Logan Ridge Finance Corp (LRFC) 2017 Q2 法說會逐字稿

At this time, I would like to welcome everyone to the Capitala Finance Corp.'s conference call for the quarter ended June 30, 2017. All participants are in a listen-only mode. A question-and-answer session will follow the company's formal remarks. Today's call is being recorded and a replay will be available approximately 3 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 August 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. In addition, the company posted a prerecorded podcast of its quarterly result August 7, 2017, on its 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 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'd like to turn the meeting over to Joe Alala.

Thank you, operator. Good morning, everyone. Thank you for joining us. We do have a new format. Podcast was posted yesterday reviewing the results. Today, I want to review with you some thoughts and plans as it relates to our current and future financial performance and address any questions you may have.

We are pleased with lowering our cost of capital during the quarter. We refinanced $113 million of baby bonds that were at 7.125% with 2 offerings: One, a $75 million 5-year non-call 2-year baby bond at 6%; and two, a $52.1 million 5-year convertible offering at 5.75%. We also renewed and extended our senior secured line of credit, expanding the accordion feature to $ 200 million and providing for a step-down rate, about 25 basis points, in the facility when certain conditions are met.

No new investments were made during the quarter. $6.5 million in add-ons were made. The pipeline remains good. We are cautious in underwriting as we may be approaching the later stages of a credit cycle. Our focus is on first lien unitranche investments, as evidenced by activity over the last 12 months. Over the last 12 months, 5 out of our last 6 new investments have been unitranche or first lien. Repayments and exits have provided us significant liquidity to be active in the lower-middle market when we find deals that are properly priced for risk-adjusted returns. We also have the liquidity to fund all company obligations, including distributions.

Management and the board are taking a long-term view related to the distribution policy. We will focus on NAV-per-share improvement and generating a return on equity that exceeds our quarterly distributions. To do this, our expanded portfolio group will work diligently to improve the performance of investments on non-accrual status. In addition, we expect to monetize additional equity positions, generating capital gains and providing additional liquidity to reinvest into first lien unitranche credit that provide safer yields. We added 3 investments to our nonaccrual list during the quarter, Cedar Electronics, Print Direction, Kelle's Transport.

At this point, I would like to turn the call over to Jack to provide a brief update for each company currently on nonaccrual status. Jack?

Thanks, Joe. First, I'd like to review the 3 nonaccrual companies from the prior period. On-Site Fuel Services, as discussed before, continues to be a long-term turnaround. This was placed on nonaccrual back in Q3 of 2015, and we've been heavily active in the business since we had a complete management restructuring back then. We continue to see improvement in the business and as mentioned in previous calls, I'm still hopeful that we can begin to recognize some (indiscernible) interest by the end of this year.

American Exteriors similarly was placed on nonaccrual in Q4 of 2015 as a long-term turnaround. It's a relatively small investment where we have a senior debt security. The business has been stable during the year. Sierra Hamilton is last for energy investments to be restructured as announced as a subsequent event, we are restructuring our first lien debt was converted to equity ownership. As of this date, Sierra is no longer on nonaccrual list. The company continues to improve performance in what has been a relatively stable pricing environment. We are hopeful that we'll be able to see future appreciation of our equity position like we have with the successful restructure of U.S. Well Services.

The 3 companies we've added as a non-accrual during the second quarter are all fluid situations involving turnaround and/or restructure activity. That being said, there is limited detail that we can provide as there are multiple parties involved in each situation. Cedar Electronics was a June 2015 subordinated debt investments in a sponsor-backed add-on acquisition. Integration issues and market softness created underperformance. While the company preserves liquidity, our [subdeposition] is on nonaccrual. We do not foresee any change in the city of situation until we have better visibility into the important holiday sales season.

Print Direction was an investment that dates back to 2005. The commercial printing industry continues to be very competitive and the market has become commoditized. As mentioned on our prior call, the company has been experiencing customer attrition, and that issue recently escalated. We're in the process of restructuring the business and transforming it to more of a marketing services provider, but this will be a long-term effort.

Kelle's Transport was a March 2014 investment where we are in a first lien position. Overcapacity in the U.S. transportation industry during last year has created softness in operating results and the company has been working to right size the business. During this effort, we are being supported in preserving liquidity, and we are hopeful that performance will improve moving into 2018. On the positive side, we realized a strong $4.5 million gain on our MJC Holdings and continue to see appreciation in many of our equity investments, including Eastport, Nth Degree, Burgaflex, LGS -- LJS, Burke and as previously mentioned, our restructured equity position in U.S. Well Services.

And with that operator, we open the line up for questions.

(Operator Instructions) And our first question comes from John Hecht of Jefferies. Your line is now open.

I guess first question that you highlighted, On-Site American Exterior and that Sierra Hamilton is a company that you're turning around, and I'm wondering with On-Site American Exterior, they're no longer on nonaccrual, how much, I guess, interest income will you be able to accrue from those in the second part of this year? With Sierra Hamilton, is there any chance for equity distributions in the equity level? What I'm really looking at, I guess, is you bridge yourself back to -- being able to support your dividend. How much liquidity do you guys think you need to deploy at what types of rates and what type of improvement on your NPA performance do you need to get before you're comfortable that you can carry your dividend?

Yes, right. And so John, those 3 companies you mentioned are still on nonaccrual. I think you said they're off nonaccrual, but they're still --.

No. I think it was -- the commentary was that there is some sort of light at the end of the tunnel that may go off of non-accrual in the later part of this year.

Yes. Again, on On-Site, I'm hopeful that by the end of the year that we will be able to start receiving some interest, and that's going to have to ramp up over time. So I don't think it'll be a meaningful contributor. It will not be -- I don't (indiscernible) they won't be a meaningful contributor to Q4 income. And as we get it started again, if we can, that will ramp up over over 2018. I can't tell you the extent of that. American Exterior is such a small investment that even if we turn on the interest their, it won't be real meaningful. And then Sierra Hamilton correctly is not on nonaccrual as of today, it was at the end of the quarter. But that is a -- it has been converted to an equity position. I don't foresee any equity distributions on that, that will be kind of an appreciation and will probably exit before we see meaningful distributions out of that. Does that help you with those --?

It helps. So I guess the second part of question is maybe you can conceptually bridge us back and you do have quite a bit of that liquidity, borrowing capacity. Should we just think about this as a situation where you're going to focus on working through the nonperforming assets, but don't expect any yield on those, and therefore, the way to get back to covering the dividend is going to be deployment of excess capital here?

Yes, John, this is Steve. As it relates to NII near-term, NII will not cover distributions and that's mainly due to the drag associated with all the liquidity that you referenced and through the impact of these non-accrual loans in the next few quarters. We're taking a long-term view in rebuilding NII. One, we are concerned about where we are in the credit cycle and the diminishing number of quality, and I emphasize quality, number of deals for consideration; two, our unwillingness to chase yield in that regard; three, our expectation to realize additional equity monetizations that can be redeployed into debt securities; and four, we have intentions to equitize some additional SBIC license at some point in the future. And fortunately, our liquidity position does give us the opportunity to accomplish all those goals. But again, we're taking a long-term view here. In the near-term, NII will not cover of the distribution.

Your next question comes from Christopher Kotowski of Oppenheimer.

Yes. I guess with -- as you look at the nonaccruals, is the issue more a softness in the economy or kind of pervasive weakness or is it that it was kind of just -- the nature of the industry is that they are investing in that and that these are all kind of somehow secularly challenged companies.

Yes, this is Jack. Each role is unique and how it goes about -- I mean, having gone through several cycles now in my professional career, I feel that right now, larger companies are reaching for growth, and that is impacting some of our lower middle-market companies as they do that. But again, each one has unique. As I mentioned with Cedar, there were some integration issues on an acquisition. Kelle's -- the transportation industry had a sick or beat-down year. Amazon's been affecting that market. So there are specific things. At this point, I would say there is kind of increased competition from larger entities, but each one's unique .

Okay. And I guess what could you -- can you say anything about the rest of the portfolio and how you feel about the asset quality among the other names? Are there any situations that we should be particularly tuned to?

I don't think other than just looking through our valuations that would indicate -- I mean, we continue to monitor all the companies in the portfolio and they are all lower and middle-market companies that experience issues from time to time. So there are always ups and downs, and we keep close eye on them. I mean, that's kind of what we went through with some of the non-accrual this period where there were plans in place to improve profitability or operations of the business. There was indicated sponsor support to back that. And in some cases, the sponsor kind of backed out of their commitment to move things forward. And then the debt had to strenuously take steps to support the business and move it forward more with an equity head on. So sometimes, we expect to see companies improve based on our plan and that plan doesn't materialize and we don't get the equity support that we thought we're going to get and it can quickly change. So that's kind of stuff we had to deal with on a daily basis. And again, we've lived through many cycles, and we'll fight through it again.

And our next question comes from Christopher Nolan of Ladenburg Thalmann.

Was the increase in (inaudible) mostly related to AAE acquisition?

That's correct, yes.

Okay. And then was part of (inaudible), depreciation charge, there's a true-up NAV offsetting the (inaudible)?

Can you ask that again, Chris? I'm having a hard time hearing you.

Yes. The unrealized depreciation charge of $9.1 million was part of that to just say true-up the NAV to offset the realized gain?

That's correct. MJC Holdings, yes, at least $4 million.

And then the decrease in the portfolio volume, should we see this as a continuing trend given the comments that we are sort of might be in a cyclical downturn, so you guys might be holding back in terms of your portfolio deployment? Should we expect, at least in the second half of the year for investment portfolio volumes to decrease?

Chris, Joe here. We still have a very active pipeline. We have moved more to our first lien unitranche focus, Five out of the last 6 deals have been in that structure. We are active on -- we still find some quality deals. We are active, we are issuing term sheets in that unitranche first lien space. Sometimes, they're re beating on pricing. So we're not sort of sacrificing too much as far as really focused on structure versus pricing, but sometimes, we are actually losing on pricing that we just can't compete with. We are not pursuing unsecured loans, mezzanine loans that are out there. There are many in our pipeline, but we are choosing not to participate in those loans, even though they're yielding 10% to 12%, sometimes 13%, is because the structure in the market now on a consistent basis is those security positions are behind 3, 4, sometimes even 5 turns of senior leverage above them, and we're choosing not to participate in those structures. We do expect to close several more deals this year. They will be in the first lien unitranche-type structure, but we are being very cautious in what we are pursuing, really focused on structure overpricing, but there is a point where the pricing gets so low that we as the VDC cannot pursue it and it makes sense. So that sort of where we are. We still have 6 full service offices. We have 8 full service originators. We're seeing a lot of deals. We're just being very cautious. And we're spending a lot of time and have added a lot of resources to the portfolio side of the business. We really believe focusing on that can really improve our NAV and help contribute to NII over the next near-term.

Final question is I estimate that on a cost basis, your nonaccruals are roughly 14% to 15% of the total portfolio value. Is -- does this start affecting your advance rate for your bank revolver?

Not this time, no. Good question.

And our next question comes from (inaudible). Your line is now open.

Yes. Can you just give us some more color on the pipeline for new investments? And what I'm really trying to understand is you don't want to chase yields, have bit of caution of your credit quality. If there's just several more quarters of lack of activity, what sort of the plan for all the liquidity? Thanks.

Yes. This is Joe back to pipeline. We do have an active pipeline. We are focused on the first lien unitranche. We do have sort of internal rates that we want to hit. We are not going to pursue an L550 unitranche. That's just a product that we cannot go out and compete, and it covers our sort of cost of capital. But there are definitely first lien unitranches where we can get, on our blended structure rate and security, 8.5% to 11.5%. We are pursuing those. We expect to close more of those this calendar year. What we don't want to do is to chase a structure that has too much inherent risk in it and definitely do not want to get into trouble with credit this late in the credit cycle. So we're choosing to be very liquid. Liquidity gives you many options. We do still have a lot of nice positive events in the portfolio. We still have over $54 million of appreciated equity position. And the larger ones are getting stronger, to Jack's point. The companies that are doing well are doing very well and those equity positions are appreciating. So we just don't want to be so short-term focused that we try to force a yield into a structure that does not make sense. That's how we continue talk about risk-adjusted pricing. And I think Steve is going to answer some more questions about liquidity you ask, but else, we would do the liquidity. That was the pipeline answer. What was the second part of your question, Doug?

Yes. Just -- what the plan is for liquidity if the first lien activities just -- like we saw this quarter for several quarters?

Well, I mean, to Joe's point on the deal flow, I think that was a good answer there. From fresh liquidity, as noted, we've paid down the line. So we've got capacity on our line, and we've used equity to do that subsequent to quarter-end. And as I mentioned earlier, we do have a desire to equitize an additional SBIC license if and when that gets moved forward.

And our next question comes from Ryan Lynch of KBW. Your line is now open.

My first question just has to do with the dividend. In the past, you all have waived incentive fees in order to support the dividend at its current level. This quarter, there was no incentive fee earned. I'm not sure if there's going to be much incentive fees earned over the next couple quarters, but are you guys still committed to waiving incentive fees necessary to support the dividend at the current level? And when I look at the current dividend level, I mean, with the NAV decline this quarter, that's about a 10.4% dividend yield return -- is a 10.4% dividend yield. Is that a reasonable return that we should expect you guys to be able to generate in today's environment?

This is Steve. Let me cover the dividend first, if I may. As you know, we announced our distributions that are approved by the board first day of each calendar quarter. So we're in the middle of Q3, and that as announced in early July. Our next announcement will be in early October for the fourth quarter of '17. I think it'd be inappropriate for me to really give you any guidance on any future levels of distributions. However, I'll tell you, we're taking a long-term view, as Joe mentioned in his opening, relative to our distribution policy with our board and the focus is really on rebuilding the NAV and generate a return on equity in excess to the distributions. And relating to the waiver, I'll let Joe comment on that because it really falls back on the manager.

Yes. Ryan, as far as the waiver, we waived millions since we first announced it early 2016. We always want to look at the waiver as an alignment vehicle, but we also need to realize that you have to have a cohesive team to address some issues. So we did experience some flight of professionals in '15, '16 when we began waiving fees. We have recently, over the past few months, restaffed 6 to 7 people that we just announced last week or 2, and we actually have plans to add more to the portfolio side. So we will always look at the waiver in sort of a best interest mindset, but sometimes the best interest is to commit more resources to maybe the portfolio and doing things that it's going to grow NAV now and ultimately grow earnings versus waiving fees and being short-term focus. So we'll look at it, but like you said, we didn't have any fee to waive this quarter, but we'll look at it on a quarter-by-quarter basis, but ultimately, we got to make a decision on what is the best use of our limited resources and how's that ultimately going to affect our NAV and our earnings because you don't want to be shortsighted there.

Sure. I mean, going back to the specific dividend, I don't, especially to your comment, I guess, on future dividend, but I mean, if you just look at it from an earnings standpoint, that's a 10.4% yield that you guys would have to generate from an NII perspective. So in today's environment where compressing spreads, you guys moving up to unitranche loans as well as the credit issues, I mean, can you -- is it reasonable to expect Capitala to generate a 10.4% NII earnings yield going forward?

I think I'm go back to my earlier answer regarding NII, and we're really taking a longer-term view here. Your question makes sense. I'm inclined to say yes, but again, we are taking a longer-term view here, and we're trying to tackle this in several phases, which is prudent investing with the liquidity, and I think if we have some patience there, I think we can find good deals that will provide the yields to support what you just said. But we're not going to chase yields to do that. I think having some more monetizations of equity and providing additional liquidity again and turning the equity security into yielding debt security, all these things collectively get us back to what you're asking is, can we earn that coverage through NII, and I think the longer-term answer is yes, it's just going to take some time.

Okay. And then moving to just the underwriting process and maybe in portfolio management, I mean, in the past, maybe 2 years ago, call it, some of the credit issues were primarily surrounding energy investment. As we look at the current non-accruals today, it's a pretty wide variety of mix of different industries and Jack, you talked about there a couple, maybe one-off-type of events that resulted in these individual companies going on nonaccrual, but if you step back and look at several different investments and several different industries are on non-accrual today, so I just want to have you guys give some commentary on are there any change that you guys are internally reviewing about the sort of the investment process that can help prevent some of these nonaccruals going forward? I know you guys hired, I think, 6 new folks a month ago or so. So any just sort of commentary or color you can provide on the investment process, how you guys are internally looking at that given the current nonaccrual situation, any improvements you guys are looking to make to that?

Yes. Ryan, this is Joe. I'm going to answer the first part and then Jack to the second part. The first part is, and this goes back to your comment on fee waiver, there's always unintended consequences of sometimes pursuing what you think is the right action. When we began waiving fees, we didn't lose significant loss of professionals in both underwriting and portfolio. That mainly occurred sort of in the '15 through when we started hiring again last December. So we did have a drain of talent. A lot of people that had underwritten some deals we're no longer at the firm. So we have overhauled our entire investment process from underwriting to -- which is involved in active portfolio management, and we did that and we beefed up all the professionals that we just announced, and we've changed all our internal processes and a big part of the change we had to add bodies to it to make it work, which we have done. But we have basically changed all of our processes, improved them, added the bodies to them, committed the resources to them. And with that, what will you add to that, Jack?

Yes. I mean, there are specific things in underwriting that we're highly attuned to. I mean, again, you alluded to some of the oil and gas deals, so we're much more concerned about any kind of commodity pricing risk as we go forward. We will reduce kind of the total amount of investments that we do in any one deal, which is and has been an issue in at least 2 of the deals done in the past. So there are a couple things specifically that we're looking at and have been built into underwriting so that we won't go down those types again. But again, we're dealing with small and middle market companies, and we're dealing with the economy that cycles through different periods, and we held onto a company that sold lumber in South Florida for 5, 6 years and had a positive return, return of all our capital and a equity gain on it because we were patient in support of the business. And sometimes, it's not pretty on a quarter-by-quarter basis, but this is what we do for a living. There are small businesses and you have to get the kind of ride the ups and the downs with them. Again, I would say more than most, we are very actively engaged at the management level really and some of these are actively participating to improve the business. It's very hands on focus, and that's why you see a lot of the equity appreciation. Sometimes, there is some risk involved in these things and sometimes, it pays off and other times, we have to work hard for our money.

Okay. That's good commentary. And then just one more small question. You mentioned moving to some more first lien unitranche loans in the quarter, and I know you said you aren't doing some of the lower yielding unitranche L plus 500-ish loans. Just curious, what sort of pricing are you guys seeing in the first lien unitranche deals you guys are actually putting in your book today?

Yes, this is Joe. And what's unique is we do have a very robust pipeline of activity. If you look at the unitranche first lien loans we've done over the past 12 months, they've all been double-digit yields. Even though when we did earlier this year, actually that one, a warrant was attached to it. I expect the current pipeline will still be double digit yields in the unitranche first lien, if not sort of maybe high 9s, but those opportunities are out there. And it's just you got to look harder for them, you got to make sure the structure is right. Again, we're not sacrificing structure from pricing. But I think we can achieve that 9% to 11% pricing in the first lien unitranche product, and we do believe that we're in the later stages of the credit cycle. And as you ,know when the credit cycle does reset, it resets fairly quickly, and then I believe the pricing environment and the structure environment get substantially better. And we want to make sure we do have liquidity from when that happens. So that's really -- we're focused on maintaining a high-level liquidity, focusing on quality deals, focusing on enhancing the non-performing investments. So we're focused on the right things, we just got to execute. And I think we ultimately can grow NAV and ultimately can have NII cover our distribution. It's just going to take some time.

And our next question comes from Chris York of JMP Securities. Your line is now open.

So most of them have been asked, but how should investors reconcile your comments about an objective of stabilizing NAV with your comments that over the near-term, that investment (inaudible).

Well, I think the question was how do you address NAV when you foresee the short-term NII not covering distributions. I think we're looking at a long-term horizon on this. And also we do have substantial sort of equity positions that can be monetized, and we do expect that those monetizations getting recycled into yield, and that's how we get back to NII covering the distribution, but we have almost $100 million of equity securities with $57 million of that being appreciated. The top positions continue to appreciate because their underlying names are performing very strong. And also if we fix these non-performing sailboats, monetize those and put those into yields, that's really -- when you look at it on a long-term basis, we get there. It's just on a short-term basis. We're not going to have the NII to cover the distribution .

Got it. That's helpful. Okay. And then kind of thinking about how the stock may behave today where it was trading as of yesterday's close. I mean, how are you thinking about buyback of shares today given that you do have low leverage.

Yes, Chris, this is Steve. We've talked about that internally. And I think for now, it's our desire to invest our liquidity into debt and to equity, again to help improve NAV per share and to help rebuild NII again through debt investments and then the equity investments help into appreciate NAV. So that's our short-term focus. We'll continue to revisit that internally as the markets speak, if you will. But that's kind of where we are right now.

Okay. And then maybe, Jack, last one here from me. It appears you made an add-on investment to AAE. And then, we've already talked about the rate that was adjusted from cash to cash to PIKs. So maybe just comments about the performance of this investment.

Yes. There was a -- we did a partial recapitalization to support that business. They have been through it. Market downturn in the prior year. Down in the Gulf area was a very slow economy last year, kind of slowest in the country. The company has been stable, but needed some support, largely in regards to kind of the assets valuations of the business. Again, without getting into much detail, it needed some capital support. We had an opportunity to provide that. We got a nice equity upside by providing that and what has been a pretty stable businesses as things improve. So I mean, that's just some support that we are providing to the business, and we think we got a nice potential upside out of providing that .

And I'm showing no further questions at this time. I'd like to turn the conference back over to Joe Alala for any closing remarks.

Thank you everyone for your time. We are around all day if you want to contact us directly. Thank you.

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