ArrowMark Financial Corp (BANX) 2018 Q2 法說會逐字稿

Greetings, and welcome to the StoneCastle Financial Corp. second quarter financial release conference call. (Operator Instructions) As a reminder, this conference is being recorded.

I would now like to turn the conference over to your host, Rachel Schatten, General Counsel of StoneCastle Financial. Thank you. Please proceed.

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 June 30, 2018. The company undertakes no duty to update any forward-looking statement made herein. All forward-looking statements speak only as of today, August 9, 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 second quarter 2018 investor call. In addition to Rachel, joining me today is George Shilowitz, President; and Pat Farrell, our Chief Financial Officer.

I'd like to start the call today with a review of StoneCastle Financial's quarterly results and then provide updates on the company. 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 $2.6 million or $0.40 per share. Total assets were approximately $190.9 million, and the value of the invested portfolio was approximately $187 million. During the quarter, the company invested an additional $5.26 million into Community Funding 2018, which was announced on last quarter's call.

The net asset value at the end of the quarter was $22.01, up $0.43 from the prior quarter due primarily to an increase in the value of Chicago Shore and Community Funding CLO. 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. This was a quiet quarter outside of the company's additional investment in Community Funding 2018. This pooled equity vehicle closed in April 2018 with total assets of $57.2 million, and StoneCastle invested $22.3 million in the preferred shares. We closed with an estimated effective yield on the preferred shares of 9.34%.

Of the 11 holdings in the vehicle, the largest investment and single state exposure was First Banchares located in Mississippi, totaling $10 million. We continue to discuss this type of financing vehicle with large institutional investors, but we have no plans to execute another investment at this time.

Another significant transaction during the quarter was the notice of intent to redeem Chicago Shore Series A and B, which we've held in the portfolio since 2014. However, as of the date of this call, securities have not yet been redeemed.

As you may be aware, Chicago Shore suspended the declaration and payment of their preferred dividends in 2016 due to a regulatory order. Since that time, StoneCastle was not permitted by GAAP rules to accrue the Chicago Shore dividends. At quarter end, the amount of undeclared and compounding dividends was approximately $1.7 million.

In early July, our adviser, StoneCastle Asset Management, exchanged our preferred stock position in Chicago Shore for a variable rate preferred stock issued by a new financing vehicle, [First Marquis Holdings]. When the Chicago Shore securities are ultimately called, First Marquis will receive a compounding but unpaid dividends and principal repayment from Chicago Shore. This will enable First Marquis to pay quarterly dividends to StoneCastle at a current rate of approximately 13% per annum commencing in Q3 this year.

Consistent with our conservative view of managing the portfolio, this transaction was designed to provide our shareholders with stable, long-term economic benefits with multiyear cash flows from the Chicago Shore investment, rather than a onetime income pickup.

Continuing with the portfolio review. At quarter end, the portfolio was comprised of the following categories: 25% credit securitizations; 21% in preferred stocks; 17% in term loans and debt; 13% in trust preferred securities; 12% in pooled equity interests; with the remaining 12% balance comprised of common stock, money market funds and cash equivalent ETFs.

At June 30, our portfolio's estimated annualized current yield was 8.72%. Without the position in PFF, the yield was 9.09%, down slightly from last quarter. At quarter end, schedule of investments can be found on the company's SEC filings and on the company's website.

Now let me turn to the market for new investments. The market remained slow with bank demand for capital below historic norms due to the high equity capitalization within the banking industry. One expected change is the adoption of CECL, which I had mentioned on previous calls. CECL or current expected credit loss, is a new FASB accounting standard which would change how financial institutions reserve for expected losses. We believe this accounting standard will create the next scalable need for capital in the industry, yet it might take 1 to 2 years or more for this reality to come to fruition.

In the meantime, as the interest rate environment continues in transition, we believe the best course of action is that of patiently investing capital. Therefore, we continue to focus on credit quality as a priority in the portfolio. As you know, we typically structure our investments as noncallable for 5 years. We're not in any hurry to invest into this relatively low credit spread environment. As always, our origination team is focused on investments that outperform and that are accretive to our portfolio, and we're currently working on a few attractive prospects, which we believe may close in the quarter.

Turning to the community bank financial trends. In general, the banks continue to show positive results. In the FDIC's latest quarterly banking profile for Q1 compared to a year earlier, 7 out of 10 community banks reported higher net income. More than 4 out of 5 community banks reported higher net interest income. More than half of community banks reported higher noninterest income. And community bank loan and lease balances rose by 7.4% during the year, reflecting a growth rate of approximately 3% higher than that of non-community banks.

As I continue to mention, as an investment, banks pays a dividend rate over 3x higher than the average community bank, with our current dividend yield of approximately 7% at the time of this call. At quarter end, banks offered a yield advantage of nearly 380 basis points above the 10-year U.S. Treasury and approximately 220 basis points above the BofA Merrill Lynch Effective Yield Index. This dividend yield does not take into account the tax advantage of qualified dividend income, which increases the overall after-tax yield of our dividend.

To conclude, we continue to believe an 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 providing 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 June 30 was $22.01, up $0.43 from the prior quarter. The NAV is comprised of 4 components: net investment income; realized capital gains and losses; a change in value of the portfolio's investments; and finally, distributions paid during the period. Let me walk through these components.

Gross income for the quarter was $4.4 million or $0.67 per share. Net operating expenses for the quarter were $1.8 million or $0.27 per share. Net investment income for the quarter was $2.6 million or $0.40 per share. The second component affecting the change in NAV for the quarter is realized capital gains and losses. The net realized capital gain for the quarter was approximately $34,000 or less than $0.05 per share.

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 second quarter, the unrealized appreciation of the portfolio increased by approximately $2.6 million or $0.40 per share. The majority of this increase was due to increases in the values of Chicago Shore and Community Funding CLO.

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 4% premium to the actual market value of the net assets of the company.

The fourth component affecting the change in net asset value is distributions. The cash distribution for the quarter was $0.38 per share and was paid on June 28, 2018, to shareholders of record on June 21.

In summary, we began the quarter with a net asset value of $21.58 per share. During the quarter, we generated net income of $2.6 million and net realized capital gain of approximately $34,000, and the unrealized value of the portfolio investments appreciated by approximately $2.6 million. The sum of these components, offset by a distribution of $0.38 per share, resulted in a net asset value of $22.01 per share at June 30, up $0.43 from the prior quarter.

At quarter end, the company had total assets of approximately $190.9 million, consisting of total investments of $187 million, cash of approximately $246,000 and other assets of $3.7 million, which includes receivables and prepaid assets.

Now let me update you on the balance of our current credit facility. At June 30, the company had $45.5 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 23.8%.

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 comes from the line of Christopher Testa with National Securities.

Josh, I just wanted to discuss potential significant changes in how you're viewing the pipeline. I mean, last year on the earnings calls, you guys were kind of offering the ability of somebody to participate in the pipe. And then today, originations are just a bit over $5 million. I mean what's kind of been, I guess, the biggest factor or factors that have caused, I guess, much lower originations than I think you had thought of the prior year?

It's really the ebbs and flows of the industry. I mean we actually, as we mentioned on the call, we have a number of deals we're working on this quarter, so it really just depends where the demand is at a point in time. There's also deal flow, but they're at rates that we don't think are particularly economic. They're just not attractive. So sure, I mean, if our investors are happy dropping our yield from 7% to 6%, we can do a lot more paper. But I don't know if that's the most prudent thing to do because I think that given the size of our vehicle, there's enough very accretive opportunities that we can be selective and find the ones we want.

Okay. No, that's fair. And what's caused this, I guess, kind of sudden onset of kind of spread compression in bank lending? I know that this had been kind of immune to it while the middle market cash flow lending was compressing for 2 years, and it seems that this kind of happened pretty quickly. Have there been new entrants in the space? I mean, what's helping banks drive terms to that point?

It's not so much that -- there's no new entrants that we're aware of. It's really -- and it's not bank specific. I mean, as we look across all corporate spreads, I mean -- being an investment adviser we talk to all the different -- we're just on with one of the senior people over at Apollo, they're having the same issue, like everything is ridiculously tight. Which, if you're prudent, you'd say, that can't last and so why do you want to rush into that? So a lot of the smart money out there, they're not pulling things off the table, they're just being more judicious about what they buy. I hear that from private equity firms. Normally, they're buying things for 6, 7x EBITDA. Now they're chasing stuff at 10x EBITDA. It's just -- the cycle is going a little longer than it should. And I'm a big believer, and so are everyone here, that we're sort of a mean reversion model to the financial markets. So wanting to put up a bunch of noncall 5 on because, let's say, a Sandler O'Neill was able to print a few trades at 5.90 for much, much larger banks, it has some smaller banks sort of saying, why don't I get that? Well, because you're not public and you're not rated and you're small. So we're just being judicious. I mean, it's not that we're not seeing a lot of deal flow coming in the door, just our committee is saying, nice credit, but we're not interested at 6.25. We'd be interested at 7.5. And we're getting some. We get some things at 9 or higher. It's just we just have to be judicious and find the best risk return because our one and only goal is to maintain a steady dividend and steady earnings, right? And with our current portfolio yield at about 9.09%, when you sort of take out just our cash equivalent, we're trying to maintain that as best we can. That may have to come down over time because you can't find the markets, but we are fighting it right now and we're still funding enough to keep ourselves generating enough income for investors that we're easily covering our dividend, and that's our primary goal.

Got it. Okay. No, that's definitely a fair answer. And would you say that the yields are still high enough that they would make sense in a community funding-type vehicle where you get some synthetic leverage?

Yes. Yes. They're -- we are still exploring those opportunities to do more vehicles of a similar kind. We're not in a rush. But yes, there is still -- I mean, this is the same side of the market. The financing rates are better than they were a year ago because the spread is compressed on that as well, so that value is still there and we're looking at that and we're exploring and in discussions, but there's nothing happening in the short term.

Got it. Okay. And we're about roughly a half year since CECL was originally announced or so. Just wondering, are the banks still just sitting on their hands waiting for the last minute? Or has there been some pickup in discussion that you've been hearing about this?

It's like -- what's the old adage? The 7 stages of denial or something like that. The banks are waking up, and what they're realizing is I'm not going to sit in my hands, I'm going to argue. So there's been some chatter in American Banker and ABA Banking Journal about banks saber rattling to the fed and to anyone they can of what can we do about this. And what I've heard on the inside is nothing is likely going to change. You can ask for this. This a GAAP issue. It's done. It's decided. So this isn't a regulator issue, this is a FASB issue. Now, again, when I mentioned it for the first time 6 months ago, we were very clear to say this is like an 18-month window before things begin because the implementation date isn't until another year or 1.5 years from now, so it's still going to take time. But yes, people are getting a bit more anxious about it, and so that is a good sign. They're thinking about it now. They're starting to quantify it. And their vocalness, if that's a real word, is because they're starting to realize, "Wow, I really would have to raise some capital here. And I don't know, that's going to cost me." Well, yes, it's going to cost you, but it's also going to make you a safer institution. So -- and that was part of the article, I think, in the American Banker today or yesterday about that same issue is, it would actually does get banks thinking more prudently about am I earning the proper rate of return for the risk I'm taking on a given loan and the duration I'm taking, which they always innately did, but not in such a quantitative way. So yes, I think it's improving -- starting. It's slow, but improving.

Okay. Great. And just curious, what are the banks saying about the 2, 10 yield curve that seems like it's on the cusp of inverting?

There's 2 schools of thought from banks I talked to. One is there's no way the fed is going to forcibly invert it because, right now, it's more of the short term being forced up deliberately where the long end hasn't really moved all that much. It's come in and up and down a little bit, hasn't moved a lot. So it would seem odd to a large group of bankers that the fed would willfully put banks in a negative carry position. That said, it can still happen. And then the other half is worried it will happen temporarily, as it has historically. That would bring some NIM compression, but credit quality is, knock on wood, still quite strong out there so it's not an immediate concern. And then the question is something is going to have to give at some point, right? I mean, the fed is pulling liquidity out of the system, China has a moratorium on increasing its treasury position, supposedly Russia is liquidating everything, who really knows? But it's not panicking anybody. The greater concern in the banking space right now is access to deposit funding. That's the topic du jour. That it's getting harder and harder to find the deposits to fill the loan demand.

Got it. Okay. So is there starting to be maybe a potential for deposit flight, now that short-term rates have ticked up for so long?

It is. It is an issue. You're seeing more money move back in the money funds because the rates you can earn on a money fund, government money fund are up at sort of where the top of bank rates are, and so that's having some bank customers explore their options. You're seeing, because of where the -- still the equity markets are, the cash balance in most brokerage accounts is near sort of long-term lows, so there's less cash in those to be redirected to banks and that's a trillion-dollar market. Prime for the larger banks, the prime money funds are $800 billion smaller than they were a couple of years ago. That used to be a huge buyer of sort of bank commercial paper, sort of uninsured deposits, and that's not there. So yes, there is -- it's not a concern because the nice part is banks can choose not to make loans, so they find themselves in a risk position but it hampers growth. And so they're having to pay more for deposits to the extent that they're comfortable paying more for deposits.

Our next question comes from the line of Devin Ryan with JMP Securities.

I guess, first question here just on the Chicago Shore detail. If you don't mind, just maybe giving a little bit of a re-explanation around the new Marquis vehicle. And I guess, really, why go through the effort to create that and delay the realization of the dividend, if I heard correctly? And then just with the acquisition of Wintrust-Chicago Shore closing at the beginning of the month, given that you're still close to the situation, do you have any sense or expectation on timing of when it could be called?

Let's do that in reverse order. No, they gave us the notice. The notice period has come and gone, and they haven't yet. I wouldn't expect it to be terribly delayed. I mean, it has to get regulatory approval. But they've already -- and along given their notice that's required, which was a 30-day notice. So I don't know when they're going to do it. In the meantime, we're still earning 9%. So okay, take all the time you want. In terms of First Marquis, when we and the board were sort of reviewing the situation, it was one thing when it was a couple of hundred thousand of accrued. But having gotten to this point of multiple years of deferral and 1.7 million of back dividends, we sort of said, look, our job is to benefit the shareholders over a long period of time, stable, predictable income. So we sort of talked to lawyers, talked to the accountants and said what are our options here because this was supposed to be, originally, something that we'd paying 9% current and would have benefited investors over all of these years since, what, 2016 or so when we bought it. So we said, look, if we can basically put this into a vehicle, like we do with other vehicles, and have that -- the benefit of all of that back interest plus still earning on the corpus, spread that over time and generate a very nice rate of return for multiple years, that actually benefits shareholders across a longer period of time than whoever was lucky enough to own it at the very moment that it prepays.

Got it. Okay. Very helpful. Appreciate that, and then just a follow-up here. On the ETFs assets, you ended the quarter at about $20 million, that's roughly flat from last quarter. I'd love to just get some thought around how you're thinking about trajectory of the ETF investments over the next couple of quarters just based on your comments on the pipeline, not trying to get too granular on how big the pipeline is, but if you just would think about replacing those or using some of the kind of capacity on the credit facility first just trying to think about kind of where you would go next in terms of funding that?

Sure. No, we would -- I mean our view and Pat can make a comment if he feels differently, is as we close these new investments, we'll be liquidating the PFF to roll from a 5.5% yield into whatever it might be, a 7%, 8%, 9-plus percent yield. So while we can't say exactly how much because we don't know, I mean we have a lot in the pipe but it depends on the timing of when they close. The goal is to work that down, but our goal is to make sure that it is invested in a way that maximizes the return for investors. And for the quarter having generated $0.40 just of NII, it seems to still be balanced, but we're going to work that down as we can roll into these investments.

Our next question comes from the line of Chris O'Connell with KBW.

So I just had a couple of follow-up questions on kind of the slower demand recently or slower pipeline and how it's going to pick up from CECL. How much of the current investments that -- or investment range of the companies that you guys are looking at are going to be implementing CECL kind of on day 1? And how many are going to be the small public entity filers or I think that there's potentially even another delay being included for private banks going out 2 years past that, the initial implementation date? Could you just give some detail around that?

Well, there's not much detail because much like what you just said, there's discussion of, but not much is decided. And even bank to bank, it's unclear. I mean, most of our portfolio are either private or small public, right, just by definition. We have very, very few, if any, that would sort of qualify as very actively traded public banks, so most of them will be on the longer-time cycle. Whether they adopt before or the first, second, I think, they'll try to wait as long as they can unless they feel they've got a good handle on it, but I'd be guessing. There's no way to know exactly what they're going to do in terms of the timing. I do want to sort of give some context and maybe reframe one of the things that -- I think I heard on 2 of the question sets is the smaller pipeline. The pipeline isn't small. The pipeline of deals we want to do that meet our return and credit profile is smaller, but don't confuse that with the pipeline. We always have a flow of deals coming in. We have active credit committee every week reviewing things. We're just not thrilled with what we're seeing, mostly from a rate standpoint. So again, if you want to put more money to work and sort of bring the average rate on the portfolio down a bit, that's not a problem at all. We feel very good about the credit, right, and be nice stable returns, just not as high as a return as we are generating at the moment. So there's plenty of pipeline, it's just at the moment, not a plethora of deals that help us maintain our kind of ballpark 9% average yield, which is we've been trying to do. But keep in mind, that's hedge fund territory and we're doing it with investment-grade credit. It's not the easiest thing to produce that. But that said, we have a number of deals in the pipe and we have pretty high confidence we'll get some deals done this quarter that will be accretive and be sort of in line with what we've done. But we're just, right now, making the conscious effort just to turn away some of these lower rate deals and let them get done by insurance companies who are fine sort of just owning a lower rate of return.

We have reached the end of our question-and-answer session. Allow me to hand the floor back over to management for closing remarks.

Thank you, operator. So thank you, everybody, for listening. Have a good rest of the summer, and we will speak to you in November.

Thank you. This concludes today's conference. You may disconnect your lines at this time, and thank you for participation.