OFS Capital Corporation 4.95% Notes due 2028 (OFSSH) Q2 2022 Earnings Report, Transcript and Summary

Good day. And welcome to the OFS Capital Corporation Second Quarter 2022 Earnings Conference Call and Webcast. 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 call over to Mr. Steve Altebrando, Vice President of Capital Markets. Mr. Altebrando, the floor is your 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 results and filed our Form 10-Q. Each of the 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 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 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. During this call, we will be referring to non-GAAP financial measures. These non-GAAP measures are not prepared in accordance with Generally Accepted Accounting Principles. A reconciliation of the non-GAAP financial measures to the most directly comparable GAAP measures is available in the Investor Relations section of our website under the heading Tax and Non-GAAP Information. With that, I’ll turn the call over to Chairman and Chief Executive Officer, Bilal Rashid.

Thank you, Steve. Good morning. As you are all aware, we are in an uncertain economic environment, which has been significantly impacted by inflation, rising interest rates, a potential recession and continued geopolitical conflict. However, we believe we are well positioned both in terms of our portfolio, which is comprised of mostly floating rate, senior secured loans in defensive industries, as well as our balance sheet, which is primarily financed with long-term fixed rate debt. Historically, a rising interest rate environment has been beneficial to our net investment income. We have been very thoughtful about this positioning and we expect positive tailwinds from higher interest rates. At the end of the second quarter, as a percentage of fair value, approximately 98% of our loan portfolio was senior secured and is well diversified across multiple industries. Our largest sector exposures are in healthcare, technology, business services and manufacturing. Perhaps equally important is that we continue to avoid highly cyclical industries. Additionally, we believe that while interest rates have increased, compared to the historically low levels since the great financial crisis, we believe the cost of corporate borrowing still remains relatively low and manageable for our portfolio companies. We believe that our financing continues to provide us operational flexibility. At the end of the second quarter, 100% of our outstanding debt matures in 2025 or later, and 49% of our debt is unsecured. In addition, in June, we extended the maturity date of our senior loan facility by three years to June 2027. This facility is non-recourse to the BDC. Our corporate line of credit is flexible with no mark-to-market provisions. As you know, last year, we took action to lock in $180 million of fixed rate unsecured debt at historically low rates. We believe this was crucial to ensuring our strong positioning for this rising rate environment. Turning to our results for the second quarter, our net asset value per share decreased to $14.57 from our all time high of $15.52 last quarter. This decrease was primarily due to unrealized depreciation, as a result of significant declines in the broader capital markets. For instance, in the last quarter, the S&P 500 declined by 16.4% and the High Yield Bond Index declined by 11.5%. Although, the Leveraged Loan Index declined by only 5.5%, it was not immune to the volatility in the broader market and our decline in NAV is reflective of that. That said, we believe the fundamentals of our portfolio remain solid and we continue to manage our portfolio as we have done through multiple credit cycles. We generated net investment income of $0.47 per share and adjusted net investment income was $0.24 per share. The adjusted net investment income decline from the prior quarter was primarily due to lower fees related to loan origination and dividend income. We slowed our origination activities in the last quarter, reflecting our cautious approach, given the uncertainty in the economy, while opportunistically continuing to buy assets when advantageous. We have the resources and expertise of a broad management platform to execute on these types of opportunities. We believe that our disciplined approach to making investments along with the strength of our balance sheet will enable us to deliver solid performance in the coming quarters. Even with several unprecedented events impacting the economy over the past couple of years, we continue to believe that we will benefit from the experience of the advisor, which spans multiple asset classes and industries. Today, it manages approximately $3.5 billion across the loan and structured credit markets, and has worked through multiple credit cycles and global economic disruptions over the past 25 years. 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. For the quarter we posted net investment income of $0.47 per share and excluding the reversal of previously accrued capital gains incentive fees, our adjusted net investment income was $0.24 per share. While our net interest income was up, our dividend income and fee income were both down, which can fluctuate quarter-over-quarter depending on portfolio activity. We took a cautious approach to new originations that generate fee income given the uncertainty and overall state of the economy. As Bilal mentioned, we believe there’s a path to an increased adjusted net investment income in the third quarter and the positioning of our balance sheet will increase the likelihood that our performance will improve in this rising rate environment. Our net asset value per share decreased to $14.57 from a historical high of $15.52 last quarter, largely as a result of rising spreads and yields in the credit markets. This decrease in net asset value was primarily driven by unrealized appreciation on credit investments, offset in part by an increase in certain equity investments. The decrease was in line with the Leveraged Loan Index during the second quarter. We had one subordinated loan that missed its interest payment this quarter, which was Eblens. They operate in the footwear and apparel retail sector, which has been especially impacted by inflation. This is one of two remaining legacy subordinated loans and we are in active discussions with the company regarding a restructure. We also had one loan where we opted to stop accruing our PIK coupon due to an unrealized decline in its fair value in the second quarter. However, it is worth noting that this portfolio company is current on another deaf tranche that requires cash interest payments. Prior to this quarter, we had not added a loan to non-accrual status since the second quarter of 2020. At fair value, we currently have 3.3% of our total investments on non-accrual. Turning to the income statement, total investment income was $10.4 million for the quarter, down from $10.9 million in the prior quarter. This was primarily due to a decrease in dividend and fee income including syndication fees, reflecting our more cautious approach given the overall state of the economy in the markets. Total expenses of $4.2 million were down $3.7 million in the prior quarter, primarily due to our non-cash reversal of a portion of our capital gains fee, which was attributable to the previously mentioned unrealized appreciation. As I mentioned earlier, net investment income was $0.47 per share for the second quarter and on an adjusted basis, it was $0.24 per share, after adding back the reversal of the non-cash capital gains fee accrual I just discussed. Earlier this morning, we announced distribution of $0.29 per share, a stable distribution from the prior quarter after seven consecutive distribution increases. While we maintain this distribution, we believe the earnings tailwind from higher interest rates will benefit us in the third quarter, with our loan portfolio being largely floating rate and our outstanding debt being primarily fixed rate. It is worth noting that 100% of our outstanding debt at June 30th matures in 2025 or later, and 49% of our outstanding debt at quarter’s end was unsecured. Excluding the SBIC debt, our debt-to-equity ratio increased quarter-over-quarter to approximately 1.6 times. Much of this was attributable to unrealized appreciation on our investments, along with slightly higher debt balances. We continue to target our long-term debt-to-equity ratio at approximately 1.3 times to 1.4 times. Turning to our investments, we are pleased by the continued performance of our portfolio companies in a tough macro environment. We believe that our underwriting selectivity and seniority in the capital structure will benefit our portfolio in the future. While we remain cautious in this environment with our new originations, several of our portfolio companies continue to identify opportunities for growth for which we are evaluating incremental funding. In today’s macro environment, knowing that company and its management team, in our opinion, gives us relationship and informational advantages in making these types of investment decisions. The majority of our investments are in loans and as of June 30th 98% of the loan portfolio was senior security. In addition 93% of the loan portfolio is floating rate and that has been a meaningful increase in benchmark interest rates since last quarter. For instance, three-month LIBOR increased by 133 basis points to 2.3% by the end of the second quarter and increased by another 0.5% to approximately 2.8% at the end of July. Given this meaningful run up in interest rates, and the fact that, 63% of our outstanding debt has a fixed interest rate, we anticipate a positive impact on our adjusted net investment income for the quarter ending September 30th. As a percentage of cost, our overall investment portfolio includes approximately 73% senior secured loans, 3% subordinated debt, 20% structured finance notes and 4% equity securities. Our portfolio remains diversified. At the end of the quarter we had 101 portfolio investments, totaling approximately $540 million on a fair value basis, with an average investment size of $5.4 million or approximately 1% of the portfolio’s total fair value. For the quarter ended June 30, the income yield on the investment portfolio, which includes all interest and amortization of deferred loan fees was 9.1%, stable from last quarter. With that, I will turn the call back over to Bilal.

Thank you, Jeff. In closing, although, we are in the midst of an uncertain economic environment, we believe our company has several attributes that are working to our advantage. First, we stand to benefit from rising interest rates, given that the vast majority of our loan portfolio is floating rate and 63% of our outstanding debt is paid through. Next, we expect to benefit from our focus on capital preservation, with 98% of our loan portfolio being senior secured, the overall quality and fundamentals of our portfolio remain solid. Our financing is primarily long-term, with all of our outstanding debt, maturing in 2025 and beyond. In addition, almost half of our outstanding debt is unsecured. We believe that this gives us operational flexibility to execute on our business plan. Our longstanding experience continues to guide us through uncertain economic times. Since the beginning of 2011, OFS has invested more than $1.8 billion, with a cumulative net realized loss of just 1.9% over the last 11.5 years, while generating attractive yields on our portfolio. Lastly, we believe the size, experience and reputation of our advisor will continue to benefit our business. With a $3.5 billion corporate credit platform within a $30 plus billion asset management group our advisor has broad resources, including longstanding banking and capital markets relationships. Our corporate credit platform has gone through multiple credit cycles over the past 25 years. It is also important to reiterate that OFS Capital’s advisor has a strong alignment of interest with shareholders holding a 22% ownership stake in the BDC. With that, Operator, please open up the call for questions.

Thank you, sir. [Operator Instructions] : :

At this time, we are showing no question. We will go ahead and conclude today’s conference call. We thank you to the management team for their time today and thank you all for attending today’s presentation. At this time, you may disconnect your line. Thank you. Take care and have a blessed day everyone.