BCP Investment Corp (BCIC) 2014 Q4 法說會逐字稿

Good morning, ladies and gentlemen, and welcome to the KCAP Financial, Inc. year-end 2014 earnings conference call. An earnings press release was distributed yesterday. If you did not receive a copy, the release is available on the Company's website at www.kcapfinancial.com in the Investor Relations section. (Operator Instructions).

As a reminder, this conference call is being recorded today, Tuesday, March 31, 2015. This call is also being hosted on a live webcast, which can be accessed at our Company's website at www.kcapfinancial.com in the Investor Relations section under Events. In addition, if you would like to be added to the Company's distribution list for the news events, including earnings releases, please contact Jamie Lillis at 203-428-3223.

Today's conference call includes forward-looking statements and projections, and we ask that you refer to KCAP Financial's most recent filings with the SEC for important factors that would cause actual results to differ materially from these projections. KCAP Financial does not undertake to update its forward-looking statements unless required by law.

I would now like to introduce your host for today's conference, Mr. Dayl Pearson, President and Chief Executive Officer of KCAP Financial. Mr. Pearson, you may begin.

Thank you. And thank all of you for joining KCAP Financial for a review of our year-end 2014 results. This morning I would like to take a moment to discuss the restatement of our financial results before reviewing some of the important highlights and activities from our fourth-quarter and year-end 2014. I will then turn the call over to our Chief Financial Officer, Ted Gilpin, who will provide a more in-depth review of our accounting restatement, as well as a more detailed recap of our fourth-quarter operating results. We will then open the line for your questions at the end of the call.

As you likely have read, we recently concluded that errors existed relating to our accounting for equity investments on our collateral loan obligation funds and the accounting treatment for cash distributions received from our wholly-owned asset management companies, Trimaran Advisors and Katonah Debt Advisors, which we refer to as our Asset Manager Affiliates.

The Audit Committee determined that the CLO accounting error was not material to the Company's previously filed financial statements. However, they did determine that the distributions from the Asset Manager Affiliates to the Company, which were historically recorded entirely as investment income over the prior periods, contained a portion of tax basis return of capital that should have been recorded as adjustments to the cost base of the investment in Asset Manager Affiliates. And this error was found to be material.

As a result, our previously issued consolidated financial statements required corrections. It is important to highlight that these corrections, which Ted will walk through in more detail, will not impact historical net asset value, net income, or importantly, total cash flow from operations. I am confident that we have taken the appropriate steps to address those errors, as guided by our Audit Committee.

For the full year, tax distributable income was $0.78 per share compared with the restated $0.70 per share for the year ended December 2013. Our share count increased by approximately 3.4 million during 2014.

Our fourth-quarter dividend was $0.25 per share, unchanged from the third quarter. Additionally, we recently announced a $0.21 dividend for the first quarter of 2015.

I would now like to discuss the performance of our loan and securities business and Asset Manager Affiliates in more detail. Turning to our direct lending business, we continue to see good opportunities for investment at attractive yields. As a result, we successfully issued 3 million shares of equity at $8.02 per share, raising net proceeds of $23.8 million in the quarter; and $42 million of debt by upsizing KCAP Senior Funding, our balance sheet securitization, which we will invest over the coming quarters.

In the near-term, this issuance is a minimal drag on our results, since we have invested all of the proceeds in a combination of middle-market loans and lower-yielding placeholder assets that we will transition over time to higher-yielding core assets.

I am optimistic in our pipeline and opportunities which lay ahead. KCAP closed 31 new deals in Q4 2014, the majority of which were first lien loans in our financing facility, KCAP Senior Funding, which was upsized by $56 million in December 2014. These 31 loans comprise approximately $77.75 million of new assets.

As usual, the first quarter of the year has been slow from a direct originations perspective, but we have a robust pipeline of new opportunities in the upcoming weeks. The mezzanine market remains challenged for lenders, and KCAP will continue to be cautious and disciplined in its lending.

As a result of our capital raise and subsequent investments in some lower-yielding placeholder loans, our weighted average yield on our debt securities portfolio did decrease from 7.8% in the third quarter to 7.3% in the fourth quarter, flat with the 7.3% generated in the fourth quarter of 2013.

Consistent with our previous practice, we will actively rotate out of placeholder loans into higher-yielding investments, and thus begin to drive the portfolio yield higher once again.

While we continue to see good deal flow in the middle market, pricing continues to be challenging from both senior and particularly junior capital investments. As always, we continue to maintain our credit standards and will not sacrifice credit quality in order to make short-term income goals.

KCAP believes that the current asset mix and allocation of first lien secured loans, mezzanine loans, and CLO equity is the appropriate balance for a proper risk-adjusted return.

Let me now turn to our asset management business. In terms of the market for new CLO funds, while the environment has remained strong through 2014 with near-record volume of CLO issuance, liability reprices continued to be relatively high. We continue to be optimistic regarding our ability to issue a new CLO fund in the near future.

As of December 31, 2014, our weighted average mark-to-market value to par of our debt securities loans and bonds portfolio decreased from 99.2 in the third quarter of 2014 to 98.6 in the fourth quarter.

As far as CLO portfolio, our weighted average mark-to-market value to par was 58 as of December 31, 2014, a decrease from the weighted average mark-to-market to par of 66 for the third quarter of 2014.

We would like to note that KCAP sold the one CLO BB in Katonah 2007-1 in Q3 2014, very close to the mark of 98.1. Also, four CLOs called in 2014. The liquidation values were also very close to the previous marks. Our 100% ownership of our Asset Manager Affiliates was valued at approximately $72 million, based on their assets under management and prospective cash flows at December 31, 2014. Our investment portfolio at the end of the fourth quarter totaled approximately $480 million.

Looking at the composition of our investment portfolio -- and our portfolio quality continues to hold up very well, with one asset with a cost base of $247,000 on nonaccrual.

At the end of the fourth quarter of 2014, our debt securities totaled approximately $320 million and represented about 67% of our investment portfolio. First lien loans now represent 68% of debt securities portfolios, and junior loans approximately 12%.

Importantly, we had no adverse credit trends in the quarter, and have exposure to only two energy credits totaling approximately $13.3 million. Both of these are low leverage secured loans. All CLOs managed by KDA and Trimaran continue to be current on equity distributions and management fees. Five of the managed funds are paying incentive fees to the AMA in 2014, although two of the funds paying incentive fees have been called for redemption by their investors.

This stable income stream from our Asset Manager Affiliates allows them to make periodic distributions to us. In the fourth quarter, there was a distribution of $2.9 million. For the year ended 2014, the Asset Manager Affiliates declared cash distributions of $11.9 million.

The Company recognized $5.5 million of this as a dividend. The difference of $6.4 million between cash and tax basis earnings and profits is recorded as a tax basis return of capital from the asset manager. It is important to note that the $11.9 million represents cash flow from operations which is available to support KCAP's shareholder distributions.

Additionally, as of December 31, 2014, our Asset Manager Affiliates had approximately $3 billion of par assets under management, with approximately $1.3 billion of CLO 1.0, and $1.7 billion of CLO 2.0.

While the fourth quarter was challenging from an origination perspective, I am pleased with the opportunities that we see and the strength of our pipeline. Our business momentum is accelerating, and I'm confident that we will be successful rotating out of lower-yielding placeholder loans into more attractive, higher-yielding investments.

And now I will ask Ted Gilpin to walk you through the details of our financials.

Thank you, Dayl, and good morning, everyone. As Dayl mentioned, we recently concluded that errors existed relating to our accounting for the equity investments in our collateralized loan obligations funds, which we determined was not material. And the accounting treatment for cash distributions received from our wholly-owned asset management companies, Trimaran Advisors LLC and Katonah Debt Advisors LLC, which we also refer to as our Asset Manager Affiliates, which was determined to be material.

As a result, the Company's previously issued audited consolidated financial statements for the years ended December 31, 2010 through 2013, as well as the previously issued unaudited consolidated financial statements for the fiscal quarters ended March 31, 2010 through September 30, 2014, required corrections.

It is important to reiterate that these corrections, which I will walk through in more detail in a moment, did not impact historical net asset value, net income, nor total cash flow from operations.

First, I'd like to review the accounting change for our investments in CLO equity. Since our inception in 2006, we have generally recorded all cash distributions that we have received from our CLO equity investments as distributions from investments in CLO fund securities, a component of net investment income, and reflected changes in the fair value of the CLO equity investments in our consolidated statement of operations.

Management determined, and our Audit Committee agreed, that the effective interest method, or ASC 325-40, is the appropriate method for recognizing investment income from CLO equity investments.

Under the effective interest method, essentially a portion of each cash distribution received is allocated to investment income and recorded in investment income from investments in CLO fund securities, with any difference being recorded as an adjustment to the cost basis of the investment.

Since we carry investments at fair value, this change in cost basis is reflected in the statement of operations in the change in unrealized gains and losses. Therefore, there is no impact to net income as a result of the restatement when we adopt ASC 325-40.

More importantly, taxable distributable income also remains unchanged, as the cash distribution from our CLO equity is taxable income to KCAP. Similarly, NAV is unaffected, as the change was just a reclassification in the equity accounts on the balance sheet.

Second, I will review the accounting change that relates to distributions from our Asset Manager Affiliates. We have restated our financial statements due to an error related to the accounting for distributions that KCAP has received from our Asset Manager Affiliates.

Specifically, distributions from our Asset Manager Affiliates to KCAP have historically been recorded entirely as investment income. It has been determined that a portion of certain distributions contain tax basis return of capital, which should have been recorded as adjustments to the cost basis of our investment in our Asset Manager Affiliates. Prior period financial statements have also been restated to correct for this error. This restatement had no effect on net income or net asset value.

The reductions in dividends from Asset Manager Affiliates, a component of net investment income, was offset by an entry to unrealized gains and losses and a reclassification between equity accounts on the balance sheet.

Going forward, a portion of our distribution from our Asset Manager Affiliates could be determined to be a return of capital from our investment in them. This reduces KCAP's cost basis in the Asset Manager Affiliates. The portion of cash distributions above the asset manager's taxable earnings and profits will be recorded as a return of capital from the Asset Manager Affiliates; and, if distributed, would pass through as a return of capital to KCAP's shareholders.

Importantly, KCAP's NAV, prior to and following a distribution, will remain unchanged as the return of capital essentially flows through to shareholders. The distribution from the AMAs represents their cash flow from operations, whether classified as income or not.

I would now like to cover some of the high-level financial information for the fourth-quarter and full-year 2014, and then go a little bit more into detail on specific metrics.

As of December 31, 2014, our net asset value stood at $6.94, down from $7.67 at the end of the third quarter in 2014, and down from $7.51 on December 13, 2013. One driver to the decline in our NAV from September 30 was our December dividend payable, which accounts for a $0.25 per share reduction.

As you may recall from last year, we have two dividends that are recorded in the fourth quarter -- the third and fourth quarters' dividends -- which has the effect of reducing the year-end NAV by the December dividend payable. This corrects itself in the first quarter.

Additionally, as Dayl mentioned, we issued 3 million shares of common stock, which although was sold above NAV, was modestly dilutive in the near term, as it will take several quarters for us to put that capital to work in higher-yielding securities.

The remainder of the NAV decline is primarily attributable to a reduction in the fair value of our Asset Manager Affiliates of $6 million, as the legacy CLOs continue to delever. The AMAs closed two managed CLOs during the year, and assets under management stood at $3 billion at year-end.

The Company declared a $0.25 distribution in the fourth quarter, which is consistent with the level paid in the third quarter and the fourth quarter of 2013. Since the end of the fourth quarter, we have also declared our first-quarter dividend of $0.21 per share. As you recall, in our Board typically looks forward four quarters when setting the dividend.

We believe that the taxable distributable income, as reported in our financial statement footnotes, is an important measure for investors as the potential level of taxable income that can be distributed to our investors in the form of the dividend. We also believe the distribution in excess of tax basis earnings and profits from our Asset Manager Affiliates will be an important component of KCAP's cash available for distribution to shareholders.

Taxable distribution for the year was $0.78 per share compared with $0.70 per share restated for the year ended December 31, 2013.

At this point, I would like to discuss the results for 2014. First, interest income on our debt securities for the three months ended December 31, 2014, was $5.6 million, or $0.15 a share, compared to $5.4 million or $0.16 a share for the third quarter of 2014.

For the period ended December 31, 2014, our debt securities portfolio continues to grow as a percent of total NII contribution, and today stands at 53% at the end of the fourth quarter, which compares to 50% contribution in the third quarter of 2014, and 52% for the full-year 2014 as compared to 40% for the full-year 2013.

Second, distributions from the investment in CLO securities as (technical difficulty) NII worth $3.6 million or $0.10 per share in the fourth quarter of 2014 compared with $3.6 million or $0.11 per share in the third quarter of 2014, attributable to the delevering of legacy CLO funds.

The portion of cash received on CLO equity investments deemed to be a return of principal created an additional $6.1 million of distributable taxable income, or $0.18 per share, in 2014. That's compared to $2.1 million, or $0.06 per share, in 2013 -- or for the prior quarter.

Lastly, our Asset Manager Affiliates dividend up to KCAP Financial of $1.3 million or approximately $0.04 per share in the fourth quarter of 2014, a decrease of $138,000 from the third quarter of 2014.

In the period ended December 31, 2014, we recorded $5.5 million or $0.16 per share in dividends from our Asset Manager Affiliates as compared with $5.7 million or $0.18 per share. In addition, the Asset Manager Affiliates distributed $6.4 million or $0.19 per share in excess of their tax basis earnings and profits as a return of capital in 2014 compared to $7 million or $0.22 per share in 2013.

The Company recorded net realized and unrealized depreciation of approximately $13.7 million or $0.37 per share during the quarter ended December 31, 2014, primarily attributable to our Asset Manager Affiliates, as compared to net realized and unrealized appreciation of approximately $3.4 million or $0.10 per share in the same period of 2013.

As noted in the previous quarter, and we have a new CLO in the warehouse space which, when it closes, will add value to our Asset Manager Affiliates and replace some of the natural runoff.

On the liability side of our balance sheet as of December 31, 2014, our debt outstanding was $224 million, consisting of $38.6 million of convertible notes with a five-year term and a fixed rate of 8.75%; $41.4 million of senior notes with a seven-year term and a fixed rate of 7.375%; and $144 million, net of discount of debt securitization financing, which is a stated interest rate that resets on a quarterly basis, based upon the then-current level of the benchmark three-month LIBOR. Our asset coverage ratio at the quarter end was 211%, above the minimum 200% required for BDCs.

For additional information regarding the above metrics, and for both the fourth-quarter and full-year 2014 results, please refer to our earnings release and our recently filed 10-K. All of our filings are available online with the SEC at www.SEC.gov, or on our website, www.kcapfinancial.com.

We would now like to turn it over to you for your questions.

(Operator Instructions). Mickey Schleien, Ladenburg.

Just wanted to ask you, looking at interest rate risk in the K, I see the language there, and the sensitivity that you've shown. I'm just curious how -- or what assumptions you've made for CLO investments and for distributions from the asset managers, in the event that rates go up or down, as you've shown in that little table?

Yes, so the table is primarily our debt securities portfolio outside of our CLO asset managers. The CLO asset manager also would have some fluctuations, depending on the timing of the resets because the assets and the liabilities in a CLO may reset at different periods.

So, depending on when LIBOR changes, you may get a benefit for a short period of time and then it goes away, or you may have pain for a short period of time and then it goes away. Although there are floors in that business as well.

So, I think, generally speaking, if it's just a modest raise in interest rates, then some of those floors would either decrease the amount that's returned; and if it goes up more, obviously it's beneficial. But again, that's offset when it resets on the liability side. So, because it's totally dependent on the timing, we didn't model that out.

Mickey, I would just add that it has no impact on the distributions from the asset manager.

Okay. How about the distributions from your CLO investments?

Right, so that's -- it would affect the equity returns on their effective yield. It does not, as Dayl said, affect what the asset manager is doing. They're just getting paid on the par amount of the assets under management.

Okay. I understand. Thanks for your time.

Troy Ward, KBW.

Just following up a little bit on Mickey, on the asset manager side. Dayl, can you just give us a little bit of color on what the prior accounting was? When you showed $12 million-plus flowing through as a dividend to shareholders here, and then that is restated down to $5 million, so you took $7 million out. What was the prior accounting? What was it looking at? Just straight revenues, with no expenses taken out?

No, no, no, no. It has nothing to do with expenses. It has to do with the tax shield that we have through the structuring of the CLOs. This is all cash that's coming, net of all the expenses of the asset managers. So the $11.9 million that was paid is actual cash that the asset manager recognized after all of its expenses were paid, including taxes. So the difference is really the benefit that the Company gets from the tax shield. So it has no impact on cash whatsoever. It's purely amortization of the tax shield.

And I think, in the past, what had been done by our outside tax consultants was to default to what the IRS would seem to default to, which is just assume it's all income so that no one underpays their taxes. And we discovered that they'd never true-upped the -- did a true-up of that. I guess that's the best way of explaining. And, Ted, I will let you -- you have a better handle on the technical side.

But I think what I want you guys to take away is the $11.9 million distribution from the asset manager in 2014 was the operating cash flow of the asset manager. So it wasn't -- we weren't making an investment in the asset manager so that they were then paying us money back. This was true cash generated by the asset manager.

Yes, the only thing I would add to that is they both, our Asset Manager Affiliates, have taxable goodwill, and one of them actually had some NOLs. So as we used up the NOL and we amortize that tax goodwill, they have the -- they don't pay the taxes on that. So they have the cash generated, and they've been [dividending] up that cash. For a tax basis, earnings and profit, those aren't included in that. So they are essentially over-distributing their tax benefit portion back up to the Company.

There's other things that go into an earnings and profit analysis for the asset managers, but what Dave historically been distributing up to KCAP is the cash they have left over at the end of any quarter, or at the end of any year. So it does not affect the ability to give us cash; it's just not all deemed to be taxable income.

Okay. How long -- is there a defined time period on how long that tax shield will be available?

It does run off over time, and I think --.

It's 15 years for both, Troy. So one of them is halfway through, or a little bit more, and the other one is two or three years in.

Okay. So as we think about the income coming up to KCAP, obviously now we see that a large portion of that has been deemed a return of capital. Going forward, when that is brought up to KCAP, can we assume that the return of capital portion is not going to be dividend out, from now on, to the shareholders? It is still going to come up to KCAP from Trimaran. But will your dividend include a portion of return of capital? I guess is what I'm trying to ascertain.

Yes, I think the answer to that is that we don't anticipate changing how we've distributed. The cash will come up. It will be distributed to shareholders. A piece of that will be qualified dividend, and a piece of that will be a return of capital.

Okay. Why wouldn't you just retain that at KCAP, instead of dividending that out to shareholders?

I think the reason we would do that is it is actual operating cash flow, and I think our shareholders are looking to get paid a distribution based upon the operating cash flow of the business. And I guess the view of the Board and management is that that is real earnings; it just happens to be that we get a tax benefit from it. And our shareholders will get a tax benefit from it.

Okay. Well, I mean, raising new capital in the fourth quarter of last year would seem to me that the Board would view retained capital as a very valuable to the shareholders, obviously. Just because the shareholders don't get it, doesn't mean it's lost value. I would think that the assets that you're seeing obviously are of an attractiveness where you wanted to raise new capital last year. I would think that return of capital would be the last thing the Board would do after issuing new equity.

But we'll move on to the capital that you raised last quarter. You made the comment that it would take several quarters to put that to work, and you had some placeholder assets in the portfolio. We obviously haven't had time to spread the portfolio out yet this morning. But what is the amount of placeholder assets? And when do you think you will be able to effectively rotate out of those, as we think about modeling over the next several quarters?

Yes, I think we look at it this way. I would say of the roughly $77 million we put to work, I would say probably half of that would be placeholder assets. And you can determine that from just the yield. Because I target yield of -- most of these assets are going -- one of the reasons we raised the capital, as opposed to upsize, is they are a very attractive debt securitization. We have a very low cost of capital. We have a lot of what we invested in were assets that are highly accretive to that. They are all accretive to that, even the placeholder assets, but I would say more than 50% would be at that target return that we look at in the securitization.

Okay. And then I had one more question. Sorry, I skipped ahead (multiple speakers).

By the way, we also used some of the proceeds to buy back some very expensive debt; the convert, as well.

Right. On the CLO, back to that for just a second -- Dayl, you talked about liability pricing is maybe not quite where you want it. Can you just put a little color around that? And where is pricing today, and where is that inflection point? And are you currently warehousing assets for the next CLO? Just a little bit of color on what we should expect from the platform over the next several quarters.

Yes, well, we had started warehousing back in September for the next CLO. We had hoped that we would close that in December or January. Pricing on AAAs widened out rather substantially in the fourth quarter of last year, from sort of the -- I think our last deal priced at around 150, low 150s, in terms of AAAs in August. They were in the 160s and 170s in December and January. They have now settled back into the mid-150s range.

We are fully ramped in our warehouse. And we can't really comment, as you know. CLOs are part of a private placement process, and it's an ongoing private placement, so we can't comment on where we stand, other than to say we are fully ramped.

And has in the change in asset prices since you warehoused those assets -- is that going to be a detriment in any way?

No.

Okay, great. All right, thanks.

(Operator Instructions). Chris York, JMP Securities.

So, KCAP had historically accounted for distributions from CLO equity investments under the cash flow method since, I believe, 2006. Could you help me understand why the Company and the Audit Committee are now deciding that the effective yield method is preferable or appropriate?

Yes, I think that, as you know, there's a couple -- at least a couple BDCs have done it on the cash method. I think that when we took a look at it, and looked at the current guidance and the current industry practice, we determined that the more appropriate, if not the appropriate way, to handle it was through ASC 325-40.

Again, as we said, since you are just splitting up the cash, you got it into two buckets. And it's not affecting your net income or your NAV or your taxable distributable income -- which, as a RIC, is what we're supposed to distribute -- that switching over to the method, since it's the more appropriate method, it was the time to do so.

(multiple speakers) I think when we started in 2006, there weren't a lot of people doing CLO equity investing, certainly in the BDC space. And we were guided by our experts, at that point, that the cash method was the appropriate method. And I think, to some extent, over time, people have changed their view of that.

Okay, yes. Second question here. So what incremental operating expenses should we expect to see associated with the restatement in 2015? Anything maybe in Q1, first half of the year?

Yes, obviously it will be some expenses associated with the restatement of the -- some of that will show up in the first quarter; some of that will probably show up in the second quarter.

Could you quantify the expected increase?

No, I actually can't. I haven't even seen the bills yet.

Okay. And then lastly here, what is the expected runoff in AUMs at the Asset Manager Affiliates for 2015?

Well, we're at $3 billion as of year-end. Assuming we close a new CLO soon, that would add another $450 million. We expect to do at least one more this year. And we probably, I think as I said, we have only $1.3 billion left in CLO 1.0 securities.

So if you assume $600 million or $700 million of that runs off, we probably get back to sort of where we were in the third quarter, which is somewhere around $3.2 billion, $3.3 billion. So we think the runoff will be replaced by new deals, as it has in 2012, 2013, and 2014.

Got it. Thanks. That color is helpful. That's it for me. Thank you.

And I'm showing no further questions.

I will now turn the call back over to Dayl Pearson for closing remarks.

Well, we appreciate everyone's time today, and patience, as this has been a more complicated discussion than normal. And we look forward to talking on our first-quarter conference call in probably five weeks. Thank you very much.

Thank you, ladies and gentlemen. That does conclude today's conference. You may all disconnect, and everyone have a great day.