Logan Ridge Finance Corp (LRFC) 2016 Q4 法說會逐字稿

At this time, I would like to welcome everyone to Capitala Finance Corp.'s conference call for the quarter ended December 31, 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, Steve Arnall.

Capitala Finance Corp. issued a press release on March 7, 2017 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, belief, strategies, future operating results, and cash flows. 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 Annual Report on Form 10-K. 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. I'm actually dialing in from Tel Aviv, Israel where I am meeting with existing and potential investors in our Private Credit Fund. I do hope the connection is good. Jack and Steve are in Charlotte, and we are pleased to be with you this morning to discuss with you the results from a very successful fourth quarter of 2016.

Highlights from the quarter include net investment income exceeded quarterly distributions without and incentive fee waiver. This represents the sixth consecutive quarter of distribution coverage from NII. Net asset value per share increased slightly during the quarter. We did have a successful wind down of our Senior Loan Fund JV at par this quarter. New investments for the quarter totaled $67 million. 72% of these new investments were first lien loans. The aggregate average yield on these new investments was over 13% cash pay. The aggregate funded debt to EBITDA on these new loans were less than 3.5 X to 1. We continue to demonstrate the high quality of deals directly originated by the Capitala platform. And when liquidity permits, we continue to demonstrate the ability to close on these high-quality deals.

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

Thanks, Joe. Good morning. As previously mentioned, on March 7, we filed a press release with our fourth-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 fourth quarter 2016, total investment income was $16.5 million, no change from the same period in 2015. Interest fee and PIK income was $0.6 million higher in the fourth quarter of 2016 compared to 2015. While all other components, mostly dividend income, was $0.6 million lower during the fourth quarter of 2016 as compared to 2015. Total expenses for the fourth quarter of 2016 were $9.8 million compared to $9.1 million in 2015. Incentive fees were $1.2 million higher during the fourth quarter of 2016 as compared to 2015 due to the incentive fee waiver in 2015. There were no other material variances to report.

Net investment income totaled $6.7 million or $0.43 per share for the fourth quarter of 2016 compared to $7.4 million or $0.47 per share for the same period last year. Net realized gains totaled $2.1 million or $0.13 per share for the fourth-quarter 2016 compared to net losses of $3.7 million for the same period last year. Net unrealized depreciation for the fourth quarter of 2016, including the written call option depreciation, was $0.8 million compared to depreciation of $12.6 million the previous year.

The net increase in net asset resulting from operations during the fourth-quarter 2016 totaled $8.1 million or $0.51 per share as compared to a net decrease of $8.9 million or $0.57 per share in 2015. Total net assets of $250.6 million at December 31, 2016 equates to $15.79 per share compared to $17.04 per share at December 31, 2015.

From a liquidity standpoint we have cash and cash equivalents of $36.3 million at December 31, 2016 compared to $34.1 million at December 31, 2015. SBA debentures outstanding at December 31, 2016 totaled $170.7 million with an average weighted 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 $44 million drawn and $76 million available under its senior secured revolving credit facility and regulatory leverage ratio of 0.6 X at quarter end.

At December 31 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-K for detailed information on the Company's interest rate sensitivity.

Now I would like to turn the call over to Jack.

Thanks, Steve. During the fourth quarter we had gross deployments of $67 million with a 13.2% yield on debt securities. Repayments amounted to $35 million, which included $20 million from the full wind down of the Senior Loan Fund. There were no significant individual realized gains or losses other than a $1.5 million realization on B12 holdings. And there was not a material change in net appreciation.

As of the end of the fourth quarter, the Capitala portfolio consists of 53 companies with a fair market value of $541.6 million on a cost basis of $513.8 million. First lien secured debt investments represent 41.8% of the portfolio, second lien debt 13.2%, subordinated debt 27.8%, and equity warrant value of17.2%. On a cost basis, equity investments comprised 8.9% of the portfolio. The total weighted average yield on our debt portfolio increased to 13.2%.

In regards to portfolio quality, we continue to maintain a sub 2 internal weighted average risk rating at 1.96. While average leverage at the portfolio increased to 4.2 X. At the end of the quarter, there were three investments on nonaccrual with a fair value and cost basis of $17.4 million and $29.5 million respectively, which represents 3.2% of the portfolio on a fair value basis.

Subsequent to year end, we successfully exited our investment in Medical Depot with a full $14.7 million repayment of our subordinated debt and $6.3 million of cash from our equity investment that resulted in a $5 million realized gain. In addition, we were repaid on our $5 million subordinated debt investment in Emerging Markets Communications and sold our second lien investment in Brock Holdings for $4.8 million. New investments include a $16 million first lien debt investment with an initial yield of 11.5%.

At this point, operator, we would like to turn it back for Q&A.

(Operator Instructions)

Mickey Schleien, Ladenburg.

Good morning, everyone. There was a pretty meaningful increase in PIK income from the third quarter to the fourth quarter. Was there some one-time event that generated that increase? If not, can you give us some explanation of what occurred there?

Mickey, this is Steve. Historically, PIK has been between about 6% and 9% of our investment income over the past couple of years. This quarter, as you noted, it was about 14%, mostly due to some income that we recognized on a restructured investment. We understand that that 14% is a little high related to our peers, and we will continue to work to try to reduce this component of total investment income. There was some one-time in there in the fourth quarter related to some income on a restructured investment.

Okay. I appreciate that. Steve, another question for you. Looks like you reclassified some of the equity accounts on the balance sheet. What was the nature of that reclassification and was there any tax impact?

No. There were just some normal reclassifications on an annual basis that had no bearing on tax distributions in the nature of those, so just some normal reclassifications.

Okay. Can you give us at least a ballpark or range of where you are spillover taxable income stands now?

Yes. Roughly -- I can be more specific than that.

I know the K shows a number for August of last year, but that's pretty dated.

The spillover is a little over $5.5 million at the end of the year.

$5.5 million spillover. Okay. My last question, Steve. On SBIC, I understand that existing subsidiaries are tapped out. Can you remind me are you -- where do you stand at looking at another license? Would that be in the BDC or would that be outside the BDC in an another part of the Capitala platform?

Mickey, this is Joe. I hope you can hear me. We are in constant communications with the SBA almost on a weekly basis, as we do have many active SBIC funds with them. We will pursue another SBIC leverage license in the BDC as soon as the SBA allows us to submit.

The reason the submission is being -- it's not being delayed. The reason the SBA has asked us not to submit is because we do have a private fund outside the BDC that when the family of funds leverage limit -- we talked about this on the last call -- increased from $225 million to $350 million that private SBIC fund tapped into the increased leverage amount and obtain more leverage. It was as if -- that took a slot in our process with SBA. They won't do (inaudible) time. Then, we would resubmit and get a subsequent license in the BDC to recapture the remaining funds available under the SBA family of funds limit. Also in time, you would recapture any of the payments made on the earlier legacy funds that are being paid down.

We are in constant communication with the SBA. We do believe that it is sooner versus later. But it's really up to the SBIC licensing committee.

Joe, I just want to make sure I understand. Are you saying that at some point, that other private fund and the BDC would share the capital available in the third SBIC license?

No. All the new available SBIC family of funds limit is going into the BDC. The Private Fund would never hit its 1.5 leverage limit, which we limited to keep most of it in the BDC. Then, when we had the increase in family funds, we were able to finally go to the 1.5 leverage in the Private Fund outside the BDC. That still allows significant SBIC monies under the family of funds limit in the BDC. However, we must get it through a new license.

None of this delay has anything to do with portfolio performance. In fact, I don't believe we've had negative SBIC retained earnings available for distribution, which means read. I don't think we've had negative read since the recession. None of this has to do with performance or SBA compliance or anything. We have great relations with SBA. We just need them to invite us to submit for another SBIC license.

The fact that we did get more leverage in our private SBIC funds earlier in 2016, they looked at this -- they looked at that as equivalent to a new license. It's just a matter of them inviting us back in, like they did in our Private Fund, to go access more capital. It has nothing to do with performance or any SBA compliance or anything. It's really just -- they look at us as if they had just provided us additional leverage in early 2016. They're just making us wait and be patient as they service other SBIC applicants.

I understand. I appreciate your time this morning. Thank you.

Thank you, Mickey.

Chris York, JMP Securities

Morning, guys, and thanks for taking my questions. Fee income contributed nicely to total investment income during the quarter. Steve, what are some of the drivers behind the pick up during the quarter? Then, how much of the income do you think is recurring?

Good question. Hey, Chris. The majority of the fee income this quarter was from investments made during the quarter, so origination fees. But for comparative and for modeling purposes to your question, over the past seven quarters, fee income has averaged about $1.2 million per quarter with about half of that coming from new investment related fees and about half of that coming from other related fees from existing investments.

For this quarter, it was a little bit of an outlier. We had a great quarter of originations and (inaudible) quarter that fee income was up. Historically and going forward, we think that will be more in line with what we've had in the past.

Okay. Then, a follow-up to Mickey's. How much income specifically was restructured income included in PIK income during the quarter?

Under $1 million, so somewhere between $600,000 and $1 million. (Inaudible). Just trying to give a ballpark range if that's helpful.

It is. Maybe Joe or Jack. We know that you had previously started to target larger companies, which is reflected in your weighted average EBITDA trends in 2015, but looking at your average EBITDA trends more recently, it's now declined for five consecutive quarters. So could you update us on how you are thinking about your target size of a portfolio company today?

I think back when we did the bond raise and we had more than ample liquidity at the time, we were much more active in the middle market space and finding near decent yields in those larger companies. I would say more recently, and certainly the fourth quarter, is a good example of this. Where we were really focused on our proprietary deals that were more -- some of those were still in the middle market, but maybe more in a $25 million EBITDA company rather than a $50 million EBITDA company. So you have seen the trend where the EBITDA, at a portfolio level, has come down some. I still think it's higher than historical levels, when we first did our IPO in 2013. It's still, overall, trending up on a long-term basis, but we haven't been doing those larger syndicated loans in the middle market like we were a year ago. I think that -- if that doesn't answer, let me know.

One thing I would add to Jack is, we do see the lower middle-market now, which we are sort of defining as $10 million to $30 million of EBITDA, as being the most inefficient market as other players have moved down market from above market and are servicing the middle market. We think the middle-market $30 million and above especially [get] $50 million and above and become very competitive -- we don't think there's a lot of risk-adjusted pricing there that to may be out of whack in our opinion. So we have really focused our direct originations into squarely the lower middle-market, as we believe that is by far the most inefficient market right now. I think the deal we just closed last quarter, those yields, those leverage attachment points and that size EBITDA really demonstrate at how inefficient it is and how we're doing a great job of finding those opportunities.

So it's safe to say that you would prioritize your proprietary originations of lower middle-market companies today as opposed to maybe some of those syndicated deals that you had looked at in 2015?

I think it's what Jack described. I think I'm saying the same thing. We are always trying to find the best risk-adjusted-based pricing. Right now, we're squarely seeing it in the lower middle-market. For a period of time, you could go above $30 million and get some really attractive pricing. But right now, I think that's a very competitive market, and we're finding such great opportunities in the lower middle-market that we are going to take part of those inefficiencies to our direct agent origination strategy.

Got it. Yes, answers my question. Makes sense. Lastly here for Jack or Joe. In regards to Sierra Hamilton, we noticed another BDC has investment marked at roughly, I think it looks like 65%, which is much higher than your marks. So implying some conservatism there. Now that the company is undergoing a restructuring, but what inputs are going into your mark that may explain the valuation differences?

Chris, we do our valuation, if they are public marks, those certainly are taken into consideration, but we don't use that to do our valuation. So it is somewhat irrelevant to us. We ran it through our normal process. It went through our external process also for this quarter, so there were plenty of checks and balances on it. It is being restructured right now. We agree with you. We think it is a conservative mark, but that was the result of the process that we run through. Yes, it does differ from others, but, again, we're not going to change the process to adopt to someone else's.

Got it. Lastly, just to confirm. Is your target leverage for balance sheet on a regulatory basis still a maximum of 0.75?

Around there. I would say put the cap around 0.8, but between 0.7 and 0.8 probably optimal.

Great. That's it for me. Thanks, guys.

Thanks, Chris.

Ryan Lynch, KBW

Good morning. Following up on Mickey's question about the SBIC. For me I think it would be helpful. What is the dollar amount of SBA debentures that are currently outside of the BDC today? Do you guys anticipate that amount growing at all?

Ryan, this is Joe. Let me be clear. The BDC was always the priority with the SBIC, and we communicated that when we came out and took those SBIC funds public. At the same time, we raised a private fund, which has a very different strategy. We limited the access of that private fund, for the benefit of the BDC. Until the family of funds limit changed from $225 million to $350 million, we were able to get 1.5 turns of leverage and we capped it at that in the private SBIC. So that 1.5 turns is approximately $110 million.

To get to your number, you just would take $350 million (inaudible) the BDC minus $110 million. And that would be the available capacity that we could pull into the BDC upon successful receipt of a new license plus any paydowns that happened in that time. And that's your number.

Perfect. That's exactly what I wanted.

Just to be clear on that.

Yes, that makes sense. That's good clarification. In a market environment where we've had a lot of BDCs already report and most of them are talking about an increasingly competitive environment. One of the results of that increase in competitive environment is pressure on loan yields and their portfolio yield. Whereas, this quarter, you all actually had a pretty nice increase in your portfolio yield from 12.7% to 13.2%. Can you just talk about what were the drivers of that big increase in the portfolio yield? Maybe more importantly, can you just give us comfort that you guys are not reaching for yield despite taking on excess credit risk?

Go ahead, Joe.

This is Joe. I've actually been on a two week road show in our Private Fund, and this is the question that comes up the most, is people are seeing the deals we did last quarter and they're saying, wow, how do you do that? It really comes back to we have these six full-service offices and our strong direct originations and we're finding these quality deals. We believe -- and I think these deals are proving it because we have been communicating this for some time now -- that they lower middle-market, the $10 million to $30 million EBITDA deals, is the most inefficient market out there.

So we are able to use our 20-year history in that market to find these opportunities. We have the reputation. We have the direct origination, and we had such great quarter. The reason we had such a great quarter, finally, we always have had the originations. We didn't have a lot of liquidity for most of 2016. As you recall, we could generated the liquidity in the BDC at the end of summer through asset sale at par, strip of asset sale. We also had a first close on our Fund V, which brought in liquidity. And we were able to deploy almost all that liquidity in the fourth quarter of 2016 into some of the best deals that we have done in several quarters.

Because the deals are out there. We are -- the deals we've already closed year to date, have the same type characteristics. We are seeing such high-quality deals. Our issue is always having the liquidity to close on these high-quality deals that we see. That's what we're addressing with raising private credit funds and also hoping the stock gets back to where we can start issuing some equity capital. Because we have more opportunity than we have liquidity.

Okay. That's good color. One last one. On-site fuel services, looks like you guys took a big write up in the fair value mark on [net] debt investment. It looks like it's now marked at par. However, that debt investment still on nonaccrual as well as the equity in that investment is marked at zero, so a couple of things going on in that business. Can you just talk about what drove the write up in that debt mark, as well as the outlook for that business?

In prior calls, I mean [on-site has comp]. That has been a multi -- a two-year turnaround process. We have made further investments into the business. A lot of operational changes have taken place, and we are finally starting to see the improvements from both the investments in dollars and in the operations. So there has been improvement in the business. We have seen good growth and at the top line there. There is still plenty of work to be done, but the performance has improved significantly. We hope to move this into a performing asset class some time in the next 12 months. It's really just reflecting the improvement there.

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

Christopher Nolan, FBR & Company.

Going back to Mickey's question on the SBA. In the past -- from what I understood, the SBA is hesitant to extend licenses to BDCs whose equity is trading below 1 times NAV. The logic being the SBA does not want to be a lender of last resort. Is that a factor in your discussions with the SBA in terms of a third license?

That's a great question. Actually, in our communication with the SBA that has never really come up. In fact, they're seeing us raise a lot of private credit funds, so they realize we are not -- that the SBA is not the only source of capital that we have [as] Capitala as a platform. They see us raising private credit funds, raising substantial separate managed accounts.

Their big issue is -- and it's really one of just process and fairness than anything. We have no covenant violations, no negative read, nothing that would prevent them from issuing a license. They look at our increase in capital in the private SBIC fund as they paid us attention. We got what we wanted. We waited in line and we got what we wanted.

Now, there were other people in line that need attention, so we have to get back in line -- and to simplify the analogy here -- but we have to get back in line and wait our turn. They don't separate the public BDC desire to increase its SBIC debentures from the private SBIC. They look at us as one firm. They said you were actually one of the first, if not to the first, to tap the increase in the family funds limit that came to your private fund. You were first in line. You got what you wanted. Now go back in line and we will be supportive of you, but you've got to wait your turn in line.

That's really a grossly oversimplification analogy. That really is what it is.

Okay. Thanks, Joe. Can you give us some sort of idea in terms of a list of priorities? Where does the baby bond refinancing come in? Because I know it's callable in June.

This is Steve. I would say it's one of my highest priorities. As you can imagine, as you mentioned, they were callable in June. Here we are in the early part of March. We are talking to lots of different friends about options to refinance that. It's a little premature to pull a trigger on anything. Rest assured, once we do come up with a solution we will share that with the market. But yes, it's a very high priority.

Great. Final question on the balance sheet. You had an increase in accumulated undistributed net investment income. Is that simply just the dividend waiting to be paid out?

Just normal reclassifications at year end.

Okay. Thanks, guys.

Next question comes from Mike Delgrosso, Jefferies.

Good morning. Thanks a taking my question. Most of my questions have been asked and answered. Just a quick housekeeping question on the equity composition portfolio. I assume you're comfortable with it at these levels. What's the outlook on that deployment going forward? Thanks.

Again, when we look at investments, we do try to get equity upside, either through direct equity investment or a warrant. We will continue to do that. When we are investing in equity, we try to keep it below 10% of the total investment. And you'll see that in our cost basis; I think it's 8.9%.

Then, we fortunately experience appreciation, and we have that in several portfolio companies that we are in. Again, those go through our valuation process, and we mark those accordingly. A lot of that is performance driven or debt reduction driven. Yes, we feel good about those marks and where those companies stand and we continue to have conversations with those.

A lot of those we are not in a controlling position. We are just a minority equity holder, so we don't control an exit process. As you can see, with the Medical Depot deal we were in that for about five years, and it went from a $1 million investment up to $6.6 million return on it. We continue to have good results with those, and it will continue to be part of our strategy.

(Operator Instructions)

Chris Kotowski, Oppenheimer.

Good morning. You show on your balance sheet accumulated net realized losses of $38 million, but you have unrealized equity gains of around $48 million. I'm wondering, given that a fair amount of those realized losses have been taken in the very recent past, if you realize any equity gains, can you use those to fill up the hole as it were? Or is that done? That was 2016, it's done, and you can only use the gains to offset unrealized losses?

Remember, too, a complicating factor for us. Our tax year ends on August 31, so we have got a complicating factor there. If you want, I'd be glad to call you off-line, Chris, and do a little research on this and get back to you, just to make sure we can talk through the specifics.

Okay. Yes, I'm just wondering if there's any chance of -- or if you just have to distribute -- if any future realized gains from the equity portfolio would be income that you'd have to distribute?

That would not be the case. It would go to fill that hole that you refer to.

Okay. All right. Yes, we'll catch up off-line. Thanks.

Okay.

That's it for me.

Thank you. I'm showing no further questions in queue at this time. Ladies and gentlemen, thank you for your participation in today's conference. This concludes the program, and you may now disconnect. Everyone, have a great day.