Oaktree Specialty Lending Corp (OCSL) 2011 Q3 法說會逐字稿

Good day, ladies and gentlemen, and welcome to the Fiscal Third Quarter 2011 Fifth Street Finance Earnings Conference Call. My name is Keith and I will be your operator for today.

At this time, all participants are in a listen-only mode. Later on, we will conduct a question and answer session.

(Operator Instructions)

And I would now like to turn the conference over to your host for today, Ms. Stacey Thorne, Executive Director of Investor Relations. Please proceed, ma'am.

Thank you, Keith. Good afternoon and welcome, everyone. My name is Stacey Thorne and I'm the head of Investor Relations for Fifth Street Finance Corp. This conference call is to discuss Fifth Street Finance Corp's third fiscal quarter ending June 30, 2011.

I have with me this morning Leonard Tannenbaum, CEO, Bernie 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 July 12, 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 earnings portion of the call, I'd like to call your attention to the customary Safe Harbor disclosure in our July 12, 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 or 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 on our capital structure, and 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. This has been a year of changing debt markets. Pricing has fluctuated quickly from frothy to normal and back again during the entire first half of the year. So far, we have been premature on our view of interest rates, as the Federal Reserve seems determined to keep interest rates near zero. However, we are well positioned to realize an immediate earnings benefit when interest rates eventually begin to rise.

Our investment-grade rating and expanded lending capacity are beginning to pay dividends, both in terms of our relationships with lenders, as well as the private-equity community. Our newly earned rating enables us to lower our cost of capital still further and ladder out our liability structure. The increased size and flexibility in our financing vehicles also enables us to offer more complete solutions for our clients in senior-only, one-stop, second-lien, mezzanine, and equity co-investments.

As we alluded to in the past two monthly newsletters, we are also continuing to work on an enhanced solution to the senior-only product, with a low cost of capital from an overseas deep-pocketed lending partner. We continue to make significant progress, but have nothing final to announce as of yet.

Our earnings were in the middle range of previously issued guidance. While I am personally disappointed that we are still shy of the $0.32 dividend for the quarter, I am hopeful that we'll be able to close the gap substantially in the second half of the calendar year. We anticipate that part of the additional earnings will come from better matching our targeted leverage of 0.6 times debt to equity. Part will come from better utilization of our credit lines and part will come from more closely matching our 75% first-lien and 25% second-lien targets.

We continue to move into larger securities, which we believe are inherently safer, with a typical deal having EBITDA of $10 million to $30 million. We believe that our high first-lien exposure coupled with investing in larger and more stable portfolio companies, and our robust diligence and portfolio-management process, will result in lower losses should the economy pull back again.

While we have added substantially to our team this year, we recently lost our co-CIO Chad Blakeman. I would like to thank Chad for helping to lead several institutional initiatives at Fifth Street, and wish him continued success.

I also want to congratulate Ivelin on his appointment of Chief Investment Officer. Ivelin has been with Fifth Street since 2005. He is one of the three partners of the investment adviser. Ivelin truly represents the discipline, work ethic and passion that drives us to succeed on behalf of our shareholders.

Our expectation is to continue to add many strong, experienced institutional-credit and operating members through the balance of the year. And I am so far pleased with the response and caliber of the individuals attracted to our organization. To service our clients, we continue to build a broad institutional platform both in terms of technology and team members.

The quarter, which ends September 30, 2011, is off to a good start with $77.6 million of originations through yesterday; $71.7 million, which were funded at close. This quarter is going to be especially difficult to predict as our robust pipeline contains many deals, which are still in the auction stage.

Fortunately, the market dislocation, which continues today, is allowing rates to improve, and our win rate should be strong. The capital markets are adding a further tailwind by preventing much of our competition from raising capital.

Our last capital raise, which was done in a very advantageous spread, should fully fund our business plan for the balance of the year should our stock fail to rise to an appropriate level, with ample capacity on our multiple credit lines and a potential second SBA line of $75 million. We are one of the few BDCs that did not ask for permission to sell stock below book value this year. In our view, raising money below book value is rarely in the best interest of shareholders.

As mentioned in our previous call, all of our indicators continue to point towards strong origination levels as the year progresses. I believe we are seeing high growth and deal volume for several reasons. One, private-equity sponsors view us as a top provider of one-stop middle-market solutions. Two, we have gained significant momentum from our recent hires and our expansion in the Chicago market. And three, we are able to offer the full suite of products including senior-only, one-stop, and mezzanine financing.

In addition, the ability to commit to an entire transaction syndicated down later provides us with some additional pricing power. We firmly 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.

We have seen continued positive momentum in the credit quality of our assets. Categories three, four, and five-rated securities now account for less than 3% of the portfolio at fair value as of June 30, 2011. This is a positive trend that positions us well for the next down cycle and allows us to increase our return on equity.

Following our approach to be one of the most transparent in our industry, we will continue to release the debt-to-EBITDA of our rating tranches, as well as update our investors on a monthly basis. As you have heard from me on previous calls, we remain focused on the potential for inflation to increase given the continued pro-liquidity stance of the Federal Reserve, and what we perceive as an inflation being exported from China. As of June 30, 2011, the current percentage of our debt portfolio with floating rates was approximately 65%.

Our continued increase in the percentage of floating-rate loans should enhance our NII as interest rates increase over the coming years. Chicago is an important market to Fifth Street. We plan on accelerating our build-out and continuing our Chicago expansion as we endeavor to be recognized as both a New York and Chicago firm -- not a New York firm that is also in Chicago. We appreciate our Chicago and Midwest-based clients and look forward to enhancing our service offerings and capabilities to them both through Greg Browne and our new partner, Sunny.

We believe that our strong brand and relationships allow us to capture premium pricing over the market. The market is also differentiating the lenders based upon balance-sheet capacity. We have led and agented an increased number of deals this year and have begun to develop strong syndicate relationships.

Our recent investment-grade rating coupled with our large credit capacity gives our clients comfort that we will make the expansion capital available to them when needed. Our reputation in middle market as a leader, as well as our market, share should continue to grow as we add to our institutional platform and provide a higher level of service. We are very excited about the opportunities in the middle market, as we expect the M&A activity to continue to increase throughout the year. I will now hand the call over to our President, Bernie Berman.

Thanks, Len. In July, we lowered the interest rate on our ING-led credit facility to LIBOR plus 300 basis points, with no LIBOR floor at all times, while we were at least 35% drawn; and LIBOR plus 325 basis points, with no LIBOR floor, at all other times. These rates are contingent upon us maintaining our investment-grade credit rating.

The size of the facility was also increased to $230 million with an accordion, which would allow for future expansion up to a total of $350 million. We are appreciative of ING, as well as the rest of the lending group, for working with us to lower our cost of debt and to increase our borrowing capacity.

We continue to make progress towards our second SBIC license. In the spring, we received a green-light letter to file an application for our second fund, which we recently filed. We continue to move through the licensing process, and we will provide an update on our next earnings call or sooner if we have something definitive to report.

Our first SBIC fund is fully drawn on the maximum $150 million in debentures. Of the $150 million, $138.3 million is fixed to extremely favorable pricing, which we previously announced; and the final $11.7 million will have its pricing fixed in about a month.

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

Thanks, Bernie. With respect to our balance sheet as of June 30, 2011, total assets were $1.05 billion, which included total investments of $1.05 billion at fair value, cash and cash equivalents of $17.6 million, and total assets of $1.09 billion. Liabilities were $318.1 million, which included $150.0 million of SBA debentures payable and $152.0 million of convertible senior notes payable. At June 30, 2011, net assets were $775.6 million, and our net asset value per share was $10.72.

With respect to our operations, total investment income for three months ended June 30, 2011 was $32.4 million. This was comprised of $29.0 million of interest income, including $3.6 million of PIK interest and $3.3 million of fee income. We ended with net investment income per common share of $0.25 and earnings per common share of $0.31.

For the three months ended June 30, 2011 we recorded net unrealized appreciation of $18.5 million. This consisted of $14.0 million of net reclassifications to realized losses and $7.1 million of net unrealized depreciation on equity investments, offset by a $1.7 million of net unrealized depreciation on debt investments and $0.9 million of net unrealized depreciation on our interest-rate swap.

Our weighted-average yield on debt investments at June 30, 2011 was 12.6%, which included a cash component of 11.2%. Our average portfolio-company investment was $20.3 million. This compares to the previous quarter, with a weighted-average yield on debt investments at March 31, 2011 of 12.8%, which included cash component of 11.3% and our average portfolio-company investment of $19.6 million.

With respect to the portfolio during the quarter ended June 30, 2011, we closed $120.1 million dollars of investments in six new and three existing portfolio companies, and funded $119.2 million across the portfolio.

At June 30, 2011, our portfolio consisted of investments of 60 companies. At fair value, 98.1% of our portfolio consisted of debt investments and 82.6% of the portfolio were first-lien loans. As of June 30, 2011, we had stopped accruing cash interest, PIK interest and OID on two investments, which have not paid all their scheduled cash-interest payments.

At June 30 2011, approximately 64.6% of our debt-investment portfolio at fair value bore interest at floating rates. With respect to our ratings, at June 30, 2011, the distribution of our debt investments on the one-to-five rating scale at fair value was as follows -- the percentage of one and two-rated securities was 97.7% in comparison to 97.2% as of March 31, 2011. We are closely monitoring all of our investments and continue to provide proactive managerial assistance.

Concerning our dividends, earlier this week, the Board of Directors declared the following monthly dividends for our first fiscal quarter of 2012 -- $0.1066 per share payable on October 31, 2011 to stockholders of record on October 14, 2011; $0.1066 per share payable on November 30, 2011 to stockholders of record on November 15, 2011; and $0.1066 per share payable on December 31, 2011 to stockholders of record on December 13, 2011.

Now, I turn it back to Stacey.

Thank you, Bill. Before I open the line for Q&A, I would like to remind everyone that for the months that Fifth Street does not report quarterly earnings, we generally release a newsletter. If you'd like to be added to our mailing list and receive these communications directly, please either call me at 914-286-6811 or send a request e-mail to ir@fifthstreetfinance.com. Thank you for participating on the call today.

Keith, may you please open the line for Q&A.

Certainly. (Operator Instructions). And your first question is from the line of Ram Shankar with FBR. Please proceed.

Hi, guys. How are you?

Good morning.

Just based on what I'm looking at my screen today, and based on your conversations with your sponsors, is there anything that suggests -- with the economy today that would suggest that middle-market M&A would be down for the remainder of this year?

You have to remember, to enter the pipeline and for a company to sell itself takes a long lead time. And so these things go -- first they have to prepare the company, and it goes to auction and the auction process -- it's determined a winner, there's an LOI. There's a long, long process.

So I think that M&A activity will still stay really good. The market dislocation, of course, should allow rates to flex higher and allow us to deploy our capital at better rates. But if anything, I think M&A activity for the next three to six months will be robust. Beyond that, I think you're definitely questioning -- it's a question whether it's January next year -- the rate continues.

Okay. And you alluded to some commentary on the Fed and the liquidity, even though prospects of a QE3 coming -- or a potential for that. Is there any change in the number of floating-rate loans that you want to have on your book -- you still targeting the 65% to 75%?

I think we're -- yes, we got -- look, every time we've set a target, whether it's 75% first lien and 25% second lien to mezz, or 65% floating, we've gotten to our targets pretty fast.

I think we are actually positioning the firm exactly where we want. We're in a much, much safer position we were a year ago, even two years ago, both in bigger deals and plenty of first-lien loans and more stable companies.

And I think as we worry about the economy today, you -- the two most dangerous sectors in 2007 for us was definitely food and retail. And food and retail are -- today only represent approximately 10% of the portfolio; and three, four years ago that was over 20% of the portfolio. So we've seen a lot of attention even to sector rotation.

Okay. Thanks for taking my question.

Your next question is from the line of Joel Houck with Wells Fargo. Please proceed.

Yeah, Len, I'm wondering what's your perspective on maybe moving the portfolio more towards second-lien loan, particularly in light of the dislocation that we're seeing currently, as well as what we may see later this year.

I think even as we move -- if we move to the 25% second-lien-to-mezz weighting, we're moving in much bigger companies -- average EBITDA is easily over $10 million; often over $15 million or $20 million. The second-lien loans are -- the first-lien loans often have substantial asset coverage.

So what -- we're really watching our rotation and, therefore, the second-lien loans are not going to be at the rates that you see some of our competitors do at, like, 12% and 3% or 13% and 3%. We're talking about second-lien loans at the 11% or 12% or 13% interest rate because these are much safer securities. Having said that, I think a 75%, 25% split is probably the right proportion for us.

Okay. And another question on leverage -- I mean, obviously you guys have raised some capitals above book and have de-levered the balance sheet. Is there some level of -- I mean, maybe "commitment" is too strong a word -- to shareholders, but some level leverage that you're willing to run the company at so that shareholders kind of get the benefit of leverage of BDC [mile]?

It seems like in the last year or so, Fifth Street has been quicker to raise equity when they haven't been fully leveraged. So I'm just kind of wondering your perspective on that.

Yes. We did try to achieve scale, which we've accomplished. We won't raise equity below book, and we haven't asked for permission to raise below book, so -- and we're prepared not to raise equity for the remainder of the year unless the stock is in the right place.

I mean, we have a fully financed business plan. The last deal was partially going to finance the second SBA license and partially going to finance this new relationship that we're trying to work on. So we feel really good about the amount of equity capital we have, and we're ready to lever to about [0.6%] target. I mean -- remember, that's the target. It'll go a little bit higher or a little bit lower at different times. But we will utilize our credit lines.

One of the big drag on earnings this quarter, of course, was the fact that we didn't utilize our credit lines appropriately. And we have an unused fee, which is a bit higher if they're undrawn. And we also had the amortization of the points upfront, both of which increased our cost-of-debt capital. We believe that will come down in the future quarters.

All right. Thanks, Len.

Your next question is from the line of Casey Alexander with Gilford Securities. Please proceed.

Hi. Len, did you guys say you have $71.7 million already funded in the current quarter?

Yes.

Okay. I just -- I wasn't sure if I caught that straight. The two deals that you got paid back here during the month of July -- Filet of Chicken and Cenegenics -- now, those weren't due until 2012 and 2014. Now you've been carrying a bank of potential prepayment fees. Did those pay any prepayment fees or premiums or anything like that?

Yes.

Okay -- all right. Let me see real quick -- I think that's all I have. Yes, I'm good. Thank you.

Thanks, Casey.

Your next question is from the line of Dean Choksi with UBS. Please proceed.

Thanks for taking my question. Len, when you were talking about the pipeline, you kind of qualified it by saying that a lot of deals were in auction stages. Is that -- I mean, is there some kind of uncertainty about how many deals will close or how do see your competitive position or how do you see the market? I'm just kind of curious why you kind of qualified that -- the pipeline where, I guess, in the past there was qualification on it.

That's a good point, and a good catch. Look, I'm surprised the pipeline is as robust as it is and the M&A activity as wide as it is, but we're also finding, depending on the deal, some regional banks sometimes, some alternative lenders, step in at rates far below where we would lend; so if that doesn't happen, our win rate is relatively high, and sometimes -- recently that's been happening more.

And in auction stages, we're only with a number of sponsors, so we don't know that our sponsors are going to win. So just because it's in our pipeline doesn't mean our sponsor is going to turn out the winner.

So it's really -- we don't -- and our existing relationships, our core relationships aren't as predominantly in the pipeline. It's a lot of new relationships, which is great. But we're less certain about the win rates of those relationships.

Thanks.

Your next question is from the line of Greg Mason with Stifel Nicolaus. Please proceed.

Great, thanks. To follow up on Casey's question on the exit fees' prepayments, Len, would you be able to provide any color as to the magnitude of any exit fees or prepayment fees on those two exits?

Not really, but needless to say, when you exit something early -- usually within the first three years -- there's a prepayment penalty. For years four and five, it's minimal if anything. I think it's the -- what we do is -- being conservative, it's the amortization of the points up front. So any time you're exiting early, obviously those will get written up in the quarter if it's prepaid early.

In some cases, like Cenegenics, the real winner here is the fact that we made a great loan. We worked well with the management team. We were refinanced out. And we still own 4% of the -- [three-point-something percent] of the equity that we get distributions through to. So we still get additional payments even though we've fully refinanced.

And that's the goal. And that equity -- we haven't had an equity gain yet -- but that equity, some day, will be sold, hopefully, and that'll go against our large carry-forwards of losses.

Great. And then could you talk about prepayments kind of as the portfolio seasons? You really have not had a lot of prepayments over the past several quarters because you've got such a young portfolio. What are your expectations for prepayments -- not just in the next quarter, but say over the next six to 12 months? You don't have a lot of maturities coming due, but what are your prepayment expectations?

I think -- you never know which quarter these things fall into. But my -- our internal estimate is about $25 million a quarter. But it could be $51 million a quarter, and it could be zero the next quarter. I mean we just -- we obviously don't have control over refinancing and repayments. But right now, that's our general expectation. That's about the best we can do.

Great. Thanks, Len.

There are no other questions at this time. (Operator Instructions). And it looks like we have no other questions for today. So with that, I'd like to close out the conference. Ladies and gentlemen, thank you for joining us and everyone may disconnect.