OFS Capital Corporation 4.95% Notes due 2028 (OFSSH) Q2 2019 Earnings Report, Transcript and Summary

Good morning and welcome to the OFS Capital Corporation Second Quarter 2019 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 would now like to turn the conference over to Steve Altebrando, Vice President of Investor Relations. 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 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 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 on 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. Today, we reported another strong quarter. Our net investment income per share was $0.36 for the second quarter, again above our $0.34 quarterly distribution. We have now declared 27 straight quarterly distributions of $0.34 per share since our IPO in late 2012. In total, we have declared over $9 per share in distributions over this time including $0.37 per share of special dividends. And over the last four plus years, our total net investment income has exceeded our total regular distribution. We attribute these continued strong results to our disciplined deployment of capital, which is largely financed with fixed rate long-term debt. We believe that maintaining our distribution and out earning it over this period of time puts us in select company within the BDC sector. Our net asset value per share at the end of the quarter was $12.95 compared to $13.04 in the prior quarter. We had no new non-accruals in the quarter. This is the fourth consecutive quarter with no new non-accruals. In terms of originations, we deployed approximately $65 million in the quarter. As discussed on prior calls, we remain committed to being highly selective even with a relatively healthy pace of deployment. As always we remain focused on capital preservation. Turning to the quarter's most notable development, I'm very excited to discuss the senior loan subsidiary that we established in the second quarter. This senior loan subsidiary will utilize a new five-year $150 million revolving credit facility to invest in lower yielding loans to larger borrowers. After much thought and internal analysis over the last year, we decided to setup this subsidiary because we believe it will help to increase our ROE while further improving the overall risk profile of the BDC. We expect that the flexibility and incremental leverage permitted under the Small Business Credit Availability Act will enable us to invest in loans that previously did not meet our return targets. We believe that we have an advantage in this part of the market since our advisor has been investing in these types of loans for 25 years and currently has $1.5 billion invested in these types of loans through other funds. In other words, this new subsidiary is just a continuation of what our advisor already does. As we have mentioned on several of our previous calls, we have been gravitating toward more senior loans and we expect that this facility will accelerate that trend. Given the nature of the loans we are in this subsidiary, we expect that consolidated leverage could exceed 2.25 times debt-to-equity. Notably, the regulatory leverage is expected to be well below two times given that the SBIC debt does not count toward the leverage test. While the debt of the subsidiary will be consolidated on our balance sheet for GAAP purposes, the debt in this facility is non-recourse to the rest of the BDC. This is similar to other non-consolidated facilities in the industry. We take any increase in leverage very seriously and the advisor's interests are aligned with those of the shareholders given that it owns more than 22% of the BDC. Turning to the current lending environment, we continue to be vigilant and cautious about our portfolio construction. 89% of our loan portfolio is senior secured as a percentage of fair value. This compares to 75% two years ago. We expect to continue to concentrate on senior secured loans and avoid highly cyclical industries. While we still believe that we are in the late stages of the current credit cycle, the U.S. economy remains in good shape. In terms of deal flow, we continue to see attractive opportunities across the middle market. 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, this was another strong quarter from a net investment income perspective and our NAV was stable. We continue to see the benefits of our increased scale and asset base. Before I get into the details of our quarter, I will provide a little more color on our new senior loan facility that Bilal just discussed. This five-year facility has a $150 million commitment and a three year investment period. Pricing can range from LIBOR plus 160 to LIBOR plus 250 basis points, and advance rates can range from 60% to 75% on first lien assets depending on the size of the borrower. The facility is secured by all of the assets held by the new senior loan subsidiary and includes customary covenants including minimum asset coverage and minimum equity requirements. We believe this entity is attractive for our shareholders by increasing our focus on lower yielding senior secured loans to larger borrowers, which we believe will improve our ROE. The range of pricing and advance rates for this facility was incorporated to allow us to invest in these types of companies. As such, we believe that this structure plays to our core strengths. As our investment advisor manages $1.5 billion of loans to larger corporate borrowers, which it has been doing so for 25 years. In connection with this new financing facility, the company's investment advisor has agreed to waive a portion of its base management fee. It is agreed to reduce its base fee to 1% from 1.75% on assets held in the senior loan subsidiary when statutory leverage is above one times debt-to-equity. Turning back to the quarter, starting with the income statement, total investment income for the quarter was approximately $12.9 million, a $600,000 increase over the first quarter. This increase was driven by a higher overall invested balance during the quarter. Total expenses of $8 million increased $500,000 compared to the prior quarter. This increase was driven by interest expense due to higher outstanding line of credit balances used to fund our investments and fees due to more dollars invested during the quarter. Resulting net investment income per share of $0.36 was unchanged compared to the prior quarter as much of our ramp-up in investments occurred late in the quarter. It is worth noting that recurring earnings, earnings excluding fee income and original issue discount acceleration are up. Turning to liquidity; we had approximately $9 million of uninvested cash at the end of the quarter compared to $15 million last quarter. Of the $9 million of cash on our balance sheet, $6 million of that cash was in our SBIC. As of earlier this week, we have approximately $700,000 of cash, $34.8 million of undrawn availability on our PacWest line of credit and $126.4 million of undrawn availability on our new senior loan facility. Our debt to equity ratio at the end of the quarter was about 1.6 times including our SBIC debt, but excluding unsettled trades. As you may know, this is well below the maximum regulatory leverage levels as the SBIC debt does not count towards the leverage test. As mentioned, we would be comfortable increasing our leverage further in order to invest in senior secured loans of larger companies, which will primarily be done through our new senior loan subsidiary. Our net asset value was pretty stable at the end of the quarter at $12.95 per share compared to $13.04 in the prior quarter. As far as our investments, at the end of the quarter we had investments in 69 companies, totally approximately $485 million on a fair value basis. As a percentage of cost our investments were approximately 76% senior secured loans, 11% subordinated debt, 6% structured finance notes, and 7% equity, approximately two-thirds of which is in preferred equity securities. 89% of our loan investments were floating rate. Our portfolio remains diversified with an average investment in each portfolio company of $7 million or 1.4% of the portfolios total fair value. At fair value we currently have only 0.1% of the portfolio on non-accrual, similar to last quarter. This is the fourth consecutive quarter with no new non-accruals. Looking at the overall health of the portfolio, we saw the majority of our borrowers exhibited quarter-over-quarter increase in both revenues and EBITDA. The overall weighted average yield to cost in our performing debt investments was approximately 11.4% at June 30th compared to 11.8% at March 31st. As expected, most of that decrease was driven by our new senior loan subsidiary that focuses on loans to larger companies that have lower yields. We deployed approximately $65 million in the second quarter across 30 investments. This consisted of $18.4 million to several existing portfolio companies and we also invested $46.5 million in 23 new companies, primarily in our new senior loan subsidiary. The new names consisted mostly of floating rate senior secured loans to larger companies. With that, I will turn the call back over to Bilal.

Thank you, Jeff. In closing, we are pleased with our net investment income this quarter. We believe that our strong performance is driven by the strength of our origination platform as well as our underwriting and portfolio management process. We are proud that since the beginning of 2011 OFS has invested approximately $1.2 billion with a cumulative net realized loss of principle of only $900,000 or just 0.07% while generating attractive yields on our portfolio. Looking ahead, we remain confident in our earnings power. We have a senior secured focus portfolio and have locked-in attractive long-term financing. By taking advantage of our higher leverage allowance and forming our new senior loan subsidiary, we believe that we can increase the ROE of the BDC and improve its overall risk profile by investing in senior secured loans of larger companies. We continue to benefit from our advisors $2.2 billion platform and its broad capabilities within the corporate credit sector. Its longstanding investment platform has been in existence since 1994 and has gone through multiple credit cycles. We believe that this experience will help us navigate any changes in economic conditions. Our focus remains on capital preservation as highlighted by our low loss experience. In addition, we believe that our performance is further aided by the adviser having considerable skin in the game since it is the largest shareholder in the BDC with more than 22% ownership. With that operator, please open up the call for questions.

Thank you. [Operator Instructions] Our first question comes from Mickey Schleien with Ladenburg. Please go ahead.

Yes. Good morning everyone. I wanted to follow-up on the senior loan facility. Could you give us a sense of the average borrowers EBITDA and what sort of coupons you're expecting on the loans in that vehicle?

Good Morning, Mickey. This is Jeff. Thanks for the question. Yes, these tend to be larger companies, average EBITDA over time could be – could be upwards of $100 million plus. The pricing on the loans that we've funded today is kind of in that L 3.50% to L 4.25% kind of range and these are first lien senior secured loans.

So Jeff, those would be either syndicated or somewhat syndicated deals?

That is correct.

Alright, and one more question if I might. What's the unused balance fee on this new facility?

Yes. So this is first of all – Mickey, this is a feed that doesn't kick-in for the first six months. So we have the ability to kind of ramp-up the facility. And then to the extent we're greater than 50% unused, we pay a 60 basis points fee. And then when the unused is between kind of 25% and 50%, we pay a 75 basis point fee. And if those 25% or less of the overall facility unused, it's a – there is no unused fee.

Alright, that was helpful. Those are all my questions this morning. Thank you.

Great. Thanks, Mickey.

This concludes our question and answer session. I would like to turn the conference back over to Bilal for any 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. Thanks.

Thank you. The conference is now concluded. Thank you for attending today's presentation. You may now disconnect.