Logan Ridge Finance Corp (LRFC) 2016 Q3 法說會逐字稿

I would like to welcome to Capitala Finance Corp's conference call, for the quarter ended September 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's Chairman and Chief Executive Officer, Joe Alala; Chief Operating Officer, Treasurer and Secretary, Jack McGlinn; and Chief Financial Officer, Stephen Arnall.

Capitala Finance Corp issued a press release on November 8, 2016, with details of the Company's quarterly finance 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 flow. Although the Company believes these statements are reasonable, actual results could differ materially from those 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. Please begin.

Thank you operator, good morning everyone. Thank you for joining us. I realize a lot of you, including everyone in this room, were likely up late into the night. This is not a live feed, but if you were able to see what we are wearing, we all have on green hats that say Make Capitala Great Again, so with that we're going to begin.

We began 2016 with limited liquidity and energy exposure on the high side of the industry average as a percentage of portfolio assets. Management began focusing on addressing both the liquidity issue and the energy investments issue. These efforts culminated into successful activity in the third quarter.

One, in August, management found, without help of any advisors and paid no advisory fees, an institutional buyer of a strip of BDC assets that represented some of the larger investment holdings of the BDC. These assets were sold at fair value, no discount, as determined by the BDC's third-party marks of the prior quarter.

Two, in August, management held an additional closing on it's Capitala private credit fund five, with target size of $500 million. The BDC benefits from the ability to co-invest with Fund 5, in accordance with the SEC coinvestment order, and Fund 5 increases lower middle-market strategy liquidity, with several years of expected liquidity in the strategy, thus allowing the BDC to always be active in the lower middle market, irrespective of the BDC's access to public market capital raises.

Three, by exiting sparse investment and addressing proactively our energy investments, the BDC has lowered its energy exposure from 12% at the end of 2014 to 4% at September 30. Management was able to maintain its direct origination capabilities, even though liquidity was tight throughout 2016, until the August liquidity events concluded. Since August, management has closed $47.5 million of directly originated deals to new portfolio companies.

These new investments were approximately 90% senior secured, and have an average cash yield in excess of 12%, conclusively showing how we are not chasing yield, but rather relying on our strong direct origination capabilities to source high-quality deals. Management continues to see a solid pipeline of quality deals to its direct origination platform, and is focused on converting the existing pipeline of new investments. Pipeline activity is similar to recently closed new investments.

Management, with its Board of Directors, decided to cut the distribution by 17% to $0.0039 per share per quarter, beginning the fourth quarter of this year, a distribution still in line with our peers. The reduction generates a more secure distribution, that should be covered by NII, and has the ability to generate maximum spillover income, in effect creating distribution reserves.

Moreover, management continues to expect to monetize equity investments as part of its investment strategy, but no longer focusing on monetized capital gains to contribute to distribution coverage. As monetized capital gains occur, management has the ability to consider special distributions, as it has paid in the past. Management is prepared to continue to waive incentive fees to assist in the covering of its distribution by NII if needed.

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

Thanks, Joe. Good morning.

As previously mentioned, on November 8, we filed a press release with our third-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, or other corporate filings.

During the third quarter of 2016, total investment income was $17.4 million, $0.9 million lower than the comparable period in 2015. Fee income for the current quarter was $1.2 million lower than the same period in 2015. All other income collectively was $0.3 million higher in the third quarter of 2016 compared to 2015.

Total expenses for third quarter of 2016 net of the incentive fee waiver were $9.9 million compared to $10.5 million last year. There are no material variances to report.

Net investment income totaled $7.4 million or $0.47 per share for the third quarter of 2016, compared to $7.8 million or $0.48 per share for the same period last year. Net realized losses totaled $17.0 million or $1.08 per share for third quarter 2016, compared to losses of $16 million last year. Jack will provide more about our net realized losses in just one moment.

Net unrealized appreciation for the third quarter 2016, including the written call option depreciation were $7.6 million, compared to appreciation of $16.2 million in the previous year. The net decrease in net assets, resulting from operations during the third quarter of 2016 was $2 million or $0.13 per share, as compared to an increase of $8 million or $0.49 per share for the same period last year. Total net assets of $248.4 million at September 30, 2016 equate to $15.68 per share, compared to $17.04 per share at December 31, 2015.

From a liquidity standpoint, we have cash and cash equivalents of $60.6 million at September 30, 2016, compared to $34.1 million at December 31, 2015. SBA debentures outstanding at September 30, 2016 totaled $107.7 million, with an annual weighted average interest rate of 3.29%.

In addition, the Company has $113.4 million of notes outstanding, bearing a fixed interest rate of 7 1/8%. Lastly, the Company has $38 million drawn and $82 million available under its senior secured revolving credit facility, and a regulatory leverage ratio of 0.61X at quarter end.

At September 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 on the Company's interest rate sensitivity. At this point, I will turn the call over to Jack.

Thanks, Steve. During the quarter, we had gross deployments of $26 million, with a 12.1% yield on debt securities. Repayments amounted to $112 million, and included full repayment from Merlin and Sparus, an energy-related investment. The successful exits from MTI Holdings and STX, and the fair value asset sale that Joe referenced.

Net realized losses of $17 million were recognized during the quarter, mostly related to the $28 million write-off of TCE Holdings that had previously been depreciated to zero. Offset by realized gains associated mostly with the exits from MTI and STX. Net unrealized appreciation was $7.6 million, that was largely impacted from reversals from the realized gains and losses.

As of the end of the third quarter, the Capitala portfolio consists of 51 companies, with a fair market value of $503.8 million, on a cost basis of $477 million. Senior debt investments represent 41.5% of the portfolio, senior subordinated debt 38.1%, senior liquid loan fund 4%, and equity warrant value of 16.4%. The total weighted average yield on our debt portfolio increased to 12.7%.

In regard to portfolio quality, we continue to maintain a sub-2 internal weighted average risk rating at 1.89. While average leverage at the portfolio remains slightly increased to 3.8X. At the end of the quarter, there were two investments on non-accrual, with a fair value and cost basis of $9.5 million, and $13.3 million, respectively, and energy investments at fair value now represent approximately 4% of the portfolio.

In regard to market conditions, we have seen a meaningful uptick in activity, and have several proprietary deals under term sheet. We have had one subsequent transaction, a $22.5 million senior secured debt investment, with a 13% cash rate, and [movable] warrant, 3% PIK interest. With that, I will turn it over to Joe.

Thank you, Jack. Thanks Steve. With that, we will open it up to questions.

(Operator Instructions)

Mickey Schlein, Ladenburg.

I wanted to start by asking about a couple of credits. The Board reduced the valuation of Medical Depot by almost $5 million and V12 by a little over $2 million, which together is about $0.40 per share, which caught me by surprise. I'd like to get some sense of what caused those fairly sharp declines, and what is the outlook for those companies?

Mickey, this is Jack. I think we had discussed Medical Depot a bit last call. They were in the midst of a process they are running, still are, that really the adjustment there really was the adjustment from initial indications that were received, and the closer to final valuation that we're expecting to exit at.

The good news is the Company's been growing so fast there are a lot of pro forma adjustments that kind of through the process, the valuation came down from earlier initial indications that we were benchmarking off of. Similar story to V12, where we're looking to exit, and just some changes in the overall valuation,

Jack, how do those valuations compare to a few quarters ago, before these processes started?

If you go back several quarters, they were probably similar to where we have now. I know both of them had been marked up, as they were going through the earlier stages of their process.

In both cases, there was early indications that the valuations would be higher. We have marked up to reflect that, and then both have come down as we get closer to the absolute exit.

Okay. I understand. There were some other credits that saw deterioration, not to the same extent, but some downward movement specifically, Emerging Market Communications, US Wells, and Print Direction. Any comments that you'd care to make on those three names?

No. We do have ups and downs and Print Direction is one where we have a large amount equity in it, so that one is subject to variability, just from even small changes or temporary changes in EBITDA, that explains most of that one.

US Well, obviously, is one of our two remaining energy investments. As that market continues to go through their downturn, we're just trying to be conservative on where we are marking it. And I think relative to some other investors in that space, I think our marks are conservative.

And again, there is still no crystal ball on where the oil and gas market is going to go, pricing has stabilized in that market. So that's a good sign. I think there's better ability for production companies in 2017 to set their budgets, which should help things and keep thing stable. At the end of the day, it's still prices that are less than half of what they were at the peak.

And Print Direction?

Again, Print Direction is one we own a lot equity in, it was a downturn in EBITDA and it impacts us with that equity holding we have there.

Okay. Turn to the balance sheet, you are carrying a lot of cash, which I assume means a lot of it is in the SBIC subsidiaries. You previously mentioned that the pipeline looks similar to the deal flow we've seen in the last couple of transactions. How much of the pipeline would qualify for SBA funding, and how quickly can you put that money to work, to make this balance sheet more efficient?

This is Steve. Good question. The pipeline is a mix of deals that will be FDIC eligible, and some will be done out of the parent. In terms of timing, we're somewhat optimistic that we'll be able to report some things out to you before too long, but I wish I could give more clarity on that.

But we did pay down the line during the quarter. We did pay off $11.5 million worth of notes during the quarter, and even with all that, we are still pretty liquid and it allows us to co-invest with fund five and do some good things during this fourth quarter. We will certainly let you know, like we did with the deal on Vintage that we just announced, as soon as we fund those deals, we will certainly let the market now.

Is Vintage an SBIC deal?

Yes.

My last question, any comments you can make on the senior loan fund? And that's it for me. On the outlook for the fund.

Yes. As some may know, our partner left during the second quarter. And we have refocused our strategy on directly originating lower middle-market investment opportunities. So to that end, we are in the final stages of winding down the senior loan fund, and by the end of the year, we'll have that fund wound down and the proceeds sent back to the two equity holders and will redivert that cash into debt securities.

We had a good dividend in the quarter, a full dividend. To be determined what we do in the fourth quarter, but our partner helped us wind down out of those positions, and it was a pretty efficient process. That's where that's going.

Steve, those structures have been popular across the industry, so can you give us any background on what caused this particular joint venture not to work out?

Mickey this is Joe, I would not say at all that the joint venture did not work out.

Okay.

In fact we think our current partner in that joint venture would do various other joint ventures with us, and also is an investor in our private fund. I would say we really decided to get back to basics focused on using our direct origination platforms, we were able to find high-quality deals, many with senior secured positions yielding double-digit yields.

If you look at the liquid senior loan fund, it was paying a nice dividend, but when we're able to originate, like we have the past few transactions, senior secured loans in companies with double digit EBITDA, with less than 4X total leverage, we would do those all day long. We just had a shift back to basics, really relying on our origination platform, and that's where we wanted to focus.

With that shift, the partner we brought along to manage that vehicle, he had to go back to invest in the strategy, which was his background. He left, very good terms. Assisted in our process of winding it down, and I think you will notice in the statement of investments we actually had a nice appreciation in that position the last quarter. It will be wound down by the end and of this quarter definitely, and I'm not sure, we may not even have any of the GRS outstanding right now, because the wind down has gone very favorably and as expected.

I understand. Thanks for your time this morning.

Ryan Lynch, KBW.

As I look at your balance sheet, you have about $60 million of cash, as well as $80 million available on your credit facility. You all have delevered the balance sheet over the last couple of quarters, but from a GAAP standpoint, GAAP leverage ratio is still at about 1.27 times and regulatory is at 0.59 times. Still fairly elevated leverage ratio.

How should we think about your practical dry powder in the BDC to deploy new investments? How should we think about those leverage ratios, both a GAAP and the regulatory leverage ratios going forward?

Ryan, this is Steve. I think we feel pretty confident that if we keep our regulatory leverage at or below 0.8X, that puts us in an optimum position from an NII standpoint, gives us some cushion for valuation fluctuations, and that's been our theme for the last few quarters. We did, as you noted, pay down some SBA debt, which is excluded, but we also paid down a line during the latter part of the third quarter. We will redraw on that line.

We have $82 million available, certainly if we're trying to stay under 0.8X, we probably still have availability to draw that whole amount. But we have some cash. We will use that, and to the extent we need to draw facilities to fund deals, we will do that as well.

Over the last several quarters, maybe the last -- certainly in 2016, and maybe even the last five quarters, you have had some pretty sizable net realized losses in the portfolio. Have you done any internal study to identify any deficiencies in the credit process, to figure out what went wrong with these credits? Are these Company-specific issues that went bad? Or is there something more systematic that you need to evaluate and try to limit those losses? Have you done any study and identify anything in the process?

This is Jack. We obviously do a lot of study on all of our good and our bad investments, to always learn lessons from them. Unfortunately, the answer is little bit too easy on the realized losses here, where most of them relate to oil and gas investments. So with $38 million of realized losses on oil and gas, and another $8 million of unrealized losses there.

As we have talked about for several quarters now, we were exposed in that area, and we have the decrease in prices. I guess lesson learned, it is commodity-based pricing. We had a lot of sensitivity around pricing, as much as a 50% discount, but as we know, the decline in oil and gas prices was more than 50%, and it lasted for much longer than anybody had predicted any downturn would last, and we're still in it. That was really the biggest factor right there.

Okay. And then, just one last one. You mentioned in the opening comments that you are prepared to waive management fees if necessary to cover the current dividend. The newly reduced the dividend. Do you anticipate over the near-term, the next quarter or two, having to waive any fees to cover the dividend, or do you expect to fully cover it without any fee waiver?

This is Joe. We have a very active pipeline. So the fourth quarter, it's how much we convert out of that pipeline. We closed a nice one last week, but we are committed to the waiver this quarter.

Our models show that if we can continue to have the liquidity to invest and convert the pipeline, that the waiver is really minimized in 2017, and should be eliminated. But we are committed to having that incentive fee waiver in place.

We did have to waive, I think, $300,000 this quarter to make it happen. We are slowly working our way out of that. We waived $2.7 million since Q4 last year.

These are permanent waivers. We are committed to it, but with the ability to create the liquidity and now do deals, we are finding some great quality deals. We should not be relying on this incentive fee waiver in 2017 to any material event.

Okay. Thanks. Those are all the questions from me.

Thank you.

Christopher Nolan, FBR & Company.

You mentioned on the new deal originations, are senior secured, can you give a little detail, because they bank ahead of you in many of these deals? Are you first lien? How would you characterize it?

This is Joe. The way we define senior secured really is, there's no term debt ahead of us. There may be a revolver beside of us. And despite some inner dynamics and inter credits with the revolver.

We really are first lien on that company and the cash flow. There's no debt above us, there's probably an asset-based revolver facility beside us. And the overall leverage is still under 4X on these deals on average.

Great, thanks Joe. Separately, what's the debt funding strategy going forward? Presuming that you are unable to grow SBA, and you also have the baby bond callable in mid-2017, is the strategy right now to call the baby bond when you're able and then just use the credit facility?

I'm going to talk about your SBIC question and let's Steve talk about balance sheet question on the bond.

We are in very good standing with the SBA program. Our private fund was one of the first funds in the nation to receive incremental leverage, once a family of funds limit was increased in early 2016. We will run that process through again, to get additional leverage in the BDC, that we could utilize the SBIC program for additional debt, now that the family of fund limit has increased.

And with that, Steve can comment on the baby bonds.

Yes, Chris, we're certainly in active discussions with a number of parties exploring all of our options as it relates to calling and/or retiring those notes in June. It is way premature to offer any specifics there, but certainly something we are highly attentive to, and very optimistic that we can find a good solution for us, to reduce that interest carry on that.

Got you. Thanks Steve.

Joe, back to your SBA comments, and thank you for the detail, should we interpret that as you will be applying for another license? And possibly in 2017, you could see a potential increase in the SBA limit?

The family of funds limit has increased. We access that with our private fund. We're always in communications with SBA. We would like to proceed with additional SBIC license in 2017.

What we do know is the SBA is unpredictable in how they process licenses, even though we are in great standing, and typically when there is a change of administration, sometimes that causes delays. We have been in the program for three different administrations, I think we entered the program in Clinton over to Bush, and then Bush to Obama. We have experienced a change of administration a few times, being in the SBIC program, and that actually adds to the unpredictability of the process.

Okay. Thank you for taking my questions.

(Operator Instructions)

I think that's all of our questions. Thank you, everyone, for your time. If you'd like a copy of our hat we are wearing on our heads, just let us know and we will send you one. Everyone have a great day, and thank you.

Ladies and gentlemen, thank you for participating in today's conference. This does conclude the program, and you may all disconnect. Everyone, have a great day.