OFS Capital Corporation 4.95% Notes due 2028 (OFSSH) Q4 2020 Earnings Report, Transcript and Summary

Good day, and welcome to the OFS Capital Corporation Fourth Quarter 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. Please go ahead.

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 fourth quarter and fiscal year 2020 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 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, 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 appreciate you joining us today to discuss our fourth quarter and full year 2020 performance. I hope that you and your families continue to be safe and healthy. OFS Capital performed well in the fourth quarter as both the firm and our borrowers continue to successfully navigate through the economic impact of COVID. As the economy begins to return toward a new normal, our portfolio continues to perform well. Our view is based on the following takeaways from the fourth quarter. A 10.5% increase in net investment income compared to last quarter. This was in line with the preliminary estimates we released in early February. A 6% increase in our NAV, which stood at $11.85 per share at the end of the year. This was at the top of our estimated range. Our NAV per share at the end of 2020 was less than 5% below our NAV per share at the end of 2019, reflecting a strong recovery of our NAV per share during the pandemic. We declared a $0.20 per share quarterly distribution for the first quarter of 2021, an increase of approximately 11% compared to last quarter and our second consecutive quarterly increase. The overall health of our portfolio is good. We had no new loans or nonaccrual, reflecting our disciplined underwriting process and signs of an improving economy. $25 million of investments in new portfolio companies and $23 million of investments in our existing portfolio companies as they pursue growth opportunities. We believe that these achievements also reflect our team's ability to execute on our long-standing priority of capital preservation while also continuing to grow our earnings. In addition, we have been able to enhance our liquidity and further strengthen our balance sheet. Earlier this year, our credit rating was upgraded to BBB by Egan-Jones. Based on our credit rating and strong market conditions, we were able to refinance a portion of our existing debt through a $100 million bond offering at a significantly lower interest rate. We anticipate that this refinancing will save us approximately $1.4 million in interest annually. For the last few years, we have been defensively positioning our portfolio, 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 fourth quarter compared to 87% 2 years ago. We have also generally avoided highly cyclical industries such as oil and gas and metals and mining. In terms of fiscal 2020, our platform performed well given the considerable headwinds posed by COVID. At the beginning of the pandemic, we focused our attention on preserving liquidity and strengthening our balance sheet. We had a minimal amount of unfunded commitments in our portfolio, which further enhanced our liquidity position. We were in close contact with our borrowers through the crisis, and as always, took a hands-on approach to portfolio management. After the onset of the pandemic, we added only 2 new loans to nonaccrual status, demonstrating the resiliency of our portfolio. As the economic conditions began to improve, in large part to very supportive fiscal and monetary policies, we started to see an increase in M&A activity. This allowed us to cautiously resume our origination activities in the second half of last year, specifically in the fourth quarter. As COVID uncertainties have abated and as we look forward to 2021, we expect continued improvement in the economy. These conditions provide a solid backdrop for increasing the pace of our originations, which we believe could lead to an increase in net investment income over time. We would anticipate an increase in our distributions to be in line with the growth of our net investment income. In that regard, we are encouraged by our increased pipeline activity. Rest assured, we intend to deploy capital in a manner that is consistent with the long-standing underwriting standards that have been in place since the inception of our adviser. We consider an increasing interest rate environment as beneficial to OFS Capital since our assets are largely floating rate and our financing is primarily fixed rate. We believe that our balance sheet and liquidity afford us operational flexibility to execute on our origination plan. As of December 31, more than 87% of our debt had maturities in 2025 or later. And the vast majority of our long-term debt is unsecured. Our senior loan facility matures in 2024 and is non-recourse to the BDC. Our corporate line of credit is flexible as well with no mark-to-market provisions. OFS Capital continues to benefit from the expertise and scale of its adviser. With more than $2.2 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. Since 1994, our adviser's credit platform has successfully navigated multiple credit cycles. In addition, we also believe that shareholders benefit from our alignment of interest with the adviser owning 22% of the outstanding shares of the BDC. We are working hard 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 color and details for the quarter and the full year.

Thanks, Bilal. Good morning, everyone. As Bilal just discussed, we are encouraged by the performance of our portfolio companies as well as the add-on activity and the increase in new deal pipeline. We are optimistic about the economy and this pickup in investment activity. However, we remain cautious moving forward. Turning to our financial results. Starting with our balance sheet. We had approximately $37.7 million of cash at the end of the quarter. $32.2 million of that cash was in our SBIC and we utilized some of that cash in the first quarter to repay an additional $9.8 million of SBA debentures. Our debt-to-equity ratio at the end of the quarter, excluding our SBIC debt, improved to approximately 1.3x from 1.4x in the prior quarter. As you may recall, the SBIC leverage does not count towards the regulatory test. Our net asset value per share at the end of the quarter was $11.85, up $0.67 from the prior quarter. This 6% increase was primarily driven by higher fair value marks on our investments. Our NAV per share has made a strong recovery since the onset of the pandemic. As Bilal mentioned, we had no new nonaccruals in this quarter. Several of our portfolio companies identified opportunities for growth, for which we provided incremental funding. We currently have 3.8% of the loan portfolio on nonaccrual at fair value. Turning to the income statement. Total investment income for the quarter increased approximately $600,000 to $11.1 million. This increase was primarily due to syndication fees and other fees as well as dividends received on certain common equity investments. Total expenses of $8.1 million were up approximately $300,000, primarily due to an increase in incentive fees. As Bilal discussed, we declared a distribution of $0.20 earlier this morning, an approximate 11% increase in the quarterly distribution rate. The Board approved this higher distribution based on our increased earnings and our confidence in the long-term outlook of the business. Our confidence is further supported by the $100 million bond offering we closed in the first quarter of this year, which will lower our interest expenses by approximately $1.4 million annually. As always, we remain focused on our liquidity and maintaining a healthy balance sheet. This bond offering improves our overall capital structure. Turning to the portfolio. We continue to actively engage with our portfolio companies and are working with some of them on add-on activity that should improve their overall size and competitive positioning. In general, we are pleased that our portfolio companies have continued to perform and believe that our selective investment process will continue to positively impact how the portfolio performs in the future. As far as our investments, at the end of the quarter, we had investments in 74 companies totaling approximately $442.3 million on a fair value basis. The overwhelming majority of our investments are in loans. 95% of the fair value of our loan investments were in senior secured loans, up 4% from the prior quarter. 96% of our loan investments were floating rate loans, up 8% from the prior quarter. We had LIBOR floors on approximately 87% of our floating rate loan portfolio with a weighted average LIBOR floor of 1.16%. Our LIBOR floor is a strong contributor in this environment as it compares to 3-month LIBOR of just 24 basis points at December 31. Our overall investment portfolio as a percentage of cost includes approximately 71% senior secured loans, 10% subordinated debt, 12% structured finance notes and 7% equity, of which approximately 55% 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 increased 17 basis points quarter-over-quarter to approximately 10.27%. With that, I will turn the call back over to Bilal.

Thank you, Jeff. In closing, we are pleased with our performance in the fourth quarter and for the full year 2020. Additionally, we are happy to announce an increase in our distribution in the first quarter of 2021. We believe that our solid liquidity position 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. Since the beginning of 2011, OFS has invested approximately $1.4 billion with a cumulative net realized loss of principal of only $13.9 million or an annualized loss percentage of 0.1% while generating attractive yields on our portfolio. We have been steadily increasing our allocation to senior secured loans and our loan portfolio consists primarily of such loans. We have also been increasing our exposure to larger borrowers. Our financing is primarily long-term. As of December 31, 87% of our debt matures in 2025 and beyond. We believe that this gives us operational flexibility to execute on our business plan. Lastly, we benefit from the experience of our adviser, which manages a $2.2 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. Finally, I want to acknowledge the continued dedication and hard work of our employees. OFS continues to work diligently to adapt to the evolving impact of the pandemic, especially by supporting our portfolio companies, employees and other stakeholders. With that, operator, please open up the call for questions.

[Operator Instructions]. The first question comes from [David Presky with Patika].

It's [David Presky]. Congratulations on the quarter. Just a question. Could you give a little color on your holdings in Pfanstiehl and how you -- what you see going forward with that holding?

Yes. David, this is Jeff Cerny. Yes, Pfanstiehl has been a very, very strong performer. They supply raw materials to the pharma industry, and they work with some of the leading biopharma firms. And we expect continued strong performance from that company, and they've got some nice tailwinds behind them in this business with COVID, but notwithstanding COVID, they've just been a very strong performer, and we expect continued strong performance moving forward.

Okay. Are you concerned about the concentration in your portfolio with that holding?

I think -- look, it certainly is a concentration in the portfolio, but our cost on that is quite low. And it's one of those assets that we're very happy to have invested in it. But yes, as the fair value continues to increase, it does cause some concentration concerns that we're thinking about.

The next question comes from Mickey Schleien with Ladenburg.

I wanted to ask you a high-level question. How do you feel about the leverage loan market supply and demand balance when we think about the amount of capital in the market and the capital providers are all chasing borrowers who are performing well during the pandemic? And what does that portend for spread compression?

Yes. So I think the -- certainly, over the last several months, I mean, we've seen that this demand supply imbalance has been growing in favor of the borrowers. I think it becomes harder to deploy capital in environments like this, but it's not impossible. I think it's is taking us more effort to find the right deals, but we're still able to find the right deals across really the loan asset class. So you're looking at larger borrowers in the syndicated asset class, also on the middle market asset class, we have still been able to find some attractive opportunities. And also, from time to time, in the structured credit asset class, I think we've been able to find some good opportunities there as well. So I think having a broad capability where you can look at relative value across the different asset classes within the credit space, I think, does benefit us. And -- but I do agree with you. I think it's harder to put money to work, but not impossible, and we're still finding some decent opportunities.

I appreciate that, Bilal. And another follow-up sort of high-level question. We're starting to see some meaningful wholesale price inflation and there's tightness in certain parts of the labor market despite all the unemployment figures. So I'd like to understand how you feel about your borrowers' ability to pass on those cost increases to their customers and protect their margins.

Yes. So I think that's a good question. I think that at least so far, we haven't seen the -- that impact through wage inflation or inflation in commodity prices. But I think when we make investments, I mean, part of our due diligence process and underwriting process is to look at the margins in companies that we are investing in and being able to make sure that in times when there's a potential for inflation or margins to go down that our investment is still protected. And so I think some of that, for us, happens when we are looking at the leverage that we are putting on these companies and also their ability to pass on some of the impact of inflation to their customers. So at this point, I think it's a little bit early. We are not seeing that pressure right now, but we believe that the way we have structured our loan investments, our hope and expectation would be that we would still be able to withstand that pressure on our borrowers.

That's helpful. And with what you just said in mind, what trends are you seeing in apart from the highly impacted borrowers related to COVID, what sort of trends are you seeing in revenue and EBITDA margins? And if you could remind us what is sort of the average revenue and EBITDA on the portfolio?

Yes. So I think right now, we're actually -- we are seeing positive trends in the sectors that have not been impacted by COVID directly. And so we're seeing both positive trends on the revenue and EBITDA side, which is very encouraging. I think as it relates to the average EBITDA and average revenue on the loans that we originate, I'll let Jeff answer that question.

Yes. As far as the revenues and loans that we originate, they tend to range from about $5 million to $20 million or so of EBITDA. And let's call it, $30 million to $150 million of top line.

Okay. So very much in the middle market. And Jeff, 1 last question, sort of a housekeeping question. Could you give us a sense of the breakdown of the senior secured loan portfolio between first-lien unit tranche and second lien?

Yes. Mickey, I'd say, about 25% of the portfolio is second lien. I would say second-lien loans tend to be the larger, more liquid loans and very valuable in this market and very liquid, higher-yielding loans. So we feel quite comfortable with that second-lien exposure at 25%.

And the tranche?

And the unit tranche, let's call it, maybe 1/3 or so of the first lien.

This concludes our Q&A session. I would like to turn the conference back over to Bilal Rashid 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. Thank you.

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