Logan Ridge Finance Corp (LRFC) 2018 Q2 法說會逐字稿

At this time, I would like to welcome everyone to Capitala Finance Corp. Conference Call for the quarter ended June 30, 2018. [Operating 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; and Chief Financial Officer, Steve Arnall.

Capitala Finance Corp issued a press release on August 6, 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.

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, further 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 that is subject to numerous uncertainties and risks, including those disclosed under the section entitled 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, and thank you for joining us today. As we discussed the results for the second quarter of 2018 announced yesterday, my comments will focus on progress made on our priorities outlined to you on previous calls and follow up on the second half of the year. And Steve will provide additional insight into our financial results.

A little over -- a little bit over 2 years ago, we changed our investment focus to senior secured structures moving away from second liens and subordinated debt. Since that time, we have invested approximately $207 million of debt investments, 86% which are senior secured structures bearing a weighted average interest rate of 11.5%. Investment activity during the second quarter of 2018 include 1-year investment and several add-on investments, all senior secured debt investments. More on investment activity in a moment.

We also have been reducing balances of nonaccrual investments that remains the focus of the management in our portfolio team. Total nonaccrual investment as a percentage of total investments on a cost basis decreased from the previous quarter. We also anticipate several significant equity exits during the normal course of business during the second half of the year and continue to evaluate other opportunities to reduce equity as a percentage of our investment portfolio. Along those lines, I am happy to discuss 2 such pending exits.

During July, the pending sale of Western Windows Systems to PGT innovations was publicly announced. Based on the sale price, we anticipate $23.3 million in proceeds, which includes full repayment of our debt at $10.5 million and $12.8 million for our equity, which had a cost basis of $3 million, producing over a 4x return on our equity investment.

Also during July, we were informed that US Well Services was entering into a business combination with Matlin & Partners, also public information. At that time -- at the time of the combination, most likely in October, our first lien debt will be repaid at $11.9 million and we'll receive equity in the newly formed public entity. The decrease in valuation from March relates to the enterprise value for the transaction being lower than anticipated.

Our shares of the publicly traded vehicle will be locked out -- 1/2 of the shares will be locked for 6 months. The other half of the shares will locked out for an additional 6 months. We do expect nice potential for equity appreciation post (inaudible). We will announce publicly additional equity and debt exits as they happened over the remainder of the year.

Liquidity for CPTA and for the firm overall will allow us to be active investors in the lower middle market. Our pipeline is as robust as it has ever been, thanks to the collective efforts of our business development staff, including our recently opened New York office. Our focus will continue to be on senior secured structures where we can invest between $25 million and $75 million across our platform, including the BDC. The BDC has begun co-investing with Capitala, especially in Lending Corp., having closed 3 deals already with several others pending. Our underwriting and portfolio processes, as previously announced, have been refined with the addition of Peter Sherman as our Chief Risk Officer.

At this point, I'd like to ask Steve to provide some color on our second quarter financial results.

Thanks, Joe. Good morning, and thanks for taking time to listen to our call today. Joe has provided you with a good summary of company priorities and our view on investing in platform matters. At this point, I want to take a moment to talk to you about second quarter financial performance, and then we'll be glad to answer any questions that you may have.

Net investment income was $0.26 per share, and it covered the distributions of $0.25 per share for the second quarter of 2018. We fully understand the importance of consistent distribution coverage. PIK income over the past few years as a percentage of total income has been elevated relative to our peers. That being said, PIK income to total income is at its lowest level in 8 reporting periods at 8.2% for the most recent quarter.

I would like to note that previously accrued PIK related to Vintage Stock, Inc. totaled $918,000 and was collected in full as a result of the repayment of the debt during the second quarter.

Total expenses for the second quarter 2018 were $4.0 million lower than the comparable period in 2017. During the second quarter of 2017, there were 2 items that were onetime in nature, but has a material impact on earnings. First, we recorded a $2.7 million loss on extinguishment of debt related to the early redemption of the 7.125% fixed rate notes. Also, interest and financing expenses during the second quarter of 2017 included approximately $0.6 million of interest on the redeemed notes during the notice period while both the 2022 notes were issued and outstanding.

Net realized losses for the second quarter of 2018 totaled $22.6 million, driven by the restructuring of our subordinated debt investment in Cedar Electronics. This realized loss did not have a negative impact on NAV per share as evidenced by previously recorded depreciation on this investment.

The net increase in net assets resulting from operations totaled $4.9 million or $0.31 per share for the second quarter of 2018 compared to a net decrease of $5.5 million for the comparable period last year. Net asset at June 30, 2018, totaled $219.3 million or $13.71 per share, an increase from $13.66 per share in March 31, 2018, and a slight decrease from $13.91 the prior year-end.

Stability and ultimately growth in net asset value per share remains one of our highest priorities. In order to achieve that goal, we need continued success on the points Joe made earlier, most notably making quality senior secured investments, reducing balances on nonaccrual status and reducing the mix of equity investments reinvesting proceeds from monetizations into senior secured investments.

At June 30, 2018, our investment portfolio includes 43 investments with a fair value of $483.3 million and a cost basis of $426.7 million. First lien debt investments on a fair value basis at June 30, 2018, comprised 50.9% of the portfolio while second lien represents 6.6%, subordinated debt represents 16.6% and equity warrant vestments represent 25.9%. On a cost basis, the equity investments comprised 13.5% of the portfolio.

And further into Joe's point about our strategy ship mid-2016 to senior secured structures, on a cost basis, senior secured loans comprised approximately 39% of our portfolio at June 30, 2016, compared to 60% at June 30, 2018.

At quarter end, we have 3 portfolio companies on nonaccrual status with a cost basis and fair value of $31.9 million and $25.8 million, respectively. On a cost basis, nonaccrual loans represent 7.5% of the portfolio at June 30 compared to 9.5% at March 31.

Again, as mentioned previously, reducing balances on nonaccrual status is an integral step in fulfillment of our performance goals.

At June 30, we have $40.8 million in cash and cash equivalents. There were no changes in the composition of our interest-bearing liabilities, including our fixed rate SBA debentures, our fixed rate notes, convertible notes and our senior secured revolving credit facility. At quarter end, we had $5 million drawn on our credit facility with $109.5 million available.

Regulatory leverage at June 30, 2018, was 0.6x compared to 0.61x at year-end. At this time, we have not asked our board or our shareholders for a reduction in our asset coverage ratio, but rather remain focused on improved financial performance. We will continue to discuss this topic with our board.

And lastly, 2 items that we included in our press release subsequent to June 30. On July 31, we sold our investment in Kelle's Transport System at our June 30 valuation of $13.3 million. The reinvestment of these proceeds should be highly accretive from this recently restructured investment. And lastly, on August 2, we invested $13 million in the first lien debt of Sunset Digital Holding, yielding 1-month LIBOR plus 7.25%.

At this point, we'd like to open up the line for questions.

[Operating Instructions) Our first question comes from Kyle Joseph of Jefferies.

I just wanted to get a sense for your thoughts on portfolio yields going forward, given where you guys are in the portfolio rotation and kind of the new strategy moving up to capital spectrum in your outlook on yields for the portfolio.

Yes, Kyle, this Joe. That's a great question. We did shift the strategy a couple of years plus ago, and at that time, we realized that going higher in the balance sheet yield would compress. We still target double-digit yields in our unit tranche structures. Primarily we get those at our first out, first lien structure, and sometimes we do a last out, first lien structure, but we want to average a double-digit yield. What has helped us is the rising interest rate environment. And I think you'll see that our yields have continued to be double digit, but we're in a much more secure position on the balance sheet. We can control the balance sheet, if we need to. But we will do double-digit yields, and we will still continue to seek selective equity participations no more than 10% on a cost basis. We are focused obviously on reducing equity in the BDC portfolio from 26% where it is now, but the strategy seems to be working. And we can get double-digit yields and get some equity participation and hopefully get mid-teen total returns on these investments over time.

That's helpful. And then last one for me, it sounded bullish on the pipeline. And I know you mentioned that these were primarily senior secured investments. But can you give us a little more color in terms of which industries you're seeing the best investment opportunities in?

Yes, we have a very robust pipeline, I think the marketing campaign around our new liquidity has made a substantial difference to the pipeline. We're able to go to the market and hold $25 million to $75 million unitranche positions. The BDC through its SEC co-investment process takes its allocation of those or at least has the right to take its allocation of those. That has opened up a lot of opportunities for us. The pipeline is very diverse coming in from all 6 offices. We are typically focused on sort of $30 million to $60 million unitranche deals in the current pipeline, and we just announced we closed Sunset Digital, which is a telecom deal that ended up being a $45 million total unitranche deal with the BDC holding $13 million of that. We have some health care deals in the pipeline. The deal we closed at the end of Q2 with the logistics deal that was a $37 million to $40 million unitranche deal, where the BDC participated, I believe, $7 million of that. So the ability to go into these lower middle market companies, both sponsor and nonsponsor and say we can hold and/or lead up to $75 million of the cash flow unitranche needs has been very effective. And also the addition of another full service office in New York has really helped, and our pipeline now is as large as it's been in many, many years, and it's primarily all first lien structured pipeline.

That makes sense, and that's helpful. Last one for me, just trying to get a sense for the health at your underlying portfolio companies. If you could talk about trends and revenue growth, EBITDA and as well as leverage.

This is Steve. I'm filling in for Jack, who's not here this week. I think our portfolio group is actively engaged and meets periodically to discuss all portfolio matters, including earnings and leverage and those types of things. I would -- from my perspective, it feels like there's some optimism. We understand that we've had some to prove to the market that we've stabilized the credit situation and stabilized NAV accordingly. It feels like how we're getting there. We've got 3 investments on nonaccrual right now. We're closely monitoring those. We hope we'll have some resolution to those soon. If you go below that, again, I think that the trends seem to be good, generally speaking. When you're in the lower middle market, you've got some volatility and earnings every 90 days when you look at those. But I would just say in general, it feels like the overall supported earnings is improving.

Yes, this is Joe. The only thing I would add to that is typically in your portfolio, you know when things are about to monetize because you'd see bankers being hired or registration statements being filed. We do see a lot more activity in the portfolio. We do expect we'll have continued monetizations of our equity positions between now and the end of the year. Now we just announced 2 of them, which is -- they're both public, Western Windows and US Wells. We will expect to announce several more of those between now and the end of the year. And I think that's really -- you're seeing these portfolios really -- and the kind of returns in these equity positions, Western Windows 4x. US Wells was once restructured energy along the ring and ultimately going to make significant return on. And then one time, it was impaired. And we have many more in the portfolio that are in those processes of hiring or have hired investment banks or filing registration statements that will monetize. And we will announce those as soon as we can, but I think that's the health of these underlying lower middle market companies where we have a significantly appreciated equity position. And the good news is these marks that we have on our portfolio, we're obtaining these marks on these exits. And I think that's very important because our cost basis and this equity position is about 13%, the fair value is about 26%. If we can continue doing that in our strategy attaching those kind of equity returns to the first lien structures, it works, and that's what we've been focused on the past couple plus years and we continue to focus on that as far as our investment strategy.

Our next question come from Christopher Nolan of Ladenburg Thalmann.

The yield on new investments was 9% versus 10.8% last quarter. I know it's only one investment, but are you -- to attract quality deals, you have to sort of give up on price?

Well, no, I think -- Chris, we're not giving up on pricing. These are, sort of -- these are market rates. A lot of these, we get better pricing on some of our directly originated non-sponsor activity, which you will get a little bit premium and price in there and better structures, lower leverage out of gate. The equity sponsor part of our business is still -- is very competitive even with the ability to hold up $60 million unitranche, it's very competitive. What we will pursue as most of these first out structured right now are first out, first lien. That means you owned the balance sheet, there's no one else in the deal with you. What can be achieved is to go and create a first out security, put that with another co-party to the unitranche and blend up a last out yield. We will have -- we do have the ability to do that, and we've been selective on how we do that. We hope to, in the future, do more of a reasonable first out bifurcated unitranche where we can blend up our last out yield and increase our basis points. And we will, hopefully, have that fully in effect by the end of the year. And that way, we can be doing the same deals, have a little bit of financial engineering on the top stack of the unitranche and blend up your yield safely into the double digits with current interest rates, and that's our goal here. But all the last loans we've been looking at, we've held the whole loan first out, first lien, which is really top of the stack lending.

And Joe as a follow-up, what percentage of your deals now have equity sponsors?

If you look back over the past deals closed, I think it's about 60% sponsor, 40% nonsponsor. Sponsor activity is very competitive. You're seeing very low interest rates and very aggressive structures, but we are doing some sponsor activity. We've been very selective. We also have the ability, which we think is something unique to our platform is do nonsponsor deals. A lot of groups do very little nonsponsor activity. We like nonsponsor activity. You get better structures. Typically, you get better pricing, and it really blends well with our sort of other control type investment strategies on the platform. We don't -- we're not afraid of getting active in these portfolio companies if we need to. But I guess about 60% or 40% right now.

Got you. And then this is the second quarter in the last 3 where you exited a nonaccrual investment at a loss and then you immediately replaced it with a new nonaccrual. Does this reflect a tightening up of the credit quality of the group, you're just trying to weed out the portfolio? Or is this your basic calling nonaccrual as they arrive? I'm trying to get an understanding as to why we're starting to see, over the last few quarters, a large exit of the nonaccrual only to be immediately replaced with the new nonaccrual?

Chris, this Steve. Yes, good question. First, as it relates to the Cedar, I mean we -- on April 1, we had announced that as a subsequent event for Q1. We restructured that investment into equity, and that transaction happened. And we reported that, and that was that. As it relates to new the new addition this quarter, we put American Clinical Solutions on nonaccrual. But if you go back to March, we already have that asset valued at about 74% of the cost basis. So it was having some liquidity-related matters and earnings-related matters previously, and we got to June 30. There's not uncertainty about the future collectibility of all the principal and interest that we felt that was the right thing to do to turn on nonaccrual. I don't think there's any correlation or any conclusion you can make that one went off and one came on and that we're tightening things. I think we address these on a monthly basis with the entire management of the company and look at asset quality and all the related risk rates and make this determinations prior to each quarter end. And so it's just kind of the way things fell out.

Our next question comes from Chris Kotowski of Oppenheimer & Co.

I'd like to kind of get a sense for the speed at which you can redeploy some of these equity proceeds into debt investments, and I just wanted to make sure I heard it everything. So Western Windows Systems, there, you're going to, in the third quarter, just get the $12.8 million and that will then be immediately available? Is that right? Is that what you said?

Right. Yes.

Okay. And the other one, US Well Services, they are merging into another company and is it already a publicly traded security that they're merging into?

Or are they doing an IPO?

I think that's correct, yes.

So it is already a publicly traded company...

No, I think it's formation of a new company and the shares that we will whole owned will be in the new entity. It's a very complicated transaction, but I don't think it's public right now.

Okay. So -- but the basic answer is we shouldn't expect that to be redeployable for another year or so?

Well, the debt will get back in October. The equity -- we will receive the equity in October, but half those shares -- all of the shares are locked out for 6 months, half are locked out for a year. And so that will be a 2019 event at the earliest, depending on how well the company performs and how -- where the shares trade.

Okay. And on some of the other ones, I know you can't talk about the specifics, but I'm curious is it in general again the same kind of structured exits that we have with these 2 cases, meaning...

I think they're more -- going to be structured more like a Western Windows where you get all your debt obviously and you get all your equity out at closing versus the US Well structure that -- it is much more, you get your debt and then you've got publicly traded stock. It's restricted for 6 to 12 months, as Steve mentioned. Most of these will be much more like, you get all your money out between your equity payments or the majority of your equity valuations at closing, and then we'd look to redeploy both the debt yields from that and the equity yields from those monetizations into first lien securities.

Okay. And just on American Clinical Solutions, I mean that -- it doesn't sound like the kind of industry that is normally economically sensitive. So is that -- that's not an economy sensitive issue ongoing into nonaccrual?

There's a lot of regulatory dynamics in that segment of the health care testing industry. But no, it's not -- it's typically not economic correlated to economy, but we will work through that one as we work through KTS. I think KTS has been on nonaccrual for a year. We worked hard there doing restructuring, got to top of the stack and we just exited, and that's a big win. We exited at our mark. We spent a year-plus working with that company we got out. Now we can take that money, put it into a 10% yield, really grow earnings. We would expect and try to do the same thing with an ACS to somehow continue working on top of the stack there, work with our other partners in the deal and create a solution where we either can get out close to our mark or put in the right capital structure, fix the underlying operational issues and start growing earnings again.

[Operating Instructions) Our next question comes from Ryan Lynch of KBW.

First question relates to just the allocation process for investments across your guy's platform. Obviously, with closing the $1 billion Capitala Specialty when the court that gives you a lot more dry powder across the platform to commit to larger hold sizes and become more relevant to borrowers. But with that large other fund versus the amount of capital you guys have in CPTA, I was just wondering how's that allocation process work when you guys look to commit to a new deal? Does the -- is it based on available capital because I -- it seems like that will leave CPTA with a fairly small allocation?

Yes. No, that's a -- Ryan, that's a great question. We do have the SEC exempt of relief. And these other pools of capital, we all set sort of portfolio constructions limit in there. And you base that really on your ultimate portfolio construction, expectations and your available capital. So if you're looking at the current deals on the BDC, I mean we want to hold our current availability $8 million to $15 million per deal, and that's really what it's obtaining the larger actually allocations right now in these deals. And what would happen over time is if your availability in the BDC were to contract and you redeployed all your liquidity and your recycle. Your hold sizes would go down, but that's because you're getting to really fully funded and sort of max leverage capacity. But all these different vehicles, and we've got more than one that we're co-investing on the lower middle market platform. We do have the large vehicle, but we also, in that vehicle, as I said, hold limits because you want to build out a very diversified 60- to 70-name portfolio. So even though the vehicle is rather large, it is a permanent capital structured vehicle. So that has no intention of being deployed in 1 year, 2 years or 3 years. It's a multiyear vehicle where you set allocation limit sort of annually, and it's really -- it's working out very well with the BDC and our other commingled funds in the lower middle market strategy where everyone's getting there sort of desired allocations. And if anything, we can hold more in a deal with some other funds participating in our lower middle market strategy because we're keeping our hold sizes very low, and I think that's a really good trend that we keep reiterating in the BDC is for a while the hold sizes, we're getting close to 20. We had several over 20 in hold size. And from that size of that portfolio, that's just too large. So we basically almost cut those in half. At the end of the day when we redeploy the current liquidity and recycle the deals that are coming in, you'll have a much more diversified portfolio on the BDC with a lot more names in it, which just makes it better portfolio. So that's how we do it. We set hold limits in each vehicle given the range, and then you allocate it per deal. The BDC has the right not to obligation to co-invest in every deal, and then you take it to your board. And it's just standard sort of SEC-exempted relief process. And to date, now we're on 3 deals. We got a lot more coming. It's worked very well.

Okay, that's very helpful commentary on that process. Touching on your kind of bullishness on the ability to monetize equity investments maybe in the back half of the year. It sounds like you've already done some in the third quarter. Can you just talk about -- and I think you said several of the portfolio companies, you have equity investments have hired investment banks are in the process of hiring bankers. I would assume that, that's why you're more bullish on monetizing those equity investments. But my question would be, why do -- I guess, why do you believe that those companies are now in the process of starting to maybe look for a transaction during the back half of the year? Is it just higher equity valuations? Or what has kind of change there? And do you have -- I would assume, you don't have any kind of minor or majority interest in any of these equities. So I would assume that you probably don't have much control over these exited processes. Is that correct?

Yes, they are -- you're correct about that. In fact, that we are minority positions in equity securities. I think if you look at our, say, or top 5 or 6 holdings, you really look how long they've been in the portfolio. And these are sort of natural, whether it's sponsor or nonsponsor, and if you -- and we put this on in the NDR, so you can see our cost basis. And if you're looking at 3x to 8x multiple return on your committed equity capital and you're sponsor and/or nonsponsor, now is a very good time to monetize these investments. You got very healthy credit markets. You got very nice multiple expansion that's happened over the years, and we're just seeing a lot of these groups go to monetize. They're going to make great returns. I mean, Western Windows is a great example. You're making over 4x return on your equity, and I think it's a 2.5-, 3-year hold. So we see other groups, and this is diversified across our portfolio. They want to go monetize that equity appreciation, and so they're hiring bankers. It's a very active M&A market. The credit markets are very liquid. So we do expect to announce several more of these exists between now and the end of the year, and that's the key to us, just taking those nice appreciate equity assets, looking at very nice realized return and redeploying that in the first lien securities, hopefully, yielding double digits. And then you see a nice path to NII growth.

That's helpful. And then just one more, you might have mentioned this, I dialed a couple of minutes. But could you just provide a little background on what drove you opening the New York office and hiring Kelle and what that really brings to the Capitala strategy?

Yes. No, I think we've always had this direct origination program of opening offices in different cities where all the underwriting and portfolio management takes place in Charlotte. Once we did secure this big alley new fund at Capitala Speciality Lending Corp., we realized that in order to do that we need to return to deploying $100 million to $150 million every quarter. And we thought opening an office in New York would really contribute to those directly originated deals and getting back to $100 million, $150 million quarterly deployments. We will also look to opening full service offices in other cities. We've been in Dallas before, that was a great office historically for us. Chicago is a great market. We don't spend enough time there. So we will open more offices as we continue raising capital and continue wanting to hit our deployment numbers of $100 million to $150 million a quarter. And it's been -- it's a -- he is been in the industry a long time, he has both the credit and origination background, and we think that will be great office for us.

We do have a follow-up question from Christopher Nolan of Ladenburg Thalmann.

Joe, should we expect incentive fee accruals to start to grow in the second half of the year? And any guidance on operating expenses in the second half of the year?

Chris, this is Steve. I can't provide you guidance on that. It's our -- I certainly hope that, that would be the case, but I can't give you any guidance on that. Operating expense wise, I think if you look at our expense history, it's pretty fixed. So I don't foresee any material changes in the expense right there at all. So you could probably use past history as a good guide there.

And ladies and gentlemen, this does conclude our question-and-answer session. I would now like to turn the call back over to Joe Alala for any further remarks.

Thank you, everybody, appreciate your time. We will continue to announce deals as they close and then deals when we can upon any exit or announced public exit. And I think you'll see that we're continuing to work hard and seeing that we're focused on 3 things, we're achieving them. And we think the second half of the year will be a very active year for us as far as deployments and realizations. Thank you for your time today. We're around all day if you want to give us the call.

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