ArrowMark Financial Corp (BANX) 2018 Q1 法說會逐字稿

Welcome to StoneCastle Financial Corp. First Quarter 2018 Investor Conference Call. (Operator Instructions) As a reminder, this conference is being recorded.

I would now like to turn the call over to Rachel Schatten, General Counsel of StoneCastle Financial.

Good afternoon. Before we begin this conference call, I'd like to remind everyone 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 semiannual reports of the company.

StoneCastle Financial has based the forward-looking statements included in this presentation on information available to us as of March 31, 2018. The company undertakes no duty to update any forward-looking statement made herein. All forward-looking statements speak only as of today, May 3, 2018.

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 First Quarter 2018 Investor Call. In addition to Rachel, joining me today is Pat Farrell, our Chief Financial Officer. I'd like to start the call today with a review of StoneCastle Financial's quarterly results as well as take time for our portfolio review due to the number of transactions that occurred during the quarter. Then I will turn the call over to Pat, who will provide you with greater detail on our financial results, before I open up the call for questions.

Net investment income for the quarter was $2.7 million or $0.41 per share. Total assets were approximately $182.6 million, and the value of the investment portfolio was $178.8 million. During the quarter, the company invested $58.2 million in 7 investments and sold 9 investments totaling $43 million. At quarter-end, the estimated annualized current portfolio yield was 8.16%. However, excluding the investment in PFF, the iShares preferred stock ETF, it would have been 9.17%. I'll add more comments on this during the portfolio review. The net asset value at the end of the quarter was $21.58, up $0.02 from the prior quarter. We believe no meaningful credit issues currently exist within the portfolio, and the majority of the investments continued to be scored investment-grade by Kroll Bond Rating Agency.

Now let me turn to the portfolio review. The first quarter was an active one, with a number of purchases in sales related to our investment in a new pooled vehicle, Community Funding 2018, which closed February 23. As I noted last quarter, StoneCastle sold 9 holdings to the vehicle, valued at $43 million, and in return received $26 million in cash and $17.6 million par amount of preferred shares. The average investment size of the holdings sold was approximately $4.9 million, with a weighted average coupon rate of 7.78%. Of the 9 holdings, the single largest region, the Midwest, totaled 35%, with Virginia as the single largest state exposure at 19.5%, followed by Indiana at a little over 18%. Upon the contribution of assets, StoneCastle realized, as expected, a loss of $1.4 million due predominantly to changes in the interest rate of some of the securities upon transfer. Since StoneCastle is the sole investor in the preferred shares of Community Funding 2018, this loss will be partially offset by the higher yields StoneCastle expects to earn going forward. The estimated effective yield we expect to receive on the preferred shares is currently 9.38%.

Let me spend a moment on the structure and the benefits of Community Funding 2018. The vehicle is comprised of 60% debt from an institutional investor and 40% preferred equity interest owned by StoneCastle Financial. This transaction gives us the opportunity to continue scaling the preferred equity interest up to $40 million. Subsequent to the end of the quarter, the company originated an additional $10 million of Tier-2 sub debt, resulting in an additional $4 million of preferred equity interest in the vehicle. We have found increased demand in the market for these types of vehicles, making them more readily available as needed in the future. Unlike the Community Funding CLO from 2015, that required a critical number of banks in alignment before we closed, with this vehicle, the company has the flexibility to more easily replicate the structure and be more nimble in responding to market opportunities. In addition to interest income, StoneCastle will receive a servicing fee of 30 basis points per annum on the total amount of collateral in Community Funding 2018, which currently amounts to $162,000 annually or approximately $0.005 per quarter. The fee is paid to StoneCastle Investment Management and is rebated in its entirety to StoneCastle Financial. According to GAAP, we're required to record the fee income separate from the interest income earned on this investment. However, when combining the cash flows from the transaction in its entirety, StoneCastle benefits from an overall current effective yield of 10.13%.

Now let me briefly turn to our purchases of the iShare preferred stock ETF. As you may recall, we have utilized PFF as part of a short-term cash-equivalent investment strategy. Its holdings of predominantly financial assets are consistent with our investment mandate. The investment currently yields approximately 5.6%, which is substantially more attractive than short-term money market fund yields, which were around 140 basis points at quarter-end. At March 31, our portfolio's estimated annualized current yield without PFF was 9.17%, an increase of 12 basis points from the prior quarter. For the first quarter, our adviser, StoneCastle Asset Management, has elected to waive its management fees on this particular investment.

Another significant transaction during the quarter was a positive corporate action related to Priam Capital. During the quarter, the company received its notification that Howard Bancorp received shareholder approval to close on its acquisition of 1st Mariner Bancorp, the key holding of Priam Capital. As a result, StoneCastle's investment was converted into common shares of Howard Bancorp. As of March 31, our initial $1 million investment was valued at approximately $1.6 million, reflecting unrealized depreciation of over $642,000 above our cost. This reflects an unrealized total return of 1.6x our investment and an annual estimated internal rate of return of approximately 14%. At quarter-end, the portfolio is comprised of the following categories: 25.6% in credit securitizations; 20.2% in preferred stocks; 17.8% in term loans and debt; 14% in trust preferred securities; 11.2% in ETFs; 9.4% in pooled equity interest; and the balance comprised of common stock and money market funds. The quarter-end schedule of investments can be found on the company's SEC filings and on the company's website.

Despite an active first quarter, the market does remain slower than usual, with bank demand for capital below its historic norms. This changes from time to time, and we, like all investors, are subject to the market conditions. As always, our origination team is focused on investments that outperform in this environment. And we believe a continued priority on credit quality is appropriate. The market, by nature, dictates rates based on many factors. We will continue to seek out attractive investments for our shareholders that meet our investment guidelines.

Turning to the industry financial trends, in general, continue to show positive results year-over-year. For example, net interest margin, NIM, for community banks widened 8 basis points from 3.58% to 3.66% during this period. Community bank NIM was 40 basis points above that of non-community banks in the latest FDIC quarterly banking profile covering Q4 2017.

If we look for a moment at banks as an investment, StoneCastle pays a dividend rate over 3x higher than the average community bank dividend rate and offers a yield advantage of over 400 basis points above the 10-year treasury and 290 basis points above the BofA Merrill Lynch Effective Yield Index as of quarter-end.

To conclude, I want to mention that we continue to believe in investment in StoneCastle Financial afford shareholders a greater opportunity for capital preservation as well as a yield advantage over other income vehicles in the market, all while offering a high credit quality portfolio.

Now I want to turn the call over to Pat to discuss the financial results and provide details on the underlying value of the company.

Thank you, Josh. As I do each quarter, I will present the financials by going through the detailed components to help you understand the value of the company. The net asset value at March 31 was $21.58, up $0.02 from the prior quarter. The NAV is comprised of 4 components: net investment income; realized capital 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. First, income for the first quarter was $4.2 million or $0.65 per share. The investment income for the quarter was $2.7 million or $0.41 per share. Net operating expenses for the quarter were $1.5 million or $0.24 per share. During the quarter, our adviser waived approximately $87,000 in management fees on the PFF investment. The second component affecting the change in NAV for the quarter is realized capital gains and losses. The net realized capital loss for the quarter was approximately $1.43 million or $0.22 per share. The majority of this loss was due to the contribution of 9 investments into Community Funding 2018. 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. For the first quarter, the unrealized appreciation of the portfolio increased by approximately $1.36 million or $0.21 per share. Nearly $800,000 of the unrealized appreciation was due to the Priam corporate action and subsequent acquisition of common stock of Howard Bancorp. As Josh mentioned, this transaction produced a total return of 1.6x our investment and an annualized IRR of approximately 14%. Also of note this quarter, Community Funding CLO had unrealized appreciation of approximately $300,000.

As I note each quarter, the vast majority of the portfolio continues to be independently marked from broker-dealer quotes. For the quarter, over 99% of the portfolio prices or marks reflect a minimum of 2 quotations or actual closing exchange prices. These quotations represent an independent third-party assessment of the current value of the portfolio. At quarter-end, the closing stock price of StoneCastle traded at a slight premium to the actual market value of the net assets of the company. We're pleased that the market is beginning to recognize the value of our company.

The fourth component affecting the change in net asset value is distributions. The cash distribution for the quarter was $0.38 per share. The distribution was paid on March 27, 2018, to shareholders of record on March 20, 2018.

In summary, we began the quarter with a net asset value of $21.56 per share. During the quarter, we generated net income of $2.7 million and net realized capital loss of approximately $1.43 million, and the unrealized value of the portfolio investments appreciated by approximately $1.36 million. The sum of these components, offset by a distribution of $0.38 per share, resulted in a net asset value of $21.58 per share at March 31, up $0.02 from the prior quarter.

At quarter-end, the company had total assets of approximately $182.6 million, consisting of total investments of $178.8 million, cash of $1.1 million and other assets of $2.7 million, which includes receivables and prepaid assets.

Now let me update you on the balance of our current credit facility. At March 31, the company had $20 million drawn from the facility. In accordance with the regulated investment company rules, we may only borrow up to 33.3% of our total assets. Our leverage percentage at the end of the quarter was 11%.

Now I want to turn the call back over to Josh.

Thank you, Pat. Now operator, we would like to open up the call for questions.

(Operator Instructions) Our first question is from Bryce Rowe with Robert W. Baird.

Wanted to ask 2 questions, Josh. One, I'm sure you are pleased to see the announcement that Wintrust is acquiring Chicago Shore. And it looks like that transaction will close late in the third quarter. So curious if you've kind of done the analysis to understand how that might affect the mark where you're carrying Chicago Shore, and any unpaid dividends up to this point.

Well, the marks are the marks. We'll see how the Street reacts. Clearly, we've made sure and communicated what's publicly out there. While I would say we don't expect any surprises, mergers aren't done until the fat lady sings. So let's just always be a little guarded, not to count our chickens until they are actually in the bank account. That said, Pat, what's our current accrual right now?

Yes. So right now we've got about $0.24 in back accruals, if you will, that Chicago Shore would be paying us up on.

As of today.

As of today, right. And that goes for about $0.22, $0.23 a quarter looking forward. So you could add another couple of quarters in possibly, depending on -- your guess is as good as ours with regard to when the timing goes, but that's the rate with them. Other than that, we don't really know anything else about it other than what was in the press release.

Got it. Okay. That's helpful. And then I guess second question. You saw the -- the activity listed here in the first quarter, including the term loan in American Capital Bancorp. Just curious maybe why that may not have fit into the new CLO.

It could be for various reasons. Sometimes it has to do with maturities, it has to do with the nature of the banks. Even though credit can be good, that particular institutional investor has some areas they like and some areas they don't like. And so in that specific situation, it wasn't appropriate to put it in there. But also we are, in a balanced way, cognizant of trying to maximize our capital to deploy. And something that's yielding generally in the high 8s or 9 or above would actually -- I mean, yes, we could get further out of it by putting it into the vehicle. But we actually get more assets deployed if we keep it directly on the balance sheet. So $7 million of $9 million on the balance sheet versus ballpark, $3-odd-million or $2.8 million, 40% of that -- actually $2.8 million exactly, add something higher, but we need to get our dollars deployed, so we can maximize earnings for the company. So in the case of American Capital, I'd have to go back if that was specifically for the sort of gross deployment of dollars for yield or if this was also one that didn't fit the specific profiles for that institutional investor. But in either case, we're happy with the earnings on that.

Our next question is from Devin Ryan with JMP Securities.

This is Brian Mckenna filling in for Devin. First one for me. Maybe could you just drill in a little bit to just some of the drivers you're seeing right now in the backdrop. I know you mentioned that it's a little bit slower. So just trying to get some additional color there. And then kind of secondarily on top of that, I know there's some puts and takes, but can you talk about what the investment pipeline looks like today? And then how that compares versus year-end 2017 and 1 year ago?

Sure. I mean the attributes that are driving demand, of course, center on always a few key issues. One is the growth rate of the loan book of banks. If the growth rate of the loan book is exceeding retained earnings, then they need capital from time to time. When you look at a private bank merging with another private bank, it's usually not a terribly desirable transaction for the acquired, if it's 100% stock of someone else's private bank, you do want to get some dollars out. So we're seeing an increase in the interest from some M&A transactions that would like to have a cash component, and a very effective way to do that is with sub debt. Because right now, we're seeing -- let's say, tepid loan growth in the industry, I mean it's fine, it's continuing to grow, but it's not down a torrid pace. The economy is sitting stable. There is just not a huge amount of retained earnings-related need. Although that topically comes up here and there. The equity markets over the last, call it, 6 months are still keeping bank valuations at reasonably high levels. So if you are a public bank, and you're buying a private bank, you're looking to raise common stock at a premium to book. And quite a substantial one that probably has at least a nominal effective cost that could be less, unless you think you're going from 2 book to 3 book, in which case, doing sub debt or preferred would make more sense. So we've seen across the whole industry, I think, a lot of folks sitting tight, because the bid-ask on some of the M&A transactions. We see them every couple of days with something getting announced. More on the small to small, but doesn't hit the tapes. But they are just trying to figure out how they want to fund things. And at the moment, they still tend to look towards some equity rather than debt. But the pipeline actually has been picking up quite a bit over the past few months. Hence, we're able to get a fair amount of deals done this past quarter. We put those into the pooled vehicles, so that we can extract a bit of additional value out of it, without taking a whole lot of additional risk. I mean, obviously, 40% preferred shares is not a lot of leverage in that vehicle compared to the 18.5% preferred from the deal we did years ago, which has, of course, performed exactly as planned to date. So yes, I think we feel pretty good about the pipeline. We've really been growing more of the outreach, not to the end banks. You can't compel a bank to issue. But we're spending more time with the association, state and national, spending more time with the law firms and the regulators, and the investment banks, more time on the ground. And that is resulting in more deal flow. So there are some other things that are going on post quarter-end. We mentioned one in my comments, but there's more that we intend to have done this quarter that's sort of in process. We do have to look forward though to whether it's a year from now, 9 months, 15 months, the whole CECL issue. And I think there's an article that's going to be coming out in American Banker soon where there's going to be some quotes from me around that because it's growing in awareness that, that can be a $20 billion, $30 billion, $40 billion capital need for the industry, not because of any losses, just because of the accounting changes. And while regulators are exploring some small changes to what they do on CECL. Broadly, they are not making any material changes that will change that need for these banks to fill a capital hole. So that could be a deep pipeline coming, but that's a TBD, right? We'll have to see.

Yes. Okay. Got it. Appreciate all the color. And then just a second one for me. Just with -- I appreciate the commentary just on the ETF's assets, but is there any kind of sense of urgency to get those kind of rolled into other longer-term investments? Or how should we think about the timing of that kind of coming and rolling off into higher-yielding investments? Just trying to gauge the timing from kind of here till year-end per say.

Oh, no. There's no rush. Pat and I are having my Mai Tais. You know, we're always trying to put it out as quickly as we can. But we didn't like the fact that the cash position and sort of the disparity in that curve, we said, look, if we pick up some of PFF, which we always like the credit profile and what's underneath there, the yield on its own is okay. But we said, look, we're not going to charge investors. And granted, it's our election. But we're not going to charge investors a full quarter of management fees to pick up a dividend. And so we waived our fee. So if you sort of waive our fee, all of the sudden that $560 million is more like 7-and-change percent. It's not bad, and it definitely helps to get the earnings. We try to be shareholder-friendly. For us, I think people know at this point, we're very long-term oriented. And so, if we can extract more free cash flow for our investors while we continue to process new credits, that seemed to be the prudent yield. We haven't actually done it in a while, but we wanted to do that while we finish up the pipeline. But no, we're not sitting on our laurels. We are pushing the team and our, sort of, referring agents as hard as we can. In fact, the ABA recently brought us another deal. So they still do earn something for that fee that we pay them, and we're happy about that. So no, we are pushing hard and want to have it deployed as fast as we can, but we are not going to bend on credit quality.

(Operator Instructions) Our next question is from Christopher Testa with National Securities.

Yes. Just curious, obviously, congrats on successfully doing another pooled transaction. Just wondering, Josh, is there a certain limit to how much securitization, as a percent of your investments, you're comfortable of doing? Is there a certain sort of soft cap that you have on that?

Well, there is, but you can't -- it's not a number. So for example, if we did a greater percent of our portfolio, where -- just to have fun with that, it was 80% equity and 20% debt, that's one thing. If we do a transaction that's 20% equity and 80% debt, that's a different thing. So we sort of drill to the underlying exposure, that's what we care about. And so we really look on that basis. I don't think, like I said, we want to do a whole lot more than what we have here. I think we would want to grow more organically from here. And we're sort of pushing for more preferred investments and other things that we see coming through. So there's technically nothing wrong with doing them as long as we're very, very careful and cognizant of what risk we're taking, and we are.

Got it. Okay. And just touching on that a bit. I know you had mentioned that you put an additional $10 million of sub debt into the structure. Traditionally, and correct me if I'm wrong, I don't know if it varies on a case-by-case basis, but is there a limit generally to how much the debtholders will tolerate in terms of how much sub debt versus term debt goes into these?

Well, sub debt and term debt are pretty much synonymous. It's whether it's senior debt or sub debt. Sub debt being a Tier-2 capital instrument, senior debt just being debt for a bank. Clearly, the sub debt is preferable for the institution -- no, but -- for the institutional investors compared to the days of trust preferreds, which were deferrable. And sub debt is a nondeferrable. They're happy with a 100% sub debt.

Oh, okay. Got it. And I appreciate your comment to the previous gentleman's question about CECL and all of that. I'm just curious to the extent that you could get your crystal ball out, how much -- when do you think banks are going to start waking up to this? Because I know you had mentioned in the white paper, basically, that you wrote that you could go from well capitalized to cease and desist overnight if this came in. And it seems that, given the kind of lackluster deal flow going on, that it seems that banks are asleep at the wheel of this. Are they just generally procrastinators by nature? Are they not fully aware of this? Any detail there is appreciated.

Great question. Well, one of my favorite Texas bankers told me a line years ago, and he said "there's 2 banker's prayers. So there's the morning prayer and the evening prayer. And the morning prayer says, God, don't let me do something first and do something stupid. And the evening prayer is, God, don't let me wait too long and miss it." And that is very much the adage of most bankers. And I say that lovingly because we do love these banks. But they are not quick to react. It has been the case that I've seen in 25 years dealing with these banks that they tend to -- I wouldn't say be asleep at the wheel, but reticent to act early, right? I mean that -- if we talk about CECL, that's exactly why the ISB and FASB are sort of forcing us down the throats of public companies, saying, "if you are not going to reserve early enough, we're going to make you do it". Because none of you guys had enough reserves going into the last crisis. So it's sort of a public recognition of -- we think that institutions are a bit slow to react until they see the fire has started. So it's not that we're seeing it coming, but you've had such benign credit markets for so many years now, the tepid management team at the bank would say, "well, there's nothing to worry about right now, it's coming in 18 months. We'll deal with it later". The problem is they have crowd mentality, right? When we get there, and all of those banks start calculating the numbers and say, "I need capital", unfortunate for them, great for us and our investors, the rates might have to go up a lot because they're just supply and demand. They're just -- there isn't $40 billion or $20 billion or even $10 billion of private community bank capital investors available. And if there is that much need, well, I'm sorry, first come, first serve. And the highest price wins. And it's not like a secret. We've told them this. We've told them this publicly. We've talked about this in bank meetings and trade association meetings. Trying to wake them up, we published that paper. So I think the ABA is spending an increasing amount of time with their accounting policy staff on this. I'm seeing the journals, American Banker, SNL writing more about it. So we can only be -- our voice is only so loud even though we're a pretty prominent voice in the industry. They have to decide on their own. And I love clichés. You can lead a horse to water, but we can't make them issue capital. So...

All right. No, I appreciate that. And last one for me, Josh. We've heard a lot about potential Dodd-Frank rollbacks. And I know you've spoken on this previously, but it's gotten more media attention recently. Just curious if you could kind of just give us the lay of the land on just how beneficial the current proposals would be for community banks. Is this really just optically something that looks nice? Or is this something that's going to be meaningfully -- a meaningful tailwind rather for community banks?

Well, okay. Couple answers in there. Hensarling had been reluctant to accept the Senate version of the Crapo Bill. There seems to be some growing pressures that may be in the coming weeks, although I've only heard it from the R side of the aisle, that we might end up taking it as is. On the other hand, I've heard from more than one congressperson that the longer this moves into December and you get closer to the election season, there's going to be a growing reluctance on the D side to pass anything pro bank. So we -- let's just sort of keep that in the back of our minds. As it relates to provisions in the current Senate draft because, of course, the House draft has a couple of different issues, will it help community banks? Yes. Do the Dodd-Frank issues have much effect? No. Where we'll help, and we were involved in some of that, working with Hensarling and his -- and other members of the House Financial Services Committee on the House side, bringing up some of the issues that bankers had raised to us, such as -- for example, HMDA data, the collecting of certain demographic -- socioeconomic data related to mortgages. Well, community banks are a small piece of the national mortgage pie, yet having to pull x number of employees of a 70-person bank to calculate this information, it's not going to change the national statistics in any meaningful way, but it was quite a burden on small banks. So there are number of those kind of things that are in there, that would help. So it'll ease things on the margin. It's not going to kick the doors down and have wild profitability because banks are already actually having quite strong profitability, with consistent year after year in the 9s. So even with a kind of a slower market, we're still generating 7-plus percent yields on strong investment-grade credits, so we like that. So the worst case is, things stay as they are, and the banks stay profitable. The best case is, no great change, but on the margin, life's a little easier for smaller banks. Maybe they could do a bit more lending. It could have a more meaningful impact for regional and money center banks that do have Dodd-Frank constraints, but that will still be a TBD as well.

We have reached the end of the question-and-answer session. I would like to turn the call back over to management for closing remarks.

Thank you, operator. Well, we as always appreciate the investor support in our company, and have a wonderful summer. And we look forward to speaking to you in August.

Thank you. This concludes the teleconference. You may disconnect your lines at this time, and have a good day.