Oaktree Specialty Lending Corp (OCSL) 2013 Q1 法說會逐字稿

Good day, ladies and gentlemen and welcome to the first quarter 2013 Fifth Street Finance Corporation earnings conference call. My name is Regina, and I will be your conference operator for today.

(Operator Instructions)

As a reminder, today's event is being recorded for replay purposes. I would now like to turn the conference over to your host for today, Mr. Gene Choksi, excuse me, it's Dean Choksi, Senior Vice-president of Finance and Head of Investor Relations. Please go ahead, Dean.

Thank you, Regina. Good morning and welcome to Fifth Street Finance Corp's fiscal first quarter 2013 earnings call. I'm Dean Choksi, Senior Vice-President of Finance and Head of Investor Relations at Fifth Street.

I'm joined this morning by Leonard Tannenbaum, Chief Executive Officer, Bernard Berman, President and Alexander Frank, Chief Financial Officer. Before I begin, I would like to point out that this call is being recorded. Replay information included in our January 15th, 2013 press release, and is posted on our website, www.fifthstreetfinance.com.

Please note that this call is property of Fifth Street Finance Corp. Any unauthorized rebroadcast of this call in any form is strictly prohibited. This conference call includes forward-looking statement 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 statement and projections.

We do not undertake to update or forward-looking statements unless required by law. To obtain copies of our latest SEC filings, please visit our website, or call Investor Relations at 914-286-6855. The format of today's call is as follows. Len will provide an overview of our results and outlook.

Bernie will provide an update on our capital structure. And Alex will summarize the financials, and I will provide some high level commentary on the BDC sector. Then we'll open the line for Q and A. I will now turn the call over to our CEO, Len Tannenbaum.

Thank you, Dean. First I want to thank the entire team at Fifth Street. It was very busy during the December quarter working on our largest investment pipeline ever. And ultimately, closing a record $422 million in gross originations.

Our December quarterly results demonstrated our focus on just-in-time capital, where we narrowed the gap between raising and deploying capital, to minimize earnings solution in the short term, while adding assets with attractive risk adjusted returns for the long term.

We are pleased to deliver strong results with $0.28 of net investment income in our first quarter of 2013, which is one penny higher than the consensus. The board is confident in our ability to maintain the dividend and declare monthly dividend through May at its January meeting, equivalent to $1.15 annualized dividend payout.

We predicted M&A volumes would continue to increase through 2012, although overall industry M&A volumes were less than we expected, the prospect for higher tax rates in 2013, which ultimately proved true, drove a significant increase in activity, particularly dividend for capitalizations and refinances.

Our overall pipeline continued to strengthen with activity accelerating in early November, after the U.S. election. In late summer, we began positioning the balance sheet for stronger pipeline through the end of the year, by raising a combination of debt and equity to help pre-fund our pipeline.

We were able to take advantage of frothy credit markets, by utilizing our investment-grade ratings to increase availability, reduce cost and extend maturities of our debt capital. One, we issued $75 million in 12-year senior unsecured notes at 5 7/8ths in October, which help to ladder our debt maturities.

Two, we expanded our syndicated credit facility to a current size of $425 million with 12 participating banks. And three, we've lowered the cost of credit by 25 basis points, and improved the terms in that facility. We are committed to increasing leverage over the long-term to our target of .6 to .7 times debt to equity, excluding SBA data, by using a combination of revolving bank credit and using the unsecured debt market.

We believe a mix of bank debt and longer-term unsecured debt is a prudent way for BDC to increase leverage. Our first baby bond trades on the New York Stock Exchange under the ticker symbol FSCE and complements our existing bank debt, due to its longer maturity. Baby bonds are attractive sources of long-term capital, though we may issue unsecured debt in the future, if market conditions warrant, with different maturities to diversify our debt structure.

Our growth is creating attractive opportunities that were not available, that are not available to many of our peers, and were not available to Fifth Street a couple of years ago. Our deep sponsor relationships formed over prior deals are leading to repeat business.

This was evident at the end of 2012 when sponsors often chose to work with lenders they knew and trusted, given the end of the year deadline. These established relationships with equity sponsors are creating attractive lending opportunities for us. The overall credit quality portfolio remains healthy, although two assets did slip to a three ranking and one asset went on picking on a cool.

The total amount of assets ranked three, four and five continues to be small at about 2% of the portfolio at fair value. These three assets, along with a reduction of the fair value of coal materials led to a small decline in NEV from the September quarter. We initiated legal action related to coal materials, so I'm limited in making further comments.

The March quarter is starting off slow, which is out of the ordinary, based upon prior years. Our origination teams remain active, and we currently expect to be within our guidance range of $100 million to $300 million in gross originations per quarter, despite the slow start.

A demand for senior debt is very strong, as banks and institutional investors are desperate for yields. This is creating attractive second lean and mezzanine opportunities as we've discussed on previous calls. As a result, our portfolio shifted towards mezzanine and second lean, with first lean assets ending the December quarter at the lower end of our target range of 60 to 80%.

The mezzanine and second lean assets we are adding are in larger, more established companies. These loans should generate attractive risk adjusted returns. We anticipate staying within our target range of 60 to 80% first lean assets.

Between the active senior market, and our larger balance sheet, we are updating our guidance for anticipated quarter pre-payments to between $50 and $100 million from between $25 and $75 million per quarter. As our balance sheet grows, we are able to originate larger deals, and expand our product offering.

We recently expanded our maximum hold size to over $100 million from $75 million for certain sponsors. Our new, larger hold size is about 6% of the current portfolio and will enable us to enter a market segment with fewer competitors and more attractive risk adjusted returns.

We are also developing syndication relationships through our capital markets desk, which should enable us to create additional value through structuring first lean last out securities for our balance sheet. We also have expanded our emphasis on capital market transactions where our sponsor relationships, underwriting expertise and market reputation create opportunities for us to agent and syndicate deals with attractive risk adjusted returns.

In 2012, Fifth Street agented $1.7 billion in transactions. We are excited about the opportunities in 2013 and beyond. We believe we are well-positioned with solid asset performance, diversified low-cost liability structure, and institutional processes and platform.

We believe there are opportunities for the larger, more sophisticated BDCs, to gain market share in the upcoming years. We continue to focus on hiring and developing the right people to capitalize on these opportunities and to utilize our substantial available investment capacity to fund them. And now, I will turn the call over to our President, Bernard Berman.

Thank you, Anne. As we promised in our last earnings call, we closed a material amendment to our ING-led credit facility. The amendment was closed on November 30th, with several subsequent amendments that added new lenders and increased the size of the facility.

As of today, we have 12 lenders in the facility and $425 million of committed capacity. When combined with our Wells Fargo and [Sunitomo] facilities, we have $775 million in flexible, low-cost bank credit. The amended facility features a 25 basis point reduction in the spread over LIBOR, higher advance rates across multiple classes of securities, and greater flexibility on eligible collateral, concentration limits and financial covenants.

The improved terms are a reflection of the growth and the size of this week's platform to quality of our portfolio and our two investment grade credit ratings from Standard and Poor's and Fetch. We continue to work on reducing our cost of capital, as well as improving the terms of, and our access to debt capital.

We ended the December quarter with leverage roughly flat versus the September quarter at 0.39 times debt to equity, excluding SBA debentures. We continue to target leverage of 0.6 to 0.7 times debt to equity, excluding SBA debentures. We are making progress in deploying a leverage in our second SBIC fund.

As of December 31, 2012, we had drawn $32 million of leverage under the second license. The interest rate on that $32 million, as well as any additional amounts we draw over the next month will lock in March and be fixed for 10 years. I'm now going to turn it over to our CFO, Alex Frank.

Thank you, Bernie. We ended the 2012 calendar year with total assets of $1.65 billion, an increase of $258 million or 18.6% quarter over quarter, reflecting a record quarter of approximately $400 million of funded investments.

Investments were $1.58 billion at fair value, and we had available cash on hand of $37 million. Net asset value per share was stable at $9.88 at calendar year end. For the three months ended December 31st, 2012, total investment income was $51.8 million, a level of payment in kind interest, a key indicator of earnings quality remained a low percentage of total income at 7.2% of total investment income, or $3.7 million as compared to 8.6% for the year ago period.

Net investment income increased 27% to $26.6 million for the quarter as compared to $21 million in the same quarter the previous year. We had five portfolio company refinancing during the quarter all of which were exited at, or above par. Net on realized losses, net of realized gains, resulted in a decline of $8.7 million for the quarter or .6% of the investment portfolio.

The weighted [aber dealed] on our debt investments was relatively stable at 11.99%. The cash component of the yield increased slightly in the quarter to 11.01%. The average size of a portfolio debt investment increased from $19.7 million at the prior quarter to $20 million at December 31st, 2012.

We originated $422 million of investment in the quarter in 20 new and 8 existing portfolio companies, bringing the total companies in our portfolio to 92 at December 31st, 2012. This compares to $95 million of deal closings in seven new and one existing portfolio company in the year-ago period.

During the quarter, we also received $50 million in connection with the exits of five of our portfolio companies. This level of repayments is in line with our current expectation of approximately $50 to $100 million per quarter, reflecting the increase in the size and diversification of our portfolio.

Approximately 96% of the portfolio by fair value consisted of debt investments. 62% of the total was in first lean loans, and 70% of the debt portfolio was at floating interest rates. The investment portfolio continues to be well-diversified by industry sponsor and individual company. Our largest single exposure is to health care, including pharmaceuticals, at 21% of the total portfolio.

The largest single individual company is a low 3.2% of total assets, and our top 10 investments represent 29% of total assets. The investment portfolio continues to be of high credit quality, and the credit profile was stable versus the prior quarter. We rank our investments on a one to five ranking scale, and the highest performing one and two ranked securities were 97.6% of our portfolio versus 99.5% in the previous quarter and 98.1% a year ago.

During the quarter ended December 31st, 2012, we had two investment in the portfolio, coal materials, and transfer A terminal and B on which we had stopped occurring income, as compared to 1 at September 30th, 2012, and 4 at December 31st, 2011. Our Board of Directors has declared monthly dividends for March of 2013 through May of 2013, of 9.58 cents per share, reflecting a continuing annual rate of $1.15 per share. Now, I'll turn it back to Dean.

Thank you, Alex. In the December quarter, we made multiple improvements in our liability structure, which is among the most diversified in our sector. However, based on past conversations with investors in the sector, I do not believe they differentiate BDCs much based on liability structure. On today's call, I'm going to talk briefly why a diversified capital structure is important.

One, it enables the BDC to offer multiple debt financing solutions and two, risk management. Having multiple sources of debt capital enables a lender like Fifth Street to offer different financing solutions while optimizing returns. For example, each of our five funding sources has different costs, collateral requirements and advance rates.

Our Wells Fargo credit facility is sometimes the most efficient way to finance first lean loans. Another facility may be more efficient to finance mezzanine because it offers higher advance rates against mezzanine assets. By utilizing multiple funding sources, we are able to create different ways to optimally fund our assets, which means we can be more competitive when pricing [as one] of our sponsors, while generating higher returns for our shareholders.

Our investment grade credit ratings are also important, because they enable us to issue attractively priced unsecured debt, like our recent 12-year baby bond. They also reduced the cost of our bank credit facilities because the bank's capital charge is less for an investment grade borrower than a non-investment grade borrower. This provides us the cost of funding advantage over our non-rated peers.

Combined, these attributes help make Fifth Street a choice lending partner for leading sponsors. Risk management is the other reason to have a diversified capital structure, and BDCs that struggled the most through the credit crisis were either too reliant on one lender or the institutional debt market, and were unable to roll their debt at maturity.

A BDC can minimize funding risk by working with multiple lenders and maintaining excess debt capacity. Debt maturities should also be staggered in the event that capital markets are not open at attractive prices at maturity. Thank you for participating on today's call. Regina, please open the line for Q and A.

(Operator Instructions). Gentlemen, your first question today is from the line of Stephen Laws with Deutsche Bank.

Hi, good morning, and congratulations on a nice quarter and a strong portfolio growth and balance sheet developments.

Thanks, Stephen.

I guess, in the one question follow up, I'll just put two out there right now and let you guys hit them, but can you talk about the competitive landscape, maybe as you move to the slightly larger deals, does it change materially? How do the returns kind of develop as you're able to take advantage of being a larger platform and sourcing larger opportunities?

And then to touch on the baby bond issue, you know, kind of, as you look out going forward, what do you guys view as kind of a optimal capital structure for the company as you look to grow from here? I appreciate your time. Thanks again.

So the first question, what we are finding is there's a bit of a hole between $125 or $150 million hold size, you can call it $200 million, so 1 to 200 million hold size. And the reason that hold develops is, not many firms have the investment capacity and balance sheet to be able to hold that size deal, and then syndicate it down.

Most are $25 or $30 million players, and play for an agency or agency fee, but the equity sponsor would rather pay another 50 to 100 basis points to not have a potential flex and know that they're done at that hold size. So we're fine, we've always wanted to enter that market. It's a terrific risk-adjusted return.

We're able to provide different leverage alternatives in that type of size. We're talking of EBIDTA of a $30 million company, so it's a very stable, large established company. And we're very pleased to be able to do one or two of those at a time. Of course, these are lumpy transactions. It's like hunting elephants.

So they can come in groups, and they can come not at all in a quarter so it may create a bit more lumpiness in terms of gross originations.

The second question was, what's the optimal right side of the balance sheet of the balance sheet capital structure? I think we're actually a little bit behind the curve in issuing baby bonds, compared to some of our larger peers. Aries has been very aggressive at issuing unsecured debt at different maturity levels

Apollo did some, I think that it's a great idea for anybody who thinks interest rates are going to go up eventually. The other great thing about unsecured debt, is it will add additional collateral for our secured debt facilities so it gives us a lot more leverage options, and leverage flexibility, advance rate flexibility.

But I think the most important thing is, you prepare for another cycle in the next five or six or seven years. These, this is the type of debt one can feel very comfortable within a cycle because there's covenants, there's no resource, it's unsecured debt and you can feel comfortable with that type of leverage versus I know that everyone's commented that we've been light and levered through today, and one of the reasons is we didn't have access, as we do today, to good unsecured debt, the possibilities of attractive interest rates.

Your next question today comes from the line of Robert Dodd with Raymond James.

Hi, guys. Just two on the credit side. I love these kinds of questions. The first one is simple, trends trade term B, you put it on "picking on the cool", the schedule of investments listed is a 12% cash loan. Can you clarify?

Yeah, we, the terms of the loan have been amended to a pick security so we're working with the company to allow for that, but we're not accruing the pick into interest, into income currently.

Robert, if you look right below the schedule of investments, you'll see a listing of the amended terms on the loans in the schedule, and the transfer is listed there.

OK, got it. The second one, just again, on the two that moved to level three, especially [Baker's] and Eagle Hospitals, both of those were originate in the third calendar quarter of 2010, and that was about the third of the capital that was originated in that quarter. I mean, is there any connection between the two? I mean, were they out of the same office, same originator, I mean, the question, obviously, is there a systematic problem with that quarter, or just coincidence?

It's more of a coincidence.

OK, got it, thank you.

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

I'm afraid, actually just to follow up on Robert's questions on the credit trends. Can you give this more of your kind of general perception of the credit trends in the portfolio? What are you seeing in terms of revenues and EBIDTA movements overall for the portfolio?

First of all, I'll comment that one of the really good things about the problems today versus the problems years ago, is on both of the deals that we just mentioned, these are not, we don't feel that they're zeros are anything close to zeros. This is going to be, we're going actually have very high recoveries, if not full recovery on both of those loans.

We just don't know yet, so we're being a little bit cautious in placing them into the watch list category. And that's very different than many, than a bunch of years ago when our EBIDTA was $3 million and some of these loans, and that goes to $2 million and that's the end of the company.

So, you know, we're cautiously optimistic that we've got a very strong portfolio team that so far this past year, led by [Brian Finklestein] has really done a terrific job, making sure the portfolio is very proactively safe.

As for credit trends, most of the companies, by the vast majority, are doing quite well. Unfortunately, some of them are doing too well, and were getting replaced out by cheap bank financing, when EBIDTA does extremely well in some of the companies, and so you are going to see some repayments.

The good news about these companies that we're getting repayments on is fortunately for us, we bought some equity. And so the equity really starts jumping in value when the high cost of debt gets replaced L400 debt. So even though credit trends are doing well, I feel like finally, we're having some equity that's doing well enough to hopefully generate some capital gains in the near future.

Great, then for my follow-up, the fee income was obviously very robust this quarter if we think about that going forward, have you changed the way that you have looked at fees and I know historically you amortize them over the life of the loan. Is with the new areas you're moving into, is that changing the fees where you're able to take more up front, or just how should we think about that as we model out forward the volatility in the fee income line?

Upmarket loans are a different characteristic of fee recognition. There are still some amortization of fees. Some of them are being, there are structuring fees, so that you take them into income.

Sometimes when we flip a loan, and this has been an interesting market for originators, where we're able to originate a loan at 98 and get out of it at 101 or 102 in a week, the increase above 100 is not even income, it goes below the line.

A capital gain.

A capital gain. So you won't even see that in an II. But that's, it's great for the shareholders, right, because it's a way to rebuild your NEV. So you know, there's all different types of characteristics, but as you move up market yes, loans are definitely different.

So we should expect more kind of upfront fees flowing into income as you move up the market versus the amortized fees, is that...

I think this is going to be a consistent every quarter amount of fees, so people think that our fees are a one-time event. No, it's just normal course of business, and every quarter we can originate loans, and every quarter we're going to get repayment and there's going to be fees in every single quarter.

Great. Thank you guys.

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

The following kind of similar line, the capital gains were fairly nominal, but you say that you received about $50 million in exits which were exited at par or above, and made $33 million in sales exited at par and above. Now, is some of that above par, actually showing up in fee income, as opposed to capital gains?

That's correct. Casey, this is Alex. That's correct. Many of the transactions are structured so that repayments result in exit and repayment fees that are properly reflected under GAAP as fee income.

Okay, that explains that for me, thank you. Secondly, your pick interest as a percentage of your total investment income, can you tell me where that kind of compares with what you think is your peer group, and you know, sort of, how do you attribute having a lower level as a percentage of total investment income, is it in the manner in which you're just structuring, or just some color on that, please?

Sure. I think it compares, it's among the lowest of our entire peer group. And there's some reasons for that.

One, some of our peers have large, all-pick securities in their portfolio and magically accrue income of an all-pick security. Now, obviously, an all-pick security has no chance of defaulting. You can almost set the interest rate at anything, and it can last a long period of time.

We do not have any large all-pick securities in the portfolio. Two, most of our securities today are floating, 70% flowing, and a lot of them are middle to upper middle, upper middle market securities, and those types of securities really don't have a lot of pick in them. There's much more pick income in smaller, lower middle market securities, and lower market securities, so that's another reason.

Three, pick is typically with a second lean or mezzanine loan, and not really with a first lean loan, and since only 30% of our, or 38% of our securities are either equity 4% or mezzanine or second lean, that is far less securities that have pick component to them.

(Operator Instructions). Your next question is from the line of Jonathan Bock with Wells Fargo Securities.

Hi, good afternoon and thank you for taking my questions. Len, looking at the new investments that you made this quarter, it was obviously very active, could you maybe give us a sense of the amount of loans that were directly originated?

I know you built out a very large platform of direct originators, relative to the number of deals that were perhaps maybe more syndicated or, I'll use that loosely, in a middle market, but say perhaps part of a larger debt syndicate that's all going to finance these portfolio companies?

Sure. And I think that's an interesting differentiator. If you look at some of our peer group, it's amazing to me that they don't have a lot of employees. We just crossed our 50th employee at Fifth Street. We really have built a very robust origination platform and underwriting platform.

And as you point out, when you participate, or even agents, some of the larger deals, you know, you don't need as many people. But if you're going to be a sole originator, on a platform you need a lot of people monitoring, structuring and evaluating every single deal.

We're currently originating as almost, as sole originator, about three to one over anticipations in middle market to upper middle market transactions, so it's still the vast majority, call it 75% of our deals are originated versus, originated solely versus agenting typically as you saw we did $1.7 billion as agent in one of the larger facilities with terrific partners like Madison or Annex T or GE. We really do a terrific job, also as agent.

Okay, so you know, the target again, maybe three proprietary deals to every maybe one more club debt, or I'll it club debt light if you will.

I would say club debt light, and I would still point out, these are sponsored, these are almost 90 plus percent sponsored transactions. We're still not really tapping the unsponsored universe. These are really coming out of our equity sponsors, even the club ones, or the equity sponsors pushing for our allocation and participation in these deals. So it's still sponsor driven.

And I noticed, you know, in your credit quality ranking, there was obviously meaningful upside to number one, investment highlighting that as you mentioned, deals were performing better than expectation, could you perhaps give us a sense of maybe pre-payment or call protection on those investments as generally, you know, once these one-investments increase, that's usually a sign that repayments typically do follow one or two quarters thereafter.

I agree. I think the one-rated securities are a good indicator of potential pre-payments, and what I think we've seen, is even though we have 101 or 102 or even 103 call protection, when these companies do well, you're getting prepaid anyway, we're just -- they're happy to pay you. And it's, that's the way it is.

We do have exit fees. We do have equity in a lot of these different transactions, so there's another way for us to make money, but we're never happy to lose a really good loan, and that's just part of the business.

Your next question is a follow-up question from the line of Casey Alexander with Gilford Securities.

I'm sorry, I kind of fell asleep at one point in time. Can you just repeat for me what the, you mentioned about the level of originations in the existing quarter and the level of repayments and sales.

That we were talking about, you told me the existing quarter being the March quarter?

Yeah.

We didn't mention anything to the...

Oh, I'm sorry, I'm sorry. Do you have any color on that?

We felt like, and I think we did mention that we were in our, we updated our range to $50 million to $100 million of repayments.

Right.

And we also felt like we were going to be within the range of our previous guidance of $100 million to $300 million of gross originations.

Okay. I got that. I thought maybe you had thrown out some specific numbers to date, so I apologize for that.

Your next question is a follow-up question from the line of Jonathan Bock with Wells Fargo Securities.

Yes, this is just one last question. So when we talk about the seasoning of those number one rated investments, would you consider those investments perhaps more seasoned than the stereotypical kind of loan portfolio, thus call protections di minimis or you know, maybe a little bit greater as these are deals that were priced higher and now in a frothy market will likely be taken out for a nice gain to you and your shareholders.

You know, I actually the repayments are all over the board. One of them was a year old investment where the EBIDTA just started to do very well. One of them was a multiyear investment. There's really no rhyme or reason to it.

Typically, we have stronger call protection in the first three years, and then almost zero after that. So I think as a rule of thumb, that's a pretty good way to think about it.

And just maybe one last follow up is that in terms of back in leverage, this is a phenomena that obviously a select group has been able to utilize to the benefit of their shareholders over time and we get, we do get that.

You know, maybe can you speak to the opportunity that you're seeing for Fifth Street to perhaps back and lever some of their, some of your, you know, more senior securities, or is this a market perhaps you're going to lay off for a while, as you're, you know, perhaps a little bit more focused on second lean and subordinated investments, at least evidenced by the last quarter?

I think that back at leverage is a terrific way to juice the yield of a first lean security while keeping control of the first lean security. And I know some of our peers have spoken very highly of it, and I happen to agree.

Developing back levering partners, we've been working on for the last three to six months. We feel like we have three good partners that are ready to do that with us. It's a matter of finding the right fields. What it does allow you to do is reduce your rate that you need to charge for those deals.

For example, you take a $30 million EBIDTA company, at 4 and a half times deep, you can charge 8% on that first lean loan, and through back levering, generating an attractive return to the last off first lean. The asset that you'll see on the book will vary depending on how much back leverage we've done, so you won't see a $120 million transaction, you'll see a $60 million or $70 million transaction.

Okay. Thank you.

Ladies and gentlemen, as there are no further questions in the queue at this time, this concludes the question and answer portion of today's program. I'd like to turn the call back over to management for any closing remarks they'd like to make.

Thanks everyone and see you next quarter.

And with that, ladies and gentlemen, we'll go ahead and close out. Thank you so much for your participation today. You may now disconnect. Have a great day.