Oaktree Specialty Lending Corp (OCSL) 2011 Q1 法說會逐字稿

Good day, everyone, and welcome to the Fifth Street Finance Corp. first-quarter 2011 earnings conference call. Today's conference is being recorded.

At this time I would now like to turn the conference over to Ms. Stacey Thorne. Please go ahead, ma'am.

Good morning and welcome, everyone. My name is Stacey Thorne and I am the head of Investor Relations for Fifth Street Finance Corp. This call is to discuss Fifth Street Finance Corp.'s first fiscal quarter 2011 ending December 31, 2010.

I have with me this morning Leonard Tannenbaum, CEO; Bernard Berman, President; and William Craig, Chief Financial Officer.

Before I begin, I would like to point out that this call is being recorded. Replay information is included in our February 2, 2011, press release and is posted on our website, www.FifthStreetFinance.com.

Please note that this call is the property of Fifth Street Finance Corp. Any unauthorized rebroadcast of this call of any form is strictly prohibited.

Before we go into our call portion -- before we go into our earnings portion of the call, I would like to call your attention to the customary Safe Harbor disclosure in our February 2, 2011, press release regarding forward-looking information. Today's conference call includes forward-looking statements and projections and we ask that you refer to our most recent filings with the SEC for important factors that could cause actual results to differ materially from these forward-looking statements and projections.

We do not undertake to update our forward-looking statements unless required by law. To obtain copies of our latest SEC filings please visit our website or call Investor Relations at 914-286-6811.

The format for today's call is as follows. Len will provide an overview, Bernie will provide an update of each of our lending facilities, Bill will summarize the financials and then we will open the line for Q&A. I will now turn the call over to our CEO, Len Tannenbaum.

Thank you, Stacey. I appreciate all of your patience regarding this call which was somewhat delayed due to our very successful and oversubscribed equity offering.

From an economic standpoint, we are witnessing a recovery although we have noticed that it is not robust or rapid. The growth in earnings is due to both margin expansion and revenue growth. In addition, since September 30, 2010, we have additional refinancings totaling approximately $54 million. The refinancing of our second lien position in Boot Barn, a Western apparel retailer, was with prepayment penalties in our first collection of [an ICC]. The transaction was executed at par.

We also have continued to aggressively pursue remedies for our portfolio problem companies, those rated 3, 4, and 5. Turnover of investments is also an important component of earnings for BDCs as refinancings typically raise short-term earnings for those companies like ours who amortize the origination points over the life of the loan as we do.

We expect this quarter to be another very strong quarter for originations. Quarter to date, we have originated $123 million and expect more deals to close in the near future.

I believe we are seeing high growth in deal volume for several reasons. Private equity sponsors view us as a top provider of one-stop middle-market solutions and we have gained significant momentum from our $273 million of investments during the first fiscal quarter of 2011. Our new Chicago office is starting to generate very positive results, and our relationships are spanning the country.

In addition, the ability to commit to an entire transaction and syndicate it down later provides us with some additional pricing power in this market. We believe it is still the preference for private equity sponsors to partner with a trusted lender rather than rely on a syndicate group to complete transactions.

I believe we have seen the turn in credit quality as many of our problem assets have been restructured or sold. Category 3, 4, and 5 securities now account for approximately 5% of the portfolio at fair value as of December 31, 2010. And with our proactive approach -- proactive portfolio management approach, we expect that percentage to continue to decline over the next year.

The investing environment is changing as highlighted in our recent newsletters. While our rates continue to get -- while rates continue to get compressed, with a $20 plus million EBITDA sponsored buyouts, premiums are still being paid for the one-stop approach and for our relationships.

In addition, we primarily are still in the $10 million to $20 million EBITDA market with an average deal size closer to the $10 million EBITDA number, allowing us premium in the lower -- in the mid- to lower middle-market versus the upper market. We were fortunate that the vast majority of our portfolio took advantage of the high return environment and we were one of the few BDCs that had ample capital to invest during the credit dislocation.

We expect that our vintage 2008 and beyond credit portfolio will generate strong returns as the economy continues to recover even though we recognize ultimately that many of these investments which were generated at high premiums, relative to today's market, may get refinanced over the coming years, which will generate an income boost when that happens.

As you have heard from me on previous calls, we remain focused on a potential for inflation to increase given the continued pro-liquidity stance of the Federal Reserve. Our continued increase in the percentage of floating rate loans should enhance our NII as interest rates increase over the coming years.

The current percentage of our debt portfolio with floating rates is over 50% and approaching 60% with the vast majority of our pipeline consisting of first lien floating rate securities. We expect that number to increase over 70% in the next 12 months positioning us to take advantage of an eventual increase in interest rates.

Some of the more recent loans have either low or no LIBOR floors as we seek to maintain our spread while capturing additional economics when interest rates rise. Our SBA leverage will also serve as a hedge against rising interest rates as the interest rate on that piece of debt is fixed for 10 years. We plan on locking an additional SBA allocation of $65 million later this month at an attractive rate.

We believe that our strong brand and relationships allow us to capture premium pricing over the market. Our reputation in the middle market as a leader, as well as our market -- our continued increasing market share should grow as we add to our platform and provide a high level of service to our private equity sponsors.

We believe the opportunities in the middle-market are large and growing as M&A continues to increase even as lenders continue to return to the market.

We plan to take advantage of the current economic climate to gain market share with these top quartile private equity sponsors, as well as to capture strong risk-adjusted returns. First lien loans currently stand at an all-time high and represent over 85% of our portfolio at fair value. Over 90% of the pipeline contains first lien one stop opportunities so we should maintain a vast majority of first lien deals.

Our overall target of first lien deals versus second lien deals is 75% first lien, 25% second lien and we recognize that we overshot the target in our quest for first lien paper. We do seek to balance that out over time. We believe this gives us one of the most secure portfolios, however, of any BDC. With our strong first lien position and further diversification and expansion of assets will position Fifth Street favorably to reduce its cost of capital over time.

I will now hand the call over to our President, Bernie Berman.

Thanks, Len. Last week, we amended both our ING led credit facility and our Wells Fargo credit facility. The size of our ING led facility was increased from $90 million to $215 million with an accordion feature which would allow for potential future expansion up to a total of $300 million.

We were pleased that Deutsche Bank, Key Equipment Finance and Patriot National Bank joined the facility and that all of the existing lenders increased their commitments as part of the expansion. The maturity date of the facility was also extended to February 2014. And if we receive a credit rating of BBB, the interest rate on the facility will automatically drop to LIBOR plus 3% with no LIBOR floor.

In addition, we also amended our $100 million Wells Fargo facility by lowering the interest rate to LIBOR plus 3% with no LIBOR floor and extending the maturity date of the facility to February 2014. We also continue to utilize SBA leverage. In addition to the $73 million of debentures which we locked in September at an interest-rate of 3.215%, an all-time low for the program, we have drawn an additional $65.3 million in SBA leverage, the pricing of which should fix in the next couple of weeks.

While the 10-year treasury rate is a little higher than it was in September, we still expect the $65.3 million to fix at a very attractive rate for the next 10 years. When it does, we will have fixed $138.3 million of the maximum $150 million in debentures available under our license.

We are commencing the process of applying for a second SBIC license, which we would hope to receive some time this year. A second license, if granted, would allow us to access up to an additional $75 million in debentures.

Finally, we are contemplating forming an asset manager in order to increase the menu of products available to our clients and to take advantage of deal flow which is already in our pipeline. In this regard, we recently hired John Trentos as our head of Capital Markets.

John has more than 20 years of syndicated loan capital markets and portfolio management experience including as a managing director at Centerline Capital Group and at Sandelman Partners LP, where he cofounded and led asset management platforms. John also worked at GE Capital where he structured, originated, and placed middle market senior secured loans.

We have already begun identifying investments which will go into the asset manager and we plan to obtain a new nonrecourse credit facility under the asset manager. We will have more to say about the asset manager in the coming months as we source more investments for this product and formally establish its legal and capital structure.

I am now going to turn it over to our CFO, Bill Craig.

Thanks, Bernie. With respect to our balance sheet as of December 31, 2010, total assets were $798.8 million, which included total investments of $742.4 million at fair value, and cash and cash equivalents of $43 million.

Liabilities were $223.9 million, which included $123.3 million of SBA debentures payable and $89 million of borrowings outstanding under our credit facilities. At December 31, 2010, net assets were $574.9 million and our net asset value per share was $10.44.

With respect to our operations, total investment income for the three months ended December 31, 2010, was $25.3 million. This was comprised of $20.8 million of interest income including $3.1 million of PIK interest and $4.5 million of fee income. We ended with net investment income per common share of $0.26 and earnings per common share of $0.32.

For the three months ended December 31, 2010, we recorded net unrealized appreciation of $16.8 million. This consisted of $10.3 million of reclassifications to realized losses, $5.5 million of net unrealized appreciation on debt investments, $0.3 million of net unrealized appreciation on equity investments and $0.7 million of net unrealized appreciation on our interest rate swap.

Our weighted average yield on debt investments at December 31, 2010, was 13.2%, which included a cash component of 11.4%. Our average portfolio company investment was $19.5 million. This compares to the previous quarter with a weighted average yield on debt investments at September 30, 2010, of 14%, which included a cash component of 11.8% and our average portfolio company investment of $16.6 million.

With respect to the portfolio, during the quarter ended December 31, 2010, we invested $238.6 million across six new and seven existing portfolio companies. At December 31, 2010, our portfolio consisted of investments in 45 companies. At fair value, 98.6% of our portfolio consisted of debt investments and 86.5% on the portfolio were first lien loans. As of December 31, 2010, we had stopped accruing cash interest, PIK interest and OID on three investments which had not paid all their scheduled monthly cash interest payments.

At December 31, 2010, approximately 50% of our debt investment portfolio at fair value bore interest at floating rates. With respect to our ratings at December 31, 2010, the distribution of our debt investments on the 1 to 5 rating scale at fair value was as follows. The percentage of 1 and 2 rated securities was 94.5% in comparison to 91.1% as of September 30, 2010.

We are closely monitoring all of our investments and continue to provide proactive managerial assistance. Fifth Street continues to pay a monthly dividend. In that regard our Board of Directors declared the following monthly dividends for our third fiscal quarter of 2011.

$10 -- I'm sorry, $0.1066 per share payable on April 29, 2011, to stockholders of record on April 1, 2011; $0.1066 per share payable on May 31, 2011, to stockholders of record on May 2, 2011; and $0.1066 per share payable on June 30, 2011, to stockholders of record on June 1, 2011.

Now I will turn it back to Stacey.

Thank you, Bill. As a reminder, for the months that Fifth Street does not report quarterly earnings, we generally release a newsletter. If you want to be added to our mailing list and receive these communications directly, you can either call me directly at 914-286-6811 or send a request e-mail to IR at FifthStreetFinance.com. Alternatively, e-mail alerts can be set up through the shareholder tool link under the Investor Relations tab on our website, www.FifthStreetFinance.com.

Thank you for participating on the call. I will now turn it back over to Cynthia to open the lines for questions.

(Operator Instructions). Casey Alexander with Gilford Securities.

Good morning. Just trying to read the future here a little bit with the tremendous expansion of the floaters in the portfolio. If interest rates do start going up, obviously, that is going to provide a positive effect to your income stream. But for the purposes of kind of benchmarking your portfolio to your buckets, wouldn't that cause a downward migration of your EBITDA coverage ratios at the same time and therefore affect the way your investments fall in their buckets? All things being equal.

First of all, you know that EBITDA is before interest, taxes, depreciation and amortization. So EBITDA does not change when interest expense rises. And if you mean net -- with the cash flow of the Company's, the net free cash flow of the Company's, we are only a part of the structure and we feel like we are very covered by the cash flow of our underlying portfolio. But debt to EBITDA is a measure and would not change.

No. You're right. You're right. Okay, thanks.

Dean Choksi with UBS.

Morning. Len, you mentioned that one of the drivers of the increased deal flow or pipeline was the ability to commit and syndicate deals later on down the line. Can you just expand a little bit further where you are in building out that syndication effort and number of relationships? How much yield volume you are doing that -- through that? And how that changes the types of loans that you are originating?

That's a very good question and we are excited to start capturing an additional fee stream to the BDC which is, of course, syndication fees. It's a fee stream that is captured by the two industry leaders, Ares and Apollo, and we contemplated doing it. We needed first the balance sheet to be able to take the larger deal sizes and commit to them. And then syndicate them down and we now are in the position given our market cap, given our balance sheet, given our multiple credit lines to be able to do that. And so in hiring a head of syndication, actually this quarter we are going to have our first syndication where we will syndicate a small piece, a small $20 million piece, and we will skim some of it and we will earn some income -- additional income because of it.

In fact, one of the better players in this space that does a great job of that is Goldman Sachs Specialty Lending even though they are not a BDC. They bill quite a bit in syndication fees.

So we know how to do that model. We are very pleased to be of the size because we believe only the larger players can really do that. And the reputation that we are being chosen to agent deals and we are talking about maybe a $70 million deal selling down 30; it could be $100 million deal selling down 50.

And we are definitely in the position to be able to do that.

Great. Thank you. Good to hear.

Ram Shankar with FBR.

Good morning. One of your peers, Ares, yesterday talked fairly cautiously about the environment and mostly on the broader syndicated market, but to some extent on the middle market segment as well. I mean, are you seeing any similar impacts, anything from the new capital in terms of pricing in your sweet spot?

That's a great question and one I am definitely going to address later on today, but the place that we are in the market and as we follow the Ares model and we believe companies like Solar, which are a similar size follow the Apollo model and there is nothing wrong with either model. They are both good models, they're just different.

Ares is up now in the broad -- towards the broadly syndicated market. It is on fire. I mean, the spreads there have compressed and I think Mike is making a very smart move in being very cautious to originate into that market and continuing to maintain the risk-adjusted returns that Ares always does. As Ares' partner in a deal with JTC Education and as we look at deals together, we are relatively similar, I believe, in our underwriting philosophy in terms of having to capture risk-adjusted returns.

In the middle market or lower middle market, both of which we play, we are not seeing the yield compression. We are seeing yield compression; we are not seeing the yield compression that the broadly syndicated have seen for two reasons.

One, CLOs for middle market companies are still not available, while CLOs for broadly syndicated, now are done at four and five times. So we are not feeling any pressure from a CLO as a competitor. In fact, we're feeling less pressure than the past when Churchill and others had CLOs to be filled up. There are no CLOs currently filling in the middle market that I am aware of or that we feel pressure from.

Number two is banks -- and we had a couple of banks through the office today and -- which confirm this view. Large banks are going to use BDCs as sort of a middleman to access the lower and middle market in terms of equity sponsors. They would rather lend to us as a -- towards investment-grade, investment grade credit. We believe we are investment grade credit. And then we lend to the non-investment-grade credits in aggregate and manage through that portfolio.

So I think for the last four weeks have seen the banks be more aggressive, but they are more aggressive to the bigger credits. They are not aggressive to the smaller ones.

And we do not believe given Basel III, and given what all the banks have told us, that they will enter that market again aggressively.

Okay. Thanks for the color. One other question if I may. And congratulations on the extensions of your credit facilities. But from a modeling perspective, are there any ramifications for the March quarter? I mean are there any upfront fees that we need to consider? And is the structure for the non-usage fee similar to how it was structured previously?

So, as you saw in the last two announcements with ING and Wells, we are continuing to push down our cost of capital because the idea is to be a cost of capital leader, which allows us to maintain spreads even as our spreads may decrease a little bit. I think we are very confident that we are going to maintain spreads through this environment, which is great.

Yes, there were some things not in the headlines that the unused fees came down a little bit and were more flexible. And that was one of the things, of course, that we are focused on as we continue to grow the Company and continue to look at different capital solutions and use our credit lines and draw them and pay them back to an extent.

So it did get a little bit better from a modeling purpose, but I don't know that it would be -- it's not an enormous move.

Robert Dodd with Morgan Keegan.

This is Bo for Robert. Two questions. Talking about the increase in floating-rate investments, how much would interest rates need to rise to be able to see a material benefit, given floors and such?

You know it's funny, I ran that analysis -- Bill is laughing because I asked for that analysis last week, and interest rates -- as soon as they start rising for the first-quarter point has some impact. The material -- the really big impact for us is going to be between LIBOR 1 and LIBOR 2 and obviously LIBOR 2 higher has a very large impact on the income.

But we will start seeing some impact from earnings even as LIBOR goes from 0.3 or 0.25 or wherever it is today, up a quarter. So you'll start seeing our earnings growth right away. And we position -- look, we position the firm in the downturn as a 96% fixed and when interest rates were declining. And my goal in the upturn is to be at least 75% floating.

But even beyond that, I just want everybody to pay attention, our borrowings of the SBA which will be fixed for 10 years are fixed, so if we get a fixed borrowing, and we want to expand our fixed borrowing of course but if we have fixed borrowing and lend floating, you make a lot of money as interest rates increase.

Got you. Thank you. One more. Looking at the yields from last quarter they looked a little bit lower than the overall companies in general. Is that simply floating rate or is that something we can look to continue in the future? Can you give us any color on that?

I think weighted average yield was 13.2% in our last reported period and we are going to continue to see that to decrease to approximately 12% is my guess over the next -- I don't know what period -- 12 to 18 months. I think that's would be -- that's if interest rates do not increase. If interest rates increase, I think you are going to see a nice offset to that.

So, who knows whether interest rates are going to increase or not? If I took the floating curve and I reverse swapped it for the three-year note, we could add quite a bit of income to our balance sheet today. We just don't do things like that.

Thanks, guys.

And there are no further questions at this time. On behalf of Fifth Street Finance Corp., we would like to thank you for your participation in our conference call today.

Thanks, everyone.