ArrowMark Financial Corp (BANX) 2015 Q3 法說會逐字稿

Welcome to the StoneCastle Financial Corporation third-quarter 2015 investor conference call.

(Operator instructions)

As a reminder, this conference is being recorded.

Now, I would like to turn the call over to Rachel Schatten, General Counsel of StoneCastle Financial. Thank you, Ms. Schatten. You may begin.

Good afternoon. Before I begin this conference call, we'd like to remind the audience that certain statements made during the call may be considered forward-looking statements based on current Management expectations that involve substantial risks and uncertainties. Actual results may differ materially from the results stated in or implied by these forward-looking statements.

This would depend on numerous factors, such as changes in securities or financial markets or general economic conditions, the volume of sales and purchases of shares of common stock, the continuation of investment advisory, administrative and service contracts and other risks discussed from time to time in the Company's filings with the SEC, including annual and semi-annual reports of the Company.

StoneCastle Financial has based the forward-looking statements included in this presentation on information available to us as of September 30, 2015. The Company undertakes no duty to update any forward-looking statement made herein. All forward-looking statements speak only as of today November 12, 2015.

Thank you. Now I will turn the call over to StoneCastle Financial's Chairman and Chief Executive Officer, Josh Siegel.

Thank you, Rachel. Good afternoon and welcome to StoneCastle Financial's third quarter 2015 investor call. In addition to Rachel, joining me today are George Shilowitz, President, and Pat Farrell, Chief Financial Officer.

On the call today, I will highlight StoneCastle Financial's quarterly results, review the current portfolio and comment on the investment in Community Funding CLO, which closed subsequent to the end of the quarter. As always, Pat will follow with details on our financial results.

I'm pleased to report that in the third quarter, StoneCastle delivered another increase in total income, our eighth consecutive quarterly increase since inception of the Company. Reported earnings in the third quarter totaled $0.37 per share. Net investment income for the quarter reached $2.4 million, also $0.37 per share, a 2% increase from the previous quarter.

The Company also generated approximately $18,000 in capital gains. At quarter end, the Company's net asset value per share was $22.09, up $0.04 from last quarter.

StoneCastle Financial deployed $12.8 million in net new investments. Total investments of $30 million in five new assets was offset by issuer repayments of $9.3 million from seven investments and sales proceeds of $7.9 million from 10 investments.

As of September 30, the Company had total assets of $203 million, consisting of total investments of $197 million, cash of $4 million and other assets at $2 million. Other assets includes receivables of $1 million and prepaid assets of $1 million.

Total investments were comprised of 40% term loans and debt securities, 24% trust preferred securities and 30% preferred and convertible preferred stock. The remaining 6% includes equity positions, short-term investments and other securities. The quarter end schedule of investments can be found on the Company's NQ and on the Company's website.

Subsequent to the end of the quarter, StoneCastle Financial purchased $45.5 million of preferred shares issued by Community Funding CLO, Ltd which closed on October 15. Let's spend a moment to discuss this transaction.

35 community banks and bank holding companies from 24 states issued $250 million of securities predominantly in the form of subordinated loans. These subordinated loans count as tier 2 capital for the issuers, the component of a bank holding company's total capital requirements. These securities rank senior in priority, the trust preferred securities, TARP, SBLF, preferred shares and common shares.

Roughly 97% of the banks in this pool received an investment grade equivalent credit score by Kroll Ratings and roughly 91% received an investment credit score from Moody's Risk Health. The names that were not investment grade were scored BB equivalents.

To allow these banks to access the Capital Markets and benefit from Capital Markets pricing, the majority of them came to market together to issue on the same day as a group. This group of subordinated loans was funded with 82% debt and 18% equity. The 82% debt was comprised of $205 million of senior secured Class A notes, rated A3 by Moody's. The 18% equity or $45.5 million of preferred shares, was purchased entirely by StoneCastle Financial.

In order to fund the purchase, StoneCastle Financial contributed $45.4 million of securities, with the balance paid in cash. The securities consisted of $26.4 million of investments made in the third quarter, including Bankwell, Lyndon, Market and Sandhills. Approximately $19 million of existing investments made prior to Q3, were also contributed and included Cornerstone, Country Bank, Freeport, Midwest, Community and Williams holdings. All the securities were contributed subsequent to the end of the third quarter.

To understand the transaction, it is best for us to first review the sources and uses of proceeds for this CLO. Funds were needed to purchase collateral with an aggregate cost of $248.3 million, and to pay for $4.9 million of deal related expenses for a total of $253.2 million needed to complete the transaction. The CLO source of funds to pay for this was comprised of $205 million of senior debt, $45.5 million of preferred shares and $2.7 million received from the banks as upfront origination fees.

Now, let's discuss the straightforward economics of the preferred shares, which is how StoneCastle Financial will make a return on this investment. Quarterly income is generated by the $250 million pool of collateral, which has an approximate yield of 7%. That income is used to pay three types of expenses; administrative expenses of approximately 5 basis points per annum on the amount of collateral; interest expense on the $205 million of senior notes, which is initially 5.75% fixed rate and then increases to 6.4% fixed rate after year five; and a servicing fee of 10 basis points per annum on the amount of collateral.

After these expenses are paid StoneCastle Financial is entitled to receive all of the remaining cash flows each quarter. Income received on the preferred shares looks to the characterization of the income from the underlying loans, which is ordinary income. It is important to note that the servicer for the CLO is StoneCastle Investment Management LLC, an affiliate of StoneCastle Partners. The servicer will fully rebate the servicing fee back to StoneCastle Financial each quarter as additional income.

I want to take a moment to explain securitizations. A securitization, by definition, is a secured financing of assets where investors have a security interest in the collateral. The term CDO, or collateralized debt obligation, is used liberally in articles but it is typically used to represent a very specific type of securitization, one backed by asset backed securities comprised of subprime mortgages.

Securitizations have been used for decades to bring funding to many asset classes including, but not limited to, student loans, auto loans and commercial real estate. They were also used in the early 2000s to fund poorly underwritten subprime mortgages, which became a component of the credit crisis. However, subprime mortgages were only one small part of a well-functioning multi-trillion dollar market of pooled or securitized financing.

By comparison, Community Funding contains no mortgages or derivatives, sub-prime or otherwise. In fact, the portfolio of non-deferrable loans owned by Community Funding is comprised of healthy, highly regulated predominantly investment grade quality banks.

To emphasize this point, in comparison to the $300 billion current CLO market, those transactions have 10% equity supporting a pool of mostly single B rated loans. Community Funding in contrast, has 18% equity supporting a pool of mostly BBB quality loans. We believe in a pooled vehicle, it is the quality of the underlying asset that should really matter to investors.

In closing, I would be remiss if I did not mention that the key point that distinguishes StoneCastle Financial from many other income vehicles, credit quality. A majority of the banks in which we invest are deemed investment grade quality, BBB or better by Kroll Ratings. Most other high-yielding income focused investment companies have a majority of their portfolio in investments rated well below investment grade. We believe that investors should focus on the underlying credit quality of StoneCastle Financial's assets relative to our share price, currently at a discount to NAV.

Now, I want to turn over the call to Pat Farrell to discuss the financial results in greater detail.

Thank you, Josh. I would like to present the financials by going through the detailed components, which help many of you understand the value of the Company.

The net asset value at September 30, was $22.09 per share. The NAV for StoneCastle Financial is affected by four components; net management income, realized gains and losses, the change in value of the portfolio's investments and finally, distributions paid during the period. Let me walk through these components.

Net investment income for the quarter was $2,396,410 or $0.37 per share. Net investment income reflects gross income from dividends and interest received from our portfolio investments minus operating expenses. Gross income for the third quarter was $4,105,132 or $0.63 per share. Gross investment income was up 4% from the last quarter.

The Company's operating expenses are comprised of various expenses, such as advisory fees, interest expense related to our use of leverage, custody and administration fees, legal fees, ABA fees and other expenses. Operating expenses net of advisory fee waivers for the quarter, were $1,708,722 or $0.26 per share.

As a result of the growth in assets, expenses were up approximately 6% from the second quarter, primarily due to an increase in the use of leverage and related advisory fees which are variable expenses. The realized gains and losses reflects securities which were sold or called during the quarter. For the third quarter, this amounted to a gain of $18,202.

The third component, changes in unrealized appreciation or depreciation of the portfolio, relates to how the value of the entire investment portfolio has changed from the previous quarter end to the current quarter end. The vast majority of the portfolio is valued by market quotations and broker quotes. For the third quarter, the value of the portfolio increased $7,998.

The fourth component affecting the net asset value is distributions. The cash distribution for the quarter was $0.33 per share paid on September 29, to shareholders of record on September 21.

To recap, we began the quarter with a net asset value of $22.05 per share. During the quarter, we generated net income of $2,396,410, realized gains of $18,202 and the value of the portfolio increased $7,998. The sum of these components offset by a distribution of $0.33 per share, resulted in a net asset value per share of $22.09 per share at September 30.

Now, let me update you on our credit facility syndicate led by Texas Capital Bank. As of September 30, the Company had $58 million outstanding from the facility. In accordance with the regulated investment company rules we may only borrow up to 33.3% of our total assets. Our leveraged percentage at the end of the quarter was 29%.

Let me also update you on a few additional items which will have an effect on future quarters. The voluntary fee waiver the advisor had in place, which expired on August 31, 2015, was extended to September 30. Effective October 1, this waiver is no longer in effect.

I am pleased to report we have renegotiated our exclusive contract with the American Bankers Association. Effective September 1, the annualized ABA fee is $250,000, a 50% reduction from the initial contract. In addition, the contract was extended to August 2017.

The ABA agreed to a reduced fee in recognition of the important source of capital the Company provides to community banks. We value this strategic partnership.

Finally, as Josh mentioned, subsequent to the end of the quarter, StoneCastle Financial invested $45.5 million in preferred shares of the Community Funding CLO. Further discussion of the CLO's financial impact on the Company will be made on the fourth quarter call.

Now, I would like to turn it back over to Josh.

Thank you, Pat. We appreciate you taking time to be with us on this call. Now, operator, we'd like to open up the call for questions.

(Operator Instructions)

Greg Mason with KBW.

Great. Thank you, guys, and congratulations on the new CLO. Regarding that income, are you able to accrue that income or does it just count when dividends for the equity is paid? And when do you expect the cash flows to the equity to start turning on with that CLO?

This is Pat. We are going to be accruing daily on that since it is going to be interest income to StoneCastle Financial Corp. The first cash flow I believe is coming in, in February but that won't affect our income accrual in any way.

All right, great. And then, just another question on the waiving of the management fee. I know when you did your equity raise, the idea was to waive that as long as the dividend isn't being earned and the dividend at that time was $0.50 and now it's been cut. So just curious, as to the reason for no longer doing the fee waiver and the impact on the business going forward?

Sure. This is Josh. We had, when we did that raise, agreed to keep it reduced through August. We spent an enormous part of this year getting the $0.25 billion of new investments lined up for the CLO, which we believe will have a meaningful impact in the future, income of the Company. And we made the decision to stop the rebate about a month after we agreed to it, sort of in recognition for what we think is potentially a higher level of income from this piece of paper and the work that we are doing going forward to continue this trend, if we can continue to do it.

And then one last question. Is there any limitations on you doing another one of these CLOs? Is there any kind of investment restrictions? If not, are there any thoughts to do more of this or expand the current CLO?

Good question. I'll go in reverse order. The CLO itself is a separate living, breathing, entity so there is no reopening, it is static for its life. So that is what it is.

There is no restriction under the 40 Act or IRS regs that restrict what we can do. That doesn't mean that we will be able to get another one done. We'd like to, but that's of course going to be dependent, as with the first one, on the number of banks, diversification of banks, capital markets activity and hopefully it?s possible, but there is no guarantee.

Great, thank you. Appreciate it, guys.

Of course, thank you.

Devin Ryan with JMP Securities.

Thank you. Good evening. Just wanted to follow-up on the CLO. Thanks for all the details around the calculations. Just want to make sure I have the math correct. Is it, if you just run through what you guys walked through, is that about $2.4 million of net investment income?

And then secondly, what other one-time costs should we be thinking about from the formation that will be hitting over the next quarter or two?

Good question. I can't talk about anything in the future. But as I mentioned a moment ago, the vehicle is self-contained. So StoneCastle Financial simply purchased $45.5 million and that is the extent of its outlay of dollars. Anything that was expensive of that deal was covered by that deal itself. So there are no separate expenses for it.

The income, as I sort of walked through on the call, the best way to think about it to calculate oneself is there's 7% income on $250 million of assets. For the first five years, there is an expense of 5.75% on $205 million, and running fees of 15 basis points.

But as we mentioned, you should basically discount 10 of the 15 because that will come back to StoneCastle Financial as additional income. So it is really only 5 basis points of third-party expense. And that is what will generate the free cash flow with fixed assets and fixed liabilities, so fairly predictable.

Of course, with the variation being if there were to be any defaults on the underlying portfolio, clearly that has an effect. But outside of that, it is a pretty predictable stream of cash flow.

Got it. That is helpful. Then with respect to the investments in the quarter, four investments ended term loans, so that was a big outlay. Was there a particular reason why term loans were more attractive this quarter? And maybe why those specific ones were not included in the CLO?

Well, we'll get into next quarter with what is in the CLO versus not in the CLO. We can't really disclose that as -- it's fourth quarter materials. To the first question, as we always said from the past two years, we can't really dictate what the bank demand is. That is their function of whether they want preferreds or sub-debt and it seems like the flavor of the month and quarter and year for 2015 has been sub-debt, be it fueled by Kroll or others. That seems to be the greatest demand.

I do think that part of that is fueled by the small bank holding companies policy act change adding over 600 banks to be able to issue holding company level debt. That really counts solely for a regulatory purpose as common equity at their underlying banks. So that seems to still be the most interesting component.

I think that what you've seen so far in 2015, with early SBLF, either repayments to the Treasury directly or refinancings, it's reflecting a cost of 9% with no tax deduction and being able to finance that with filling that after tax could have a 4.5% cost, that is clearly something you can get with sub-debt which you cannot get with non-tax deductible preferred. So I think those are some of the drivers that maybe are changing that -- the choice from a bank loan.

Got it, okay. That?s it for me. Thank you.

Thank you.

Bryce Rowe with Robert W. Baird.

Thanks. Good evening, Josh and team. Josh, just wanted to understand or maybe have you repeat, the $45 million or $44 million of securities that you contributed as part of your investment in the CLO. I got the four that you mentioned, the $26.4 million. But $19 million, can you just go over those again? You said them a little bit too fast.

Oh sure. Give me a second. The other $19 million, those were investments we made earlier in the year. And this was Cornerstone, Country Bank, Freeport, Midwest Community, and Williams Holdings. And so to your question there, to purchase the preferred shares of Community Funding CLO, there were just two semantic ways to do it, that was just the choice of the most efficient way.

We could have sold those securities to the CLO and then bought preferred shares. Or what was easier was just contributing them as like kind, rather than selling and turning into cash. It was really just semantics. There were assets that StoneCastle Financial held that satisfied the CLO's criteria and were good assets. So, those were contributed in and we took back with a little bit of extra cash, we took back the 100% of the preferred shares.

Okay, makes sense. So the remaining, the remaining assets went into the CLO, will we have some disclosure as to what the CLO owns? That is one question. And then number two, did you, StoneCastle, the parent organization, source those or were they sourced from a different source?

Good question. So from the sourcing question, the majority of those came to the CLO from a wide variety of broker dealers who brought those transactions. Clearly, as the buyer of the equity, as with the buyers of the senior debt, they all had an opportunity to look at the portfolio prior to close to decide if they were comfortable.

Not everything that was originally looked at made it in. And so, we had input. And affiliates of StoneCastle did do the underwriting on those. But ultimately, it was a group selection of all of the investors in Community Funding CLO.

What was the first part of your question again? Oh the disclosure. Right now, the list is still subject to some existing nondisclosure agreements with those banks. There are some public banks in the portfolio that haven't necessarily gone out with their notifications yet. But we would expect at some point in the not so distant future that that will be available.

That is great. And then I've got two more questions if I can?

Yes, of course.

The five basis points of fees that will take, will soak up some of the cash flow, that is on the $250 million?

That's correct.

Okay. And then the second question or my last question, you still have some level of place holder investments within the investment portfolio beyond the CLO, how do we think about future investments? Are there other opportunities out there that would fit the subordinated debt category? Or are some banks still considering preferreds, (technical difficulty), et cetera?

That is a great question. We have things in the queue that are preferred and sub-debt. I would say honestly right now, it is probably skewed more to sub-debt still. As I mentioned in the previous question, it is still the flavor right now. But we do have some preferred opportunities in front of us.

In terms of the percent of the portfolio or how we think about place holders, we still have a number of place holders that are, I would say, currently earmarked for rotation out into higher yielding investments. But, depending on what could happen in the future, we still have a number of TARP positions that are yielding 9%. And if we can find something that's yielding 9.5% or 10% and we don't feel that we are taking more risks to get there, then we would trade out of that as well with a goal of minimizing risk and maximizing return for our shareholders.

Okay that's great. And then, I guess, one more follow-up. The banks that contributed or are part of the $250 million in the CLO, was a lot of that tied to refinancing of the SBLF preferred?

That's a great question and the answer is about a third. About a third of the portfolio used the proceeds for taking out SBLF and a little bit of TARP.

As I think we mentioned, over the last couple of years, it really hasn't changed for us in 15 plus years. It's always been about one-third, one-third, one-third. I think you have heard me repeat that before and this pool is no different. It's about one-third refinancing, one-third acquisition financing and one-third growth. I don't know how it is always one-third, one-third, one-third, but it always seems to be that way.

Thank you, guys. I appreciate it.

Merrill Ross with Wunderlich Securities.

You addressed it a number of times, but I want to maybe hit it a little more head on. Was this CLO a one-off? Or do you anticipate that the need or desire for sub-debt among the community and regional banks could facilitate further transactions?

That is a great question, Merrill. I would like to hope with all the effort put in, that it is not a one-time thing. But I can't promise there will be another one. It is so dependent on factors out of our control.

Would we like to do another one? Categorically, yes. But I couldn't tell you when we could do one or if one can get done.

That said, to the second part of your question, I always rely on people's good sense of their pocketbook and that is going to come down to cost of capital for a bank. As long as banks, the plural no BANX, but banks can make opportunity out of 4.5% after tax cost of capital versus something more expensive, I think there will be opportunity.

If you think about your average bank in America throwing off today roughly about a 9% ROE as per FDIC, they would have to basically issue common stock at 2 times book to be at the same cost as raising this tier 2 capital. And given that under the new policy they no longer have any capital directives for sub-billion dollar banks, at the holding company level, it should just economically behoove them to consider a portion of their troubled capital in this form. Not an oversized amount, but a prudent amount.

So I do think that there academically should be a good audience for this, but I couldn't tell you how quickly they show up, do they show up in the numbers we need? That will be proven out over time.

It just seems so compelling. The second question it is a minor point. But the marketing with the ABA, has that actually been productive? Do you really feel like what you are spending is worth, even though it is now half, right? Does it still make sense for you?

The short answer is, yes. We have had a number of direct investments come from the ABA. Not as many as I would have liked at the outset, but as we always said from the beginning, there is two ways we think about the ABA; offensive and defensive.

So from a franchised standpoint, protecting the investors that we have and making sure that we get more opportunity shown to us than hopefully anyone else, the ABA still serves an amazing capacity there. The ABA also has us on every piece of marketing material, every news bite they put out, every conference on every wall, almost to the chagrin of others even not in our space, we get an enormous amount of billing because of the importance.

To us, it is very worthwhile and I have to be honest, at half the price, even more interesting. That is why we extended into another year of August 2017, because at half the price for all the same reach and benefit, it seems to be a very good value.

Okay, thank you.

Christopher Testa with National Securities.

Good evening. Thanks for taking my questions. Just on the quarterly activity with the investment comp, the senior term loans went up significantly, while preferreds backed off. Was that just in anticipation of what was getting funded into the CLO or was that just opportunistic based on pricing?

That is a good question. It is a little of both. There is definitely less preferred activity going on in the market in general even for $1 billion plus banks, excepting the money center and large regionals. So there's just has been more sub-debt issuance in the last 6 to 12 months in the market.

But at the same time, clearly with the pool that we did and another pool that closed after us, there seems to be a focus on sub-debt. So if we think about the origination that came our way in the last three to six months, it was $0.25 billion of institution. So pretty happy about that.

And not all of that would have been possible if we tried to earn a rate of 8.5% or 9% from all of those. Some of them just, that was too expensive. But at the pricing they were able to with a pricing of 7%, they found that to be economically compelling and in the right structure, financed appropriately, it creates a piece of paper that we were very happy with. So yes, your answer is, yes.

Do you expect the preferred issuance to kind of remain muted until at least the SBLF refinances are done?

I would have to imagine that's the case because SBLF is stepping up to 9%. So to do another preferred to replace a preferred with only a 50 basis point benefit, not as compelling as a 450 basis point benefit. So I would agree with you.

Okay. And I just wanted to verify, the first cash flow for the CLO is going to be in February, is that correct?

The first cash flow. But as do probably the only other two RICs out there, which is I think Eagle Point and Oxford Lane, who buy CLO equities, their GAAP basis is to accrue. And that is the same way that we are doing it. We are not trying to do anything different than what the market convention under GAAP is. It will accrue through the quarter, but the cash shows up in February.

And just, just some nuances here. So was the CLO interest is that going to show up as preferred equity? Or are you going to have a separate category for that on your schedule of investments?

No it will be in the preferreds category. So it is a preferred security. It is not a DRDQDI, so it's ordinary income. But it will be a preferred and will be accrued in that category.

And the income will show up on the interest line item.

Okay, that's all going to be in the interest. And is that also going to be netted for the 10 basis points of the rebate?

No. There will actually be a separate line item for the 10 basis points that will show up, which is roughly $250,000 a year.

Okay that's all for me. Thanks for taking my questions.

Of course.

(Operator Instructions)

Greg Mason with KBW.

Thanks. A couple of just real quick modeling questions on this CLO as well. For the GAAP accrual, the $4.9 million of deal related expenses, does that get accrued over the life of the fund as an expense as well that we need to account for? And how many years is that amortized over?

Good question. No, it does not. It was capitalized in the CLO itself as that separate company.

The only thing we have is a $45.5 million investment in the preferred. None of the expenses of the CLO are StoneCastle Financial's expenses.

Okay, then we don't have to subtract $5 million out of the $250 million asset? That $250 million yields 7% even with that deal expense capitalized in that number, is that correct?

That's correct.

Great. Okay, thanks guys.

Devin Ryan with JMP Securities.

Thanks for taking my follow-up here. Again on the CLO, just trying to get any perspective that you can share around how many of the participating banks you are already in discussions with around some type of financing, or you already had a relationship with? Really, what I'm trying to determine here is how fast this one came together forever to think about a future CLO, really how fast it came together?

Slow, is the answer. But it wasn't a linear slow. As you can imagine, as we talked to more vaguely last quarter and the quarter before, when it was from the R&D phase to exploratory to, as we moved through, there was an enormous amount of education required in the bank community.

What is this again? I haven't seen this type of instrument in a while. How do I think about it as a small bank? So there was a lot of that. And then as we moved into the fall, it picked up pace.

Now does that give any future look? No. It really depends on ebbs and flows and as you're getting into the holidays and then banks have their Q1 call reports. So there is any number of things that could change the pace.

If the short question is, are we going to return to the torrid days of capital markets issuance by small banks? I have no idea. There is still demand. There were banks that did not make it into this pool that expressed interest so I'm hoping that there is some continued flow.

I think it was Merrill Ross who asked, we are hopeful we can get another one done and another one and another one. But there's no way to know. We are going to take it day by day and still do things on the balance sheet as they come in?

Got it, thanks. Just with respect to the CLO leverage, is that the standard level that in prior deals that you have structured? Is that the right way to think about a leverage dynamic?

Well, there is a loaded question there. I've never structured anything like this. This was the first of its kind. So in that case, being the one purple bird with feathers, that's what they look like.

It is hard to say what the next one looks like. But generally, as with most things in rated finance with any rating agency, templates tend to be created. So I don't think it is an unrealistic assumption to think the next one would look like this one, but could change.

Got it. I know you had done a number of structured products in your day at Smith Barney. Anyway that's helpful. Thank you very much.

Absolutely.

There appear to be no further questions at this time. I would like to turn the floor back over to Management for closing comments.

Great. Thank you, Operator. As always, we appreciate your continued support of StoneCastle Financial. Since our next call will be in 2016, at this time, I want to wish everyone a healthy and happy holiday season and a happy New Year and we will talk to you next year.

This concludes today's teleconference. You may disconnect your lines at this time. Thank you for your participation.