Logan Ridge Finance Corp (LRFC) 2016 Q2 法說會逐字稿

At this time, I would like to welcome everyone to Capitala Financial (sic) Corp's conference call for the quarter ended June 30, 2016.

(Operator Instructions)

Today's call is being recorded and a replay will be available approximately three hours after the conclusion of the call on the Company's website at www.capitalagroup.com under the Investor Relations section.

The hosts for today's call are Capitala Finance Corp Chairman and Chief Executive Officer, Joe Alala; Chief Operating Officer, Treasurer, and Secretary, Jack McGlinn; and Chief Financial Officer, Steve Arnall. Capitala Financial (sic) Corp issued a press release on August 9, 2015 with details of the Company's quarterly financial and operating results. A copy of the press release is available on the Company's website.

Please note that this call contains forward-looking statements that provide information other than historical information, including statements regarding the Company's goals, beliefs, strategies, future operating results, and cash flows. Although the Company believes these statements are reasonable, actual results could differ materially from those were projected in the forward-looking statements.

These statements are based on various underlying assumptions and are subject to numerous uncertainties and risks, including those disclosed under the sections titled Risk Factors and Forward-Looking statements in the Company's quarterly report on Form 10-Q. Capitala undertakes no obligation to update or revise any forward-looking statements. At this time, I would like to turn the meeting over to Joe Alala.

Thank you, operator. Good morning, everyone. Thank you for joining us for second-quarter results. Capitala covered the distribution with net investment income. This was for the fourth consecutive quarter. The manager continues to waive incentive fees to support net investment income and distribution coverage.

The waiver amounted to $800,000 for the quarter and totaled $2.4 million since announced earlier this year, demonstrating manager and shareholder alignment. Net asset value per share at $16.28, unchanged from the first quarter. We're hopeful that the net asset value has stabilized, having been negatively impacted by valuations related to our energy investment.

However, our energy exposure is now at approximately 5% based on fair value at June 30 compared to 12% at the end of 2014. No real investment activity during the quarter. This was driven by two things: one modest liquidity, and two, our commitment to not chase yield and sacrifice quality of investments.

Looking ahead, we did have the successful exit of MTI Holdings. The debt was repaid at par, while the equity generated a realized gain of $8.6 million for a cash-on-cash return of 5.3 times. Redeployment of these proceeds into a yielding investment will help reduce our reliance on the incentive fee waiver.

We also continue to work towards the first close on our private credit fund, which will provide additional liquidity to the platform and allow the Company to co-invest with affiliates, having received a co-investment order from the SEC during the second quarter. We continue to focus on our direct origination platform to seek out lower middle market investments with proper risk-adjusted returns and pricing.

At this point, I would like to turn a meeting over to Steve and Jack to provide additional comments on our operating and financial performance.

Thanks, Joe, good morning. As previously mentioned, on August 9, we filed a press release with our second-quarter 2016 earnings. I would invite you to visit the Investor Relations portion of our website to learn more about the Company, review quarterly investor updates, and to automatically receive email notifications of Company financial information, press releases, stock alerts, and other Corporate filings.

During the second quarter of 2016, total investment income was $17 million, an increase of $1.9 million over the same period last year. Total interest, fee, and PIK income was $1.5 million higher in the second quarter of 2016 compared to 2015, driven by a larger investment portfolio. All other income increased by $0.4 million.

Total expenses for the second quarter of 2016, net of the incentive fee waiver, were $9.6 million compared to $9.8 million in 2015. There are no material variances to report. Net investment income totaled $7.4 million, or $0.47 per share, for the second quarter 2016, compared to $5.3 million, or $0.33 per share, for the same period last year.

Net investment income and the coverage of quarterly distributions continue to be a high priority for Management. Net realized losses totaled $5.6 million, or $0.35 per share, for the second quarter of 2016, compared to net gain of $15.8 million for the same period in 2015. Jack will provide more about our net realized losses in just a moment.

Net unrealized depreciation for the second quarter of 2016 was $5.4 million, compared to depreciation of $16.2 million last year. The net increase in net assets resulting from operations during the second quarter of 2016 totaled $7.3 million, or $0.46 per share, compared to a net increase of $4.9 million, or $0.31 per share, for the same period last year.

Total net assets of $257.5 million at June 30, 2016 equate to $16.28 per share, compared to $17.04 a share at December 31, 2015. From a liquidity standpoint, we have cash and cash equivalents of $20.1 million at June 30, 2016, compared to $34.1 million at December 31, 2015. SBA debentures outstanding at June 30, 2016 totaled $182.2 million, with an annual weighted-average interest rate of 3.34%.

In addition, the Company had $113.4 million of notes outstanding, bearing a fixed interest rate of 7.125%. Lastly, the Company has $69 million drawn and $51 million available under its senior secured revolving credit facility and a regulatory leverage ratio of 0.71 times at quarter-end.

At June 30, 2016, the Company's balance sheet and future net investment income will not be materially impacted by changes in short-term interest rates. Please see Form 10-Q for detailed information about the Company's interest rate sensitivity. At this point, I'll turn the call over to Jack.

Thanks, Steve. Let me first comment on market activity. As has been commonly reported, the M&A market activity is low off the historical pace of the last several years. While we continue to see ample deal flow, many of the deals we saw in the second quarter were [store recredits] and we passed on most of these opportunities.

Further, with our lower liquidity, we were not aggressively pricing potential investments. This led to no new platform investments in the second quarter. We recently have been seeing an uptick in market activity as the summer comes to an end, and this coupled with our increased liquidity will lead to more investments in the second half of the year.

As of the end of the second quarter, the Capitala portfolio consists of 54 companies with a fair market value of $595.1 million on a cost basis of $576.8 million. Senior debt investments represent 36% of the portfolio; senior subordinated debt, 43%; senior liquid loan funds, 3%; and equity/warrant value of 16.8%.

In regards to portfolio quality, we continue to maintain a sub-2 internal weighted average risk rating at 1.81. Weighted-average yield on our debt portfolio continue to be strong at 12.5%. Realized losses of $5.6 million were recognized during the quarter, mostly related to $6.6 million recognized loss from Abutec, one of the energy investments and formally a non-accrual asset.

Net unrealized appreciation was $5.4, million which included a $5.7 million reversal on Abutec. Appreciation on several investments helped offset the further $5 million depreciation in oil and gas services business, TCE Holdings. That now has no remaining fair value.

As a further update on our investment in the energy space, the four remaining investments at fair value totaled $32.4 million, or 5.4% of the portfolio. At the end of the quarter, there were three debt investments on non-accrual, with fair value and cost basis of $9 million and $37.2 million, respectively, a continued improvement from the prior quarter.

As mentioned, we have had significant subsequent repayment activity, with a $5 million repayment of [Maxim Frameworks], $18.4 million from Merlin International, and $18.6 million from MTI Holdings that included a $10.6 million payment for our $2 million equity investment. With that, I will turn it back to you.

Thanks, Jack. Thanks, Steve.

We want to reemphasize that we continue to focus on distribution coverage with NII. The fee waiver commitment from the manager has assisted in that. We do expect NAV stability due to the reduction of energy and non-accrual investments, and with our improved liquidity, we will continue to focus on directly originated lower middle-market investments with proper risk-adjusted pricing.

With that, operator, we're ready to address questions.

(Operator Instructions)

Mickey Schleien, Ladenburg.

Good morning, everyone. Hope you're all having a good day. First of all, can you please update us on the exit of Abutec, which was a non-accrual. I would just like to understand the reasoning for that exit?

As with some of the other -- (multiple speakers)

Jack, by the way, it is really hard to hear you.

As with some of the other oil and gas services deals, the prolonged downturn and pricing has gone on for over 18 months. Abutec was a smaller company. We had a couple of different opportunities to look at restructuring on that, none of which were really appealing, as it involved further investments into the business without great visibility in the long-term viability of the business, so we passed on that and wrote off the investment.

I understand. That's a good segue into my next question, and I do have a couple of more on energy. TCE was completely written down. Can you update us on that company? Is it in bankruptcy? Are they restructuring? Where are they in the cycle?

It's a similar story, we're -- they're looking to restructure, and cannot comment too much on that individual investment, but at this point, we didn't think it was appropriate to have any value recognized on that.

Okay. My last energy question. Is the Sierra Hamilton loan a second lien?

It is a first lien behind some working capital revolver.

Okay. That's valued at [50%], but it's current. So I'm curious what strategies they are using to remain current, given where you valued the investment?

They continue to maintain a pretty good availability, as far as their working capital goes. They continue to perform. They were able to burn down some AR at the beginning of the downturn in pricing. We're optimistic that they'll continue to perform but we're also being cautious with the valuation.

All right. I understand. I just want to confirm with Steve that most of the dividend income this quarter was from the senior loan fund. Is that correct?

That is correct.

Taking that into consideration, then the equity portfolio has generated almost no dividends this quarter. I would like to understand what the outlook is, if you could give us some more specificity on monetizing some of the larger positions, like Medical Depot, or MTI, or City Gear, or Navis, which you control?

MTI -- we actually reported that in the earnings. Beyond that, as we've talked about in the past, Mickey, we wish we could give you some more clarity on all that, but it would just be inappropriate to do so. When those events happen, we will certainly be sharing that news with the market, but to do so ahead of time would just not be appropriate.

Okay. A couple of modeling questions. G&A fell pretty meaningfully from $1.2 million to $0.9 million. Can you tell me what accounted for that?

Nothing specifically, just some lower expenses, and some of the timing related to some professional fees.

So is $0.9 million a good run rate number or could we expect that to trend back up?

There is a range in there that makes sense. $0.9 million may be on the low-end because, again, some of the professional fees related to year-end hit in the first quarters. So in the second quarter, there might be a slight decrease, but I wouldn't look for a substantial change from that, maybe just stay in a range of $0.9 million to $1.2 million would be appropriate.

Okay. And Steve, if I recall correctly, one of your SBA debentures is due soon, so how much of your cash is within the SBIC subsidiaries?

The majority of our cash, including the repayments that we've already reported out, is in the subsidiaries. To your point, we've got $11.5 million maturing on September 1 and that is the highest priced money we have with all-in costs of over 6.5%, so we'll be repaying that on 9/1. Going forward, that really has a pretty immaterial impact to our future financial statements.

Okay. My last question. We saw a pretty sharp decline in portfolio net leverage. Could you give us some sense of what caused that to occur? According to the presentation?

(Multiple speakers) some EBITDA improvement. Some had just been maturing of the portfolio with no real significant investments over the quarter, and just one in the first quarter. As the portfolio matures, and when we first get into it, obviously, the leverage is usually higher at the transaction multiple, and companies have been paying down debt and improving EBITDA. So that is part of it. So it is just part of some of the exits that we have had.

Thank you for that. Those are all of my questions today. I appreciate your time.

Jonathan Bock, Wells Fargo Securities.

Good morning and thank you for taking my questions. Joe, Steve, if we look at the BDC space broadly, we've seen a series of dividend reductions. In some cases these are reactive post losses, post portfolio underperformance. In some cases, they are proactive in order to realign according to a better improved cost of capital to originate high-quality deals that generate good risk-adjusted returns.

And the $64,000 question that we would want to ask here would relate to your dividend policy, because today at NAV, you are offering a yield at 11.5%, and again, it is all based on an NAV basis. If you plug in the math of fee structure, et cetera, before the waiver, we're arriving at a required portfolio ROA of about 12.5%, 13%.

Joe, clearly you can wave your fees and bridge to the other side, but the question is how confident are you in the ability to bridge to the other side, because to the extent that you couldn't get there anyway, it would seem that the market is allowing you a prime opportunity to reduce the dividend in line with a number of your other peers, so that you and Chris, and Jack, and the team can originate high-quality, and I will emphasize, safe, although that is a tough word in this environment, safer risk-adjusted return.

Your policy in the face of what you are originating and the safety level at which you are originating it, not exposing to the [industrial] losses, that is really the key question faces the shares and faces the opportunity. The uncertain time is how long you would want to waive that fee and its effects on your business, and more importantly, your partners and yourself?

This is Joe. One, the Board determines the dividend. We review that with them every quarter before announcing. Two, what we commented on earlier in the year is we needed time to rotate out some of these equity positions, get that liquidity and redeploy it to yield.

Part of your question is that yield you are redeploying into, does it cover that 12.5%-ish to get to where to you are covering NII without a fee waiver through redeployment in that yield. What we have now is that we have created the liquidity, especially over the past two or three weeks, we have created the liquidity. We'll actually forecast increased liquidity in the near-term future for more repayments.

We will have also have parallel liquidity we forecast with the private credit fund. So then we have to go back through our investment strategy of direct origination with all of this liquidity, with some monetized equity positions, and see where we can deploy that without having to chase yield.

That is a very important question and that will be answered over the next quarter or two to see how we deploy all this liquidity that we are about to have, but we will not chase yield. We will continue to focus on direct originations. We will be realistic in presenting to our Board and our Board considering all of these factors to set its dividend and distribution policy.

That is very helpful and appreciated because, at the end of the day, the alignment is apparent in your past decisions and we know it is certainly there in future ones. Then the question just relates to the underlying risk levels at which folks are deploying at in the middle market and how you gauge the overall competitive dynamic. My apologies, I know this always gets touched on.

But how would you describe the competition for the first lien, second lien product you could offer, a general unitranche you could offer, and then finally a first mezz, which we understand the first mezz option has really become a bit in vogue as second lien pricing now effectively -- there is no difference between a second lien and a mezz piece. So would you give a sense of the all-in levels of risk -- I don't want to just describe it by leverage -- but risk in either first, second /unitranche/first mezz options that you are exploring for sponsors?

I just want to reiterate that we're not going to chase yield. We have a unique origination platform that we do both sponsor and non-sponsor activity. On a transaction-by-transaction basis, we move around the capital structure. I know we will not chase yield and take on higher risk deals just to make that yield work.

But we're still finding some very attractively priced opportunities in the market. Having said that, we haven't done a lot of deals lately, but we have changed that dynamic, that now we do have the liquidity, so the quality of deals are picking up. We do have the liquidity, so it we really goes back to what does the rest of the year hold for us, and that is what we are eager to pursue.

We call it hunting season. We think that it starts in September when everybody gets back from their August vacations and the kids get back to school. We will enter that season with a significant amount of improved liquidity. We have a motivated origination platform and underwriting and portfolio resources, so we will really be able to answer that question better as we go throughout 2016.

Got it. We know -- one, we appreciate the waivers and the alignment; two, understand that you certainly can deploy and also are going to be conservative; and three, I appreciate you guys taking the time to answer my questions this morning. Thank you.

Thank you.

Chris Kotowski, Oppenheimer.

I was looking at a number of the values on the equity positions and I noticed that a couple that were written up nicely like LJS, Nth Degree, and STX. I'm wondering, does that just reflect good markets or does it reflect Company fundamentals or does it reflect a process underway to monetize those investments? If you can say.

This is Jack. I cannot say specifically, but it is all of those factors, as we look across the portfolio. LJS had improvement in performance, so each one of those factors you mentioned applies somewhere in the portfolio, but I don't want to be too specific about transactions that are going on. But some of that does impact our evaluation, as something moves towards that, but as Joe likes to say, a deal is not done until cash is in the bank.

Okay. Then obviously, since the beginning of the year, energy prices have improved and stalled out in the last couple of weeks again, and I am wondering, in general, for some of your energy credits, is it too little too late to help you resolve -- or to help the companies resolve the situation? Or is $40-ish oil sufficient to let the companies work through the remainder of the cycle?

From what I have heard in the market, the 2016 budgets were pretty well set. The fluctuations that were going on in the oil prices really haven't impacted the market all that much. The rise back into the $50s gave hope for 2017. The dip back down -- the hope isn't as strong that budgets for 2017 going to show a lots of new rigs and stuff.

TCE and Abutec have been our ones that are most heavily impacted by the oil prices, and their valuations reflect that there is not a lot of optimism for growth in those markets. Our other energy investments are more first lien in nature, and we have had better luck, better optimism on those companies. I don't think $30, $40, $50 of oil is making much of a difference at this point. But again, that is more for -- related to Abutec and TCE.

Okay. That is it for me. Thank you.

Thank you.

Ryan Lynch, KBW.

Good morning. My first question is following up on Mickey's question on Sierra Hamilton. That investment -- it remained pretty steady quarter-over-quarter from a fair value market. I've seen markdowns quite a bit, but it was steady quarter-over-quarter. Does that fair value mark reflect the general uncertainty surrounding that company or is there any balance sheet restructuring talks going on with that?

No on the latter. Again, we have kept it steady just because there hasn't been anything pointing in either direction as far as our visibility on it

Okay. Then one general question. Spreads have been coming down across basically all yield products, certainly for all these syndicated loans. Because of that spread compression, have you guys been seeing any increase in your portfolio of companies come to you with the potential of discussing repaying your debt now that credit spreads and interest rates are compressing more than we've seen over the last couple of years?

We've reported some repayment activity. I'm not sure that was really driven by the spreads at all. I would generally answer your question as no, we haven't seen that kind of activity or pressure.

Okay. That is all from me. Thanks.

Thanks, Ryan.

Christopher Nolan, FBR & Company.

Hi guys. Given the $11.5 million in SBA paydowns on 9/1, is that funding going to be replaced with additional SBA borrowings?

Not at this time. No.

Okay. So I estimated it impacts EPS roughly by $0.03 or so. Is the plan to take the realized equity gains from MTI Holdings and just roll that into offset the EPS impact from the SBA roll-off?

Maybe we could talk offline about your calculations, when you factor in management fees and all of that in there. I'm not sure that I get to the same spot, but absolutely related to monetizations and redeployment. That has been our strategy for the whole year and will continue to be for the rest of the year.

Okay. Then could you explain a little bit about how the private credit fund is going to co-invest with the BDC and how do you reconcile -- you're basically -- how do you reconcile potential conflicts between the BDC and the credit fund?

We do have SEC approval to co-invest and that approval is publicly out there, the filing. The fund five private credit fund, when online, will offer the BDC the opportunity to co-invest in the deals pro-rata. You take that through a process with the Board and they determine co-investment ratios and actually approve or disapprove of the deals.

It is very similar to the other ones in place. There is nothing out of the ordinary with it, and our focus now has been to have that private credit fund come online to really give us investment strategy and liquidity over the next several years, so you know how to continue running your business.

So the private credit fund essentially enables you to invest more into a particular portfolio company, the overall Capitala Organization?

Yes. If you raise the private credit fund, that liquidity comes into that strategy, so that increases your liquidity along with the same investment strategy so you can do larger deals. But more importantly for us is, over the past few quarters at the BDC, the inability to raise debt and/or equity capital creates an unforecastable liquidity position.

It's been hard to run a business when you have all of these five origination offices out there sourcing deals, and we, as a Firm, do not know our liquidity in the BDC because it is not predictable. This will have predictable liquidity and that way you can continue running your business and not be subject to the capital markets that our BDC has been subject to in the past couple quarters.

Okay. And the waiver. Am I correct that the waiver expires in the fourth quarter of 2016?

When we announced the waiver first of 2016, that included Q4 of 2015. We have been waving it for, what, three quarters now. We feel that waivers should be in place for all of 2016 because when we announced the waiver, we really wanted to have time to rotate out these equity positions, generate liquidity through that, and redeploy and see how that affected our NII. Part of our strategy was to do that. We'll reassess management fee waiver of 2017 in the future.

Okay. But the philosophy is really protect the dividend, number one, so going to 2017, so we could see a renewal of the waiver?

In 2017?

Yes?

We will reconsider at the time. We are really focused -- our real focus now is finishing out 2016.

Okay. Thanks for taking my questions, guys.

Thank you.

Mike Del Grosso, Jefferies.

Good morning, guys. Thanks for taking my question. Most have been asked and answered, but I did want to touch on origination activity and deal activity you saw during the quarter. What trends were at play there, and more importantly, what's your outlook for the remainder of the year?

We always have a pipeline. The quality and the type of deal, sponsor versus non-sponsor, always varies. We do think that we were primarily focused on creating liquidity and that liquidity is now in place. It is hard to run your business with modest liquidity when you're not able to speak for an entire deal, and you are having to share deals or co-invest with other groups, to complete a deal, and then there is maybe a competitor that can hold it without syndication risk.

That is a hard position to be in so we have addressed the liquidity issues. We're going to enter into September and the rest of 2016 with materially increased liquidity. We believe that the quality of deals will increased, it will match our liquidity. We expect to have a very strong origination pace between September 1 and the end of the year.

We have shown over time that when we do raise capital, when we did the bond offering, when we did a subsequent equity offering, that the quarter following or the quarter of those offerings, that we were able to deploy capital. We just really have had very modest liquidity most of this year. It frustrates an origination platform that tries to directly source and underwrite and hold all of these loans and investment positions we take.

Understood. Appreciate that. Thank you.

I'm not showing any further questions. At this time, I would like to turn the call back over to our host.

I would like to thank everyone for their time. We are around all day. Please give us a call for any more questions. We look forward to a very active rest of 2016. Have a great day.

Ladies and gentlemen, this does conclude today's presentation. You may now disconnect. Have a wonderful day.