296.9 million on a fair value basis. As a percentage of cost, our investments were approximately 69% senior secured loans, 21% subordinated debt and 10% equity of which 8% were preferred securities. We believe that our portfolio is well diversified with an average investment in each portfolio company of $7.1 million or 2.4% of the total portfolio is fair value. The overall weighted average yield to cost on our debt investments declined to 11.7% from 12% last quarter, as we had a higher mix of senior secured loans in our portfolio. The weighted average yield of new debt investments made in the second quarter all of which were senior secured was 9.8%. At the end of the quarter 76% of our loan portfolio had floating rate coupons which are benefiting from rising rates since one, three and six month LIBOR rates are all above 1%, the typical LIBOR floor written into our loan agreements. At quarter’s end we had two debt investments on non-accrual Community Intervention Services was placed on cash non-accrual resulting from a senior lender blocking interest payments due during the second quarter. My Alarm was placed on non-accrual in the second quarter due to a decline in the company’s financial position. My Alarm has since been removed from non-accrual status after restructuring in early July through which we received new securities. We derived approximately $8 million in total investment income in the second quarter roughly the same amount as in the first quarter. Higher average investment outstandings were offset by the two non-accrual assets I just discussed. Total expenses of $3.7 million decreased compared to $4.7 million in the prior quarter. The decrease was primarily driven by reduced net investment income incentive fees due to our follow-on equity issuance completed early in the quarter and the reversal of a $283,000 capital gains incentive fee, which was originally booked in the prior quarter. For the second quarter net investment income was $4.3 million or $0.33 per share, while adjusted net investment income, a non-GAAP measure was $4 million or $0.31 per share. As we mentioned on our last earnings call in early May, this quarter was expected to be soft due to the impact of the share issuance completed at the beginning of the quarter. Also mentioned on the call there was a $235,000 write-off of deferred offering costs in the second quarter related to the expiration of the legacy shelf registration statement that expired on April 30, 2017. These costs included capitalized legal accounting and printing expenses related to the unused portion of the legacy shelf registration statement. As a comparison the capitalized deferred offering costs on our balance sheet from our new shelf registration statement are approximately $52,000. As to deal activity, during the second quarter we closed transactions with an aggregate invested amount of $66.1 million. We anticipate maintaining a consistent risk tolerance in our sourcing and underwriting and expect to maintain access to meaningful deal flow that allows us to be selective. We believe that the strong historical performance of our portfolio has been driven by a commitment to prudent underwriting and structuring, a commitment that we intend to maintain. As far as liquidity, at quarter’s end we had approximately $47 million of cash of which $40 million was in the SBIC. We had $19 million available on our $25 million line of credit. We continue to believe that we have liquidity including the flexibility to access the capital markets to allow us to meet our borrowers’ needs and increase our earnings per share. With that I will turn the call back over to Bilal.

Thank you, Jeff. We believe that this was an important quarter in setting the stage for the long-term growth of our platform. Given the strength of our balance sheet, we are optimistic about the outlook for our company. We believe that the capital raise improved our competitive position by allowing us to better serve our borrowers needs and reduced our concentration risk in the portfolio. We believe that this will create additional value for our shareholders overtime. We intend to maintain our focus on delivering capital to the lower middle market, which is where we continue to find attractive risk adjusted returns. Our investment platform has a long history and has weathered multiple credit cycles and changes in the economic environment since its inception in 1994. We believe that we are well positioned for rising interest rates given our attractive long-term fixed rate financing through the SBIC program with a weighted average coupon of 3.18%. Additionally approximately 76% of our loan portfolio is floating rate. We believe that the manager is strongly aligned with our shareholders with 22% ownership of the BDC. Our focus is to provide long-term value to all our stakeholders including both shareholders and borrowers. As a lender, we intend to continue to meet the needs of our borrowers by providing them flexible capital solutions. With that operator please open up the call for questions.

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

Good morning everyone. Couple of questions, first just a housekeeping question. Did you accrue any interest income on My Alarm during the second quarter?

Mickey, no we did not.

Okay. And secondly, if I’m not mistaken community interventions have been on non-accrual for a year, and it’s already been restructured once, if I’m correct. I believe you’re in that deal with several other BDC’s. Is this a sponsored transaction and who sort of leading the way on the restructuring and what’s the outlook to return this investment to performing status?

Yes, Mickey. So it is a sponsored transaction. We’re in with several other BDC’s and Triangle is I would say probably the lead on that transaction. The company continues to work through some challenges; it has not rebounded as quickly as we had thought it was. But we still like the sector; it’s in the behavioral health sector. And we feel good about the overall business. So I think it’s taken a little bit longer for the performance to ketchup. They’re going through some restructuring and we’re optimistic that will include some of their loss.

That’s very helpful. Thanks for your time this morning.

Thanks Mickey.

And the next questioner is going to be Christopher Testa with National Securities Corporation. Please go ahead.

Hey, good morning guys. Thanks for taking my questions. I’m just curious so – obviously the equity offering in quarter two with very well balance sheet leverage on a regulatory basis. How should we be looking at your target leverage going forward? We be looking at this as all in leverage multiple or leverage exclusive of the SBA debt? Just curious how we should kind of look at this?

Yes. I think that – as I said in my remarks earlier, we are planning to come back to the – at least come back to the leverage that we had before the equity offering. Again, we’re very focused on the type of leverage that we’ll be getting as long as we feel that it’s long-term fixed rate and gives us all the operational flexibility to run the business. I think it will be comfortable taking the business back to the leverage level that we had prior to the equity offering and at least to that level.

Okay. So is it fair to say that maybe you’re looking towards when the cash position obviously goes down more to potentially do end of this year or early next year potentially a baby bond offering.

We are evaluating all options in terms of debt financing baby bond is certainly one of them. And in terms of the capital raise, our thought would be that that timeframe that you mentioned seems reasonable. But again, it will all depends on the requirement for capital – debt cap that we have. But certainly, your ideas are in the right direction.

Okay, great. And obviously this quarter the origination volume was extremely robust. Just curious if you could just give us some more color on that, just in terms of what the uses of capital lure from your borrowers particularly the new portfolio companies that you added on.

Yes. So it was a good quarter for origination, we’re very focused on prudently deploying the equity offering proceeds. As you know, we have capital in our SBIC, capital in our BDC. And yields approximated kind of in that 10% range, they were virtually all your secured, we had a couple of small equity investments. We had six new transactions, and I think there were four or five existing borrowers that we had in exposure too.

Okay, great. And just –are you guys seeing a pickup in M&A in the lower middle market specifically the non-sponsor space that you guys operate in. Do you guys think that entrepreneurs are aware of where valuation multiples are and are more likely to sell or is that more kind of reserved for kind of the sponsor space?

Yes. We are beginning to see more activity on the non-sponsor side as well I think the – we are seeing the owners of companies looking to do more M&A transactions. I think they are getting good value for their companies. So, we are definitely seeing more M&A activity in the lower middle market certainly within the non-sponsored space that we tend to focus on.

Okay, great. That’s all for me. Thanks for taking my questions.

Thanks, Chris.

And the next questioner will be Bryce Rowe with Baird. Please go ahead.

Thank you. I was curious of the originations in the second quarter. What percentage were SBIC eligible or SBA eligible? And then, maybe if you have it, how the pipeline works in terms of SBA eligibility. Thanks.

Yes, Bryce this is Jeff. I think that relatively low percentage of the originations were SBA eligible in the second quarter. We continue to have a robust pipeline, we feel good about it. As you know, when you’re working on these transactions sometimes they do move to the right a little bit and we’ve experienced a little bit of that. So we feel strongly about the pipeline and the ability to deploy that SBA cash. But the majority of what we deploy in – the vast majority of what we deployed in the second quarter was not SBA eligible.

Okay. And then second question from a yield perspective and capital structure perspective. Should we assume that your preference is to maintain investments here in the future predominantly in the senior secured portion of the capital structure and consequently yields will continue to kind of range around 10% here in the future? Thanks.

I think the historical mix and the historical yields that you’ve seen will continue. We would expect that to continue. This quarter was more concentrated in the senior secured and we have about a weighted average yield of around 10%. I think you should expect to see similar portfolio mix and similar yields to what you’ve seen in the past.

Okay. Thank you.

Thanks, Bryce. This will conclude the question-and-answer session. I would like to turn the conference back over to Bilal Rashid for his closing remarks.

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.