Logan Ridge Finance Corp (LRFC) 2018 Q1 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 March 31, 2018. (Operator Instructions) 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 host 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 May 7, 2018, 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 results May 7, 2018, 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 would like to turn the meeting over to Joe Alala.

Thank you, operator. Good morning, everyone. Thank you for joining us. Yesterday, we released our results for the first quarter of 2018.

Net investment income was $0.28 per share, covering our first quarter distributions of $0.25 per share. Net asset value per share was $13.66 at quarter end, down slightly from the year-end.

During the quarter, we invested $27.8 million into 2 new and 5 existing portfolio companies. $27 million represented debt investments, all of which were senior secured structure with a weighted average yield of 10.8%. Since the second quarter of 2016, we have publicly discussed our desire to underwrite less risky senior secured structures, moving away from mezzanine, second lien and subordinated debt loans. During that 7-quarter period, we have invested $196 million of new debt investments, 85% of which were senior secured structures with a weighted average yield of 10.15%. Reducing balances of nonaccrual investment remains a focus for management and the portfolio management team. During the quarter, we exited our position in American Exteriors LLC. Subsequent to the quarter-end, our investment in Cedar Electronics Holding (sic) [Holdings] Corp. was restructured into a preferred equity position, thus removing it from nonaccrual status. We continue to evaluate options to monetize certain equity positions, while we anticipate additional exits during the normal course of business, we are also evaluating other opportunities to allow us to reduce equity as a percentage of our investment portfolio.

Lastly, I want to talk for a moment about the recent announcement regarding Capitala Special (sic) [Specialty] Lending Corp. This new vehicle is a $1 billion permanent capital vehicle that was raised from global institutional investors. This vehicle benefits the BDC by: one, providing platform liquidity that allows the BDC actively to co-invest in new transactions, irrespective of the BDC's liquidity and holdfast limitations; two, the BDC benefits from the additional resources, as the firm is actively growing and hiring very talented seasoned professionals, opening new full-service offices and significantly upgrading its information technologies and platform software.

Lastly, it validates the long-term 20-year track record of the firm and its ability to generate top-tier, risk-adjusted returns and its various investment strategies over long periods of time. To our knowledge, this private pool of capital is one of the largest permanent capital vehicles that has been raised from all global institutional investors that targets a lower middle market senior debt investment strategy.

While the BDC began to shift its investment focus to senior debt loans in early 2016, this new vehicle is a substantially different investment strategy from Capitala's prior funds that were focused on mezzanine investments. By raising a significant-sized private pool of capital that focuses exclusively on senior debt loans, the BDC can further commit to its senior debt focus, and now it has the parallel liquidity on the platform to be very active in this new senior debt investment strategy through its ability to selectively co-invest with Capitala Specialty Lending Corp.

At this point, operator, we will open the line for questions.

(Operator Instructions) And our first question comes from the line of John Hecht with Jefferies.

First, just want to get your thoughts on tax reform, are you seeing any different -- just discussing or just -- in discussions with your borrowers, any changes in their appetite for borrowing or changes in their optimism around their business with respect to their initial takes on tax reform?

John, this is Steve. From [us, we] have not seen or heard of any of those conversations going on with our portfolio companies. Good question, I think there's still more to come.

Okay. And then, maybe can you talk about EBITDA, then EBITDA and revenue trends within the portfolio, just in terms of thinking about the forward credit book?

Yes. John, this is Jack McGlinn. I would say it's stable, probably better this year than it was last year at this time. I think forecast for 2018 were pretty in line with 2017 in general. So I don't think anybody was overly optimistic going into '18 at the same time. They weren't looking for any downturns either. I think for the most part, people are on budget kind of tracking towards their 2018 goal. So I would say it's pretty stable year, all in.

Okay. And then final question. You guys [get to slide] of your recent deals. Clearly, you've been successful moving up -- I guess, up capital structure, I think, 10 of 11 deals of first lien that you highlight. I wonder, can you tell us, within that category, where is leverage now? And what type of terms are you seeing in that market?

Yes, the recent leverage trends on our last sort of 7 quarters of deal with the BDC, we think we're still getting pretty good pricing, double-digit yields on those senior debt structures. The majority of those structures, if not all of those structures, are under 4x on average, total funded debt to EBITDA, which is a leverage ratio we monitor. Another way to monitor it would look at loan-to-value. So what's the loan outstanding relative to the enterprise value, with the bulk of those being 50% or less, loan-to-value loans. So we are very much focused and disciplined on structure, not sacrificing structure in this -- at this point in the credit cycle. Pricing is competitive on some deals, especially some sponsor activity deals, but we've been able to hold our pricing in the senior structures and still getting double-digit yields on average on these loans. And we're being very disciplined at this part of the cycle, but we are still seeing lots of opportunity. And we will miss the deal if the structure gets outside of our comfort zone and our risk-tolerance zone. And we're trying to be very competitive on pricing.

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

The weighted yields on the debt portfolio in the quarter was 12%. Last quarter, the press release says 12.8%, but now it currently says the fourth quarter is 11.9%. I'm just trying to understand what the difference is?

Yes, we now are showing the yield inclusive of the impact of nonaccrual loans, where previously, as we had disclosed, it got a little complicated, we were excluding nonaccrual loans. So that's inclusive now.

Got it. And correct that you guys are still sort of in a wait and see in terms of increasing of threshold. You have not gotten board approval or shareholder approval?

Yes, Chris, this is Joe. What -- at the BDC, we're still focusing on really the same 3 things that we've been focusing on for several quarters. These things ultimately should help our earnings grow and drive NAV stability, if not growth. And that is we've rotated into focusing on quality senior debt loans, move up the balance sheet, move in a better risk position, still getting paid for it. We're still focused on rotating some of this equity at around 25% equity. And the portfolio is too high of a concentration of equity for the BDC, we need to get that down much closer to 10%. And we're working hard to try to do that. And lastly, we're spending a lot of time focusing on the nonaccruals and the proven -- those underperforming loans. So as we manage and work through those things -- and you have a portfolio that has less equity, more less-risky senior debt structures and less nonaccruals. We think that's the best time for it to look at some of the regulatory leverage options that are out there and focus at that time on shareholder's discussions and board discussions on whether that's the appropriate thing for this BDC.

Got it. And Joe, pending any sort of approval from the board or any approval from shareholders, what is now the internal leverage threshold for the BDC?

Yes. Chris, this is Steve. I think if we can get up in the 0.7, 0.75 range, that's probably optimal for us right now from an earnings perspective. And again, still giving us that cushion with this equity book for some cushion there. So 0.7, 0.75 probably a good number for us.

Okay, so it's pretty steady from before?

It is.

Okay. Velum Global Credit are now matured at year end 2017, any sort of update on that?

No, there really isn't too much of an update on that. That's also kind of a wait and see. There's some assets in the underlying business there that we're waiting for them to be monetized. And it's really -- we're not sure when that will happen. So it's just kind of a wait and see.

Okay. And Jack, for Cedars (sic) [Cedar] Electronics, [are] those restructured into preferred equity with a 19% coupon or part of that? Is that a cash coupon, or is that a PIK?

No, that's noncash.

Okay. So your PIK income is -- should be going up?

The -- No, we won't be recognizing that PIK income.

Okay. So Cedar Electronics going to remain nonaccrual?

It's not a debt investment anymore. If you look at the subsequent disclosure [book in there], it will be not debt. [We can] talk offline if you want to.

And our next question comes from the line of Chris Kotowski with Oppenheimer.

Most of mine were asked but just wondering, on the $1 billion Capitala Specialty Lending Corp., is that all closed? Do you have exempt of relief? And how do you plan to allocate investments between the 2 vehicles, this and the BDC?

Yes. Chris, this is Joe. Thanks for the question. Lending Corp. is not closed. We will continue to raise money, its structure is a permanent capital vehicle that can have access, new investors can have access, and that pool can grow. We received SEC exempt of relief probably 18 to 24 months ago. And it's your standard relief that allows you to co-invest in the same strategy based on your liquidity at the time pro rata, same security, same structures. We think this is a really big benefit for the BDC for that exact reasons. As we move towards a senior debt focus, back in early '16, we also moved to much smaller hold sizes in the BDC. And having a parallel pool of liquidity allowed the BDC to maintain its investment strategy at a much smaller hold size. And I think you'll see the trend over the past 2 years of hold size is almost cut in half. At the BDC, we're trying to have a much more diverse portfolio of senior credit loans. And one key to that is having some parallel liquidity that you can run your strategy and hold smaller hold sizes across the vehicle. So we think that's a very big benefit. We do have SEC exempt of relief to do that. And that's very much a part of our strategy going forward.

And when do you anticipate the close on the vehicle, when can you start kind of co-investing?

Oh, I'm sorry, the vehicle is ready to -- I thought you meant close meaning can we accept new investors. This vehicle's already closed. We're about to take some assets off a warehouse any day now. And any new loans that are being pursued or being led by the private vehicles, including this vehicle, Specialty Lending Corp and the BDC has the right but not the obligation to co-invest. And that sort of how the SEC exempt of relief order processes that. So all new deals are being led by the private vehicles now, which allows the BDC the right to co-invest to the degree it feels -- it wants to.

And our next question comes from the line of Ryan Lynch with KBW.

I just wanted to follow up on Chris' question on the permanent capital fund you closed and the exempt of relief. So this is a senior debt-focused permanent capital fund, I know you guys have kind of shifted CPTA's investment focus to more senior debt, but historically, had it been a little more subordinate mezzanine debt. Just wondering, what -- I guess, is there going to be a high percentage or low percentage of crossover deals that you think CPTA will be able to co-invest with this private fund?

Yes. Ryan, that's a great question. This is Joe. We think it'll be a very high percentage. We're still able to, through our direct originations, do senior structured deals and get double digit on average yields. So it's, call it, 10% of what we were talking about earlier in the release. We think that's an attractive opportunity for the BDC. We do have a private mandate that believes that's an attractive opportunity. So we think there will be heavy co-investing. And we're just continuing to move the BDC away from these mezzanine loans as -- where we had our credit stress and losses, much more to the senior debt focus. And I think if you look at the loans over the last 2 years in that focus, very little credit, if any credit stress at all, performing loans or top of the capital structure. And we believe that's the best place to be if there is any type of reset in the credit markets, we want to own the balance sheet, and we want to be actively working with issuers to restructure the companies, if needed, to get them through any kind of economic stress.

And our next question comes from the line of Chris York with JMP Securities.

So I'm going to stay on the positive topic of the Capitala Specialty Lending. I'm curious, what types of changes do you expect to occur at the platform, maybe via new hires, risk management? And then secondly, are there any economic benefits that you expect to accrue to CPTA in either the short term or long term?

That's a great question, Chris. We sort of mentioned a little bit in the prior conversations on the release, but we're growing again. So this new pool of capital allows us to start hiring again because it increases the revenues across the platform. We're -- we have opened a New York Office that -- we hired a partner there, very talented professional, 25 years in the business. He's opened that office in New York. We're hiring more in both underwriting and the portfolio side of the team. We're putting in a very sophisticated, not cheap at all, software and IT system upgrade, which is very dynamic, which is very seldom seen in lower middle market credit managers. So we're hiring. And another great benefit is, other than software and IT, is the ability for the BDC to still maintain its lower hold sizes, and continue its strategy, and that's key. We want to focus on $30 million to $60 million unitranche senior debt loans, the BDC as a standalone entity could not hold those. Over the past 2 years, we've been focused on the same strategy, but we've been doing a lot of syndicating of those loans to other groups, including some of our other private funds. But now that we have the pool of liquidity, we can hold the entire loan. The BDC can still maintain its appropriate hold size of anywhere from $6 million, $8 million, $10 million, $12 million per name, but the entire senior debt of $30 million to $60 million is held throughout the platform in that strategy. That's a key difference. We were -- we have experienced a loss of deals, especially sponsored deals that get more competitive. When we show up, and we cannot hold the entire senior debt ask. At this point in time, we can hold that entire senior debt ask, and we do believe, if you go back over the past 2 years, we had that ability, our deployments in senior debt activity would be substantially higher because we did lose deals because we couldn't speak for the entire senior debt needs of that transaction.

That's very important and helpful color. Joe, maybe staying a little bit on the topic of the benefits for Specialty Lending, have there been any changes in the market awareness from, maybe, your private equity sponsors with the close of the new fund and then maybe somewhat the change in the new strategy?

Well, I think that's another very important question, is that we are now back telling all of our relationships, spending a lot of time. A lot of people just thought of us as a mezzanine provider. We've really moved away, even though we've moved, since early 2016, to more senior debt focus. We still have to keep educating the market and telling the market that this is our new product. The larger senior debt hold sizes, not just a mezzanine shop. And we're spending a lot of time and resources sort of reintroducing ourselves to the market with this new capacity. And I think you'll see that, over time, this really changes our deal flow dynamics and characteristics. We're seeing that, and we believe we're in a really good place now that we do have the ability to hold, on the platform, these $30 million to $60 million credits and not have to ask the borrower to take the risk of syndication with us when we had to bring in other partners to close those tight hold sizes. And we definitely don't want the BDC to get to a place where its hold sizes are out of line with its appetite. We do believe some of our hold sizes are a little larger than we wanted. And now that we can hold lower hold sizes that makes the BDC able to diversify on a lot of senior debt risks and loans.

Sure, yes. Makes a lot of sense. And then maybe, moving up the capital stack to senior secured investments, has your pursuit of maybe receiving equity as a co-investment with your borrowers changed?

We're being more selective on these equity co-investments, one because the BDC is working hard to reduce its portfolio from 25% to a much lower number; two, we do believe we're later in a credit cycle, and we're analyzing the equity opportunity on a sort of a separate investment analysis than the credit opportunity. So it may be a great credit, but if you're only going to invest 10% in equity, pick the ones where you think the equity upside is very achievable, not just in every transaction. We do have the ability in the new Specialty Lending Corp. to take double-digit equity, co-invest in that vehicle, which is very unique. Our strategy is always to take equity, let's be selective on the equity positions we take, let's have it 10% or less in the portfolio, and then you can have a nice portfolio of senior debt loans paying double digit on average yields with some equity upside. And that's really where we're focused and trying to move the BDC portfolio into that same structures or private vehicles.

Makes sense. And then you said equity is 25% on the portfolio, it's going to move to a much lower number. Maybe, what is that optimal equity number? Is that 10% or greater? Just trying to get a frame for that.

I think we spend a lot of time analyzing this. We think 10% on the cost basis is a good number. Just to reiterate, the 25% in the BDC, that's the fair value basis, the cost basis is...

12.

12%. So that's a nice 2x appreciation on average in those positions. And you'll see -- because we list those on the NDR. You'll see that a lot of those positions are -- some have depreciated, some have appreciated. So it's a nice diverse pool of equity securities. Most of the values, probably, in the top 6 names. And of those top 6 names, we expect a majority of those to normally materialize this year in 2018. We have no control of that, of course. But if that were to happen, we rotate into senior debt loans with that recycled equity rotation, then you start seeing a path of nice earnings growth. And we hope that happens, and we hope to eventually have upward pressure on the dividend.

Congrats on, of course, Specialty Lending.

Thank you, and I'm showing no further questions. So with that, I would like to turn the conference back over to Chairman and CEO, Joe Alala, for closing remarks.

Thank you, everybody, for participating. Thank you for your questions. We are around all day if you want to call and have any further discussions. Have a great day.

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