Oaktree Specialty Lending Corp (OCSL) 2016 Q1 法說會逐字稿

Good day, ladies and gentlemen, and welcome to the Fifth Street Finance Corporation Q2 2016 earnings conference call. At this time, all participants are in a listen-only mode. Later, we will conduct a question and answer session, and instructions will follow at that time. (Operator Instructions).

As a reminder, this conference is being recorded. I would now like to introduce your host for today's conference, Ms. Robyn Friedman. Ma'am, you may begin.

Thank you, Lauren. Good morning and welcome to Fifth Street Finance Corp.'s first-quarter 2016 earnings call. I am joined this morning by Todd Owens, Chief Executive Officer; Ivelin Dimitrov, President and Chief Investment Officer; and Steven Noreika, Chief Financial Officer.

Before we begin, I would like to note that this call is being recorded. Replay information is included in our February 9, 2016 press release and is posted on the Investor Relations section of Fifth Street Finance Corp.'s website, which can be found at (technical difficulty).fifthstreetfinance.com.

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

Today's conference call may include forward-looking statements and projections that reflect the Company's current views with respect to, among other things, future events and financial performance. Forward-looking statements may include statements as to the future operating results, dividends, and business prospects of Fifth Street Finance Corporation. Words such as believe, expect, seek, plan, should, will, estimate, project, anticipate, intend, and future or similar expressions are intended to identify forward-looking statements, although not all forward-looking statements include these words. These forward-looking statements are subject to the inherent risks and uncertainties predicting future results and conditions. Certain factors could cause actual results to differ materially from those projected or implied in these forward-looking statements. New risks and uncertainties arise over time, and it is not possible for the Company to predict those events or how they may affect it. Therefore, you should not place undue reliance on these forward-looking statements.

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. To obtain copies of our latest SEC filings, please visit our website or call Investor Relations at 203-681-3720.

FSC undertakes no obligation to update or revise any forward-looking statements whether as a result of new information, future events, or otherwise, except as required by law.

The format for today's call is as follows. Todd will provide an overview of our results and outlook, and Steve will summarize the financials. Then we will open the line for Q&A.

I will now turn the call over to our CEO, Todd Owens.

Thank you, Robyn. For the quarter ended December 31, 2015, FSC generated $0.18 of net investment income per share, covering our dividend for the fourth consecutive quarter, despite an increase in professional expenses.

During the quarter, we continued to operate within our target leverage range of 0.6 to 0.8 times debt to equity, and subsequent to the end of the quarter, we announced a reduction in FSC's base management fee.

As discussed on our previous earnings call, the FSC board and leadership team welcome an open dialogue with our shareholders and are committed to improving returns for all FSC shareholders. To that end, over the past couple of months, we have spoken with many of our largest shareholders, including RiverNorth, to understand their thoughts on our business and recommendations for this year and beyond.

As a result of these discussions and an extensive review by our external manager, I am pleased to report that on January 19, FSC's investment advisor, with the approval of the FSC Board of Directors, agreed to amend the investment management agreement to permanently reduce the base management fee. Beginning January 1, 2016, the base management fee on total gross assets, excluding cash and cash equivalents, has been reduced from 2% to 1.75%. The 25 basis point fee cut is permanent and pertains to all fee earning assets without thresholds. We will continue to charge no fees on cash and cash equivalents and maintain an 8% hurdle, among the highest in the industry.

The reduction in FSC's base management fee places our fee structure to approximately the median for the industry and will increase FSC's return on equity. We view the base management fee reduction as a positive step toward unlocking shareholder value.

Overall, in 2015, the middle market experienced its weakest year for sponsored loan volumes since 2009. The December quarter has historically been the most active for new originations, but mirroring broader middle market M&A trends, the Fifth Street platform saw muted volumes.

During the December quarter, we closed on $338 million of investments, which, while higher than the September quarter, is lower than the typical seasonal surge in volume that occurs in the December quarter.

There were several factors contributing to a soft December quarter for the market, including weakness in the energy and commodity sectors combined with spread widening.

Looking ahead, we anticipate the March quarter will follow the traditional seasonal pattern of lighter volume with activity picking up later in 2016 as the market adjusts to higher borrowing costs.

We ended the December quarter at 0.74 times debt to equity within our target range. This slight increase in leverage quarter over quarter was mainly driven by the decline in net asset value, and we aim to manage leverage down slightly in the future to maintain operating flexibility.

As we look at the credit profile of our portfolio, we feel comfortable with the overall quality of our loans, despite some credit deterioration in a small number of portfolio companies. Our portfolio remains conservatively positioned and well diversified with approximately 80% of the portfolio consisting of senior secured loans with investments spread across 131 portfolio companies.

As we have previously stated, we made the decision to rotate out of energy over two years ago, and I am pleased that our energy exposure remains low at only 1.7% of our portfolio at fair value, spread across three companies.

In addition, we have no CLO exposure, debt or equity.

Despite the positive view on our overall portfolio, we experienced a decline in net asset value due to market conditions, as well as to credit deterioration in a handful of investments. Approximately 40% of the decline in NAV is attributable to broader market fluctuations as global growth concerns and a flight to better known, large cap issuers caused credit spreads to widen.

Also, as we described last quarter, there are a few portfolio companies that have continued to underperform. During the quarter, we added one loan to nonaccrual, and as of December 31, 2015, the five investments on nonaccrual comprise 4.6% of our debt portfolio at fair value.

As discussed last quarter, Ameritox, which represents 2.8% of total investments at fair value, has underperformed primarily due to a significant reduction in Medicare reimbursement rates and, to a lesser extent, lower testing volumes. As a consequence, Ameritox has been marked down to 65% of par and moved to nonaccrual. Our portfolio management team is working closely with the Company's management and sponsor owners to improve its operating performance and restructure the investment.

During the December quarter, we incurred $7 million of professional expenses, which represents an increase of $5.9 million from the previous quarter. The incremental expenses are related to the FSC pending litigation and our year-end audit and, to a lesser extent, preparation for our annual meeting.

As a result of these additional costs, our quarterly NII was above our hurdle rate, but within the catch-up, which means that incentive fees paid by FSC to our investment advisor were lower by $3 million.

I would like to point out that this is an example where the 8% hurdle rate, among the highest in the industry, has a positive impact for FSC shareholders. If FSC had a 7% hurdle rate, by example, which is the median for our peer group, shareholders would have paid an additional $2.5 million in incentive fees.

As we have previously disclosed, FSC repurchased $20 million of its stock during the September quarter. While we did not repurchase any additional shares during the December quarter as stated in our earnings pre-release two weeks ago, we intend to repurchase shares through open market, privately negotiated transactions or otherwise this quarter. We believe that repurchasing shares builds on FSC's proven track record of opportunistically returning capital to and driving value for shareholders, and is a prudent use of our capital. We look forward to updating you on the results of our plan in the future.

Over the course of the last year, we have taken a number of steps to reposition FSC for the benefit of our shareholders. We have covered our dividend for four quarters, operated within our target leverage ratio range, lowered fees on prospective capital raises, exited noncore strategies, maintained a well diversified senior secured portfolio, avoided CLO exposure, largely avoided energy exposure, and shifted to a more aggressive posture on share buybacks. A reduction in base management fee is discussed earlier as another step on this path toward enhancing shareholder value.

I would now like to turn the call over to our Chief Financial Officer, Steve Noreika, to discuss our financials in more detail.

Thank you, Todd. We ended the first quarter of 2016 with total assets of $2.5 billion, down slightly from $2.6 billion at 2015 in fiscal year-end. Portfolio investments totaled $2.3 billion at fair value, which were spread across 131 companies at December 31, 2015.

At the end of the December quarter, we had $95.2 million of cash and cash equivalents on our balance sheet. Net asset value per share was $8.41 as of December 31, as compared to the net asset value per share of $9 at the end of the September quarter. For the three months ended December 31, 2015, we generated total investment income of $65.1 million, an increase of $1.4 million as compared to the prior quarter. The quality of our income continued to be high as net PIK, which is PIK accruals recorded in excess of PIK payments received, represented only 4.2% of total investment income.

Net investment income was $26.6 million for the quarter ended December 31.

During the quarter ended December 31, we closed $338.3 million of investments in six new and five existing portfolio companies, and we received $226.2 million in connection with the full repayments of seven of our debt investments, all of which were exited at or above par, including $119 million of principal plus additional fees from First Choice ER, which was our largest non-control investment.

Furthermore, we received an additional $96.5 million in connection with syndications and sales of debt investments in the open market. The credit profile of the investment portfolio continues to be solid as 94% of the portfolio at fair value was ranked in the highest one and two rating categories. We believe we are conservatively positioned relative to our peers with 94% of the portfolio at fair value consisting of debt investments, 80.5% of the portfolio invested in senior secured loans, 78.7% of the debt portfolio consisting of floating-rate securities with no CLO investments and limited energy exposure at quarter end.

FSC's joint venture with an affiliate of Kemper Corporation continues to perform well, generating a 13% weighted average annualized return on FSC's investment during the December quarter. As of December 31, 2015, the joint venture had $360.4 million of assets, including investments in a range of one-stop and senior secured loans to 32 portfolio companies.

For the December quarter, the weighted average yield on our debt investments, including the joint venture return, was 10.4% with the cash component of the yield making up 9.9%. At December 31, 2015, the average size of a portfolio debt investment was $20.4 million, the average portfolio company EBITDA was $38.4 million, and our top 10 portfolio company investments represent only 28.7% of total assets.

Earlier this week, our Board of Directors declared monthly dividends of $0.06 per share for March, April and May, consistent with the last three quarterly dividends. We expect our Board of Directors to continue declaring monthly dividends on a quarterly basis, subject to various factors, including Company performance, capital availability, level and timing of share buybacks, as well as general economic and market conditions.

I will now turn it back over to Robyn.

Thank you for joining us on today's call. With that, Lauren, please open the line for questions.

(Operator Instructions) Terry Ma, Barclays.

Thanks. I think most shareholders appreciate the lowered base fee, but can you maybe just give some color on whether or not you guys have contemplated maybe reducing the incentive fee and/or adding a total return hurdle as well?

Hi, Terry. Thanks for the question. Look, as we said in the script, we feel good about the fee structure by lowering it to 1.75%. It really puts us at the median for the industry as a whole. We think that that is an important step, and it puts us in the right place in terms of overall fee structure. We also, for better or worse, had a quarter where the 8% hurdle came into play in a big way for our shareholders, and that is among the highest in the industry. And so we feel good about the fee structure today.

I think, having said that, we and FSC's Board of Directors regularly review the fee structure, at least annually, and often times more frequently than that, and we will consider changes in the future as and when those make sense.

Got it. And just given that you guys have a $100 million buyback raise, I am actually surprised you guys weren't a little bit more aggressive buying back shares in the December quarter. So maybe can you guys just talk about your appetite for buybacks going forward?

Yes. I would say a few things, and that is a good question. I would say a few things. Number one, we bought $20 million worth of stock back in the September quarter. And, as we have announced both today and a couple of weeks ago when we pre-released our results, we intend to buy back stock in this quarter -- in the March quarter.

We did not buy back shares in the December quarter for a variety of reasons. The December quarter is an important quarter for us. It is historically, and in this most recent quarter, typically the highest origination volumes, number one. And number two, there was substantial volatility in the market, and we were very focused on maintaining appropriate leverage levels, as well as supporting our sponsor clients in what is traditionally the busiest time of the year. And, for those reasons, principally, we did not buy back stock in the December quarter.

Got it. That's helpful. And just on the professional fees, can you maybe just give some color on where you expect that to trend going forward?

Yes. Terry, I wish I knew. It is going to be very hard for us to predict where the professional fees are going to go because we just can't, as we sit here today in March, anticipate the direction that the litigation or the shareholder discussions we are having is going to go. So it is very difficult for us to predict what the professional fees will be this quarter or in the future.

Doug Mewhirter, SunTrust.

I just had two questions. First, there seems that, obviously, there is -- the senior loan market has received quite a bit of volatility, and it sounds like the middle market is sort of starting to experience some of that. I guess it would be favorable for new deals for you in terms of wider spreads. Are you seeing better risk-adjusted spreads on your new deals that are coming across your desk? And could you -- I mean would you expect that to possibly even move the needle on your overall portfolio going through the year?

Doug, thanks very much for the question. I think Ivelin probably is the right person to address that.

Hey, Doug. It is a good question. We see the same -- probably the same trends we see every year with the March quarter. There are less deals in the market. There is a flight to quality. You see bankers dust off old books that nobody looked at in the prior quarter, and they are trying to get those businesses sponsored and draw some demand. But we do see wider spreads. We do see some quality properties coming to market, and we are able to get better structures. We are able to get tighter covenants and more appropriate leverage level and higher pricing.

So it remains to be seen whether it is a phenomenon that is going to continue the rest of the year. So far, this year is shaping up to be much better in that respect than 2015. So we are optimistic, but we will see how the business goes.

All right. Thanks for that. My second question, either Steven or Ivelin. If you would aggregate your portfolio into one big company, what would be the aggregate year-over-year revenue and/or EBITDA growth of that aggregate portfolio this quarter?

For the December quarter, I think if you look at the portfolio, not all the companies have reported yet, so we don't have all the stats. But, anecdotally, we can give you guidance that we are seeing companies come up year over year by single digits. They are missing their budget expectations. And I am hesitant to make general statements like this because it really depends industry to industry. We are seeing some softness in certain aspects of the healthcare side. We are seeing robust growth in some of the more technology recurring revenue businesses. But, in general, if you were to aggregate it, we would see probably single-digit growth year over year in the portfolio companies.

(Operator Instructions) Ryan Lynch, KBW.

Just a more of a philosophical question on how you kind of view share buybacks, given the big discount in your stock today versus go into the markets, supporting your existing portfolio and existing companies with deploying more capital into those existing companies, versus deploying capital into the marketplace as terms and pricing continues to trend more favorably?

Thanks for the question. Look, I think you're hitting on it. The way that we think about it is, it is important to do both, and it is important to achieve a balance between the buybacks given the stock price but, also, supporting our core business and supporting our core relationships. And at the risk of repeating myself a little bit, in the December quarter, we thought it was important, given everything that was going on in the market, given the market volatilities, given some of the uncertainties that we saw, as well as a quarter where we traditionally see the most active originations and the most activity in the sponsor community, we concluded that it made sense not to buy back stock.

But in September, we bought back -- in the September quarter, we bought back $20 million worth of stock. We do have $100 million authorization from our Board of Directors, which was renewed at the end of last year, and we intend to be buying stock in this quarter under that authorization given the price levels.

Okay. Great color. And then, you guys have actually done a pretty good job of backing off of energy investments, before the fall in energy prices. So do you have any appetite to maybe dip your toe back in the energy market considering the big pullback in destruction of that industry, or is that better served to just stay away from it as of now?

Yes, Ivelin can probably address that.

Thanks for the question. That is actually something that a few people have brought up to us, and we do look at the widening investment spectrum. There are different opportunities out there. However, in energy, of course, we don't feel we have the necessary expertise to be able to actually ascertain when is the right time to -- and what kind of business to support. And, second, just looking at the things we are seeing and the limited exposure that we have, we feel there is still a lot of reckoning that needs to happen in this space, and there are still companies that are surviving based on a lifeline by lenders. And so there is another shoe to drop.

So from that perspective, we are staying on the sidelines, and we will see what happens down the road.

Okay. Thanks for that. And then, one last one on Ameritox. I want to get a clarification and then a question. Did I hear correctly that you guys are working right now on restructuring that investment, and if so, when do you guys believe you will have some sort of solution and maybe restructuring and rightsizing that balance sheet and get that company back on accrual status?

That is a good question. It is Ivelin again. We are in the process of having those negotiations. There are a number of moving parts. So I am hesitant to give you a timeline, but we are cautiously optimistic that it will be soon.

Basically, all the players involved are incentivized to reach a resolution soon. We feel there is a lot of potential in front of this business. Going forward with the right capital structure and the right support in front of it. So we are excited about the business, we are excited to support it, and we are excited to figure out the appropriate restructuring there.

Chris York, JPM Securities.

I am curious to learn a little bit more about the thought process for the reduction in the base management fee. Was the result more -- or I guess, was the result of the change from the board more a result to be in line with the median for externally managed BDCs or more a result of, say, maybe a Gartenberg analysis that would determine a lower value of the services provided by the investment manager?

Chris, thanks for the question. Look, our Board of Directors reviews the contract annually, at least annually, and thinks about the contract in the interim periods. And we work closely with the board in thinking about the provisions or the terms, I should say, of the contract. And I think in the normal course of that process, in recognition of some of the things that are happening more broadly in the industry. The Board of Directors of FSC, in conjunction with the manager, thought it made sense to reduce the management fee. And by reducing it 25 basis points, as we have said, it puts us right at the median for the industry as a whole, and that felt like an appropriate place to be at this point in time.

Jonathan Bock, Wells Fargo Securities.

Thank you for taking my questions. Perhaps, first, a question as it relates to the professional fees. Todd, the $6.8 million or so, as it goes to various lawyers, etc., the fundamental question investors are going to ask -- and I think we posed it to you once -- is, explain why shareholders should pay this fee when the problem really rested in the external manager, right, that you are still paying fees to? While that external manager also receives full indemnity from the (inaudible) planning to ask for it -- I understand that is an industrywide practice -- but it seems odd that shareholders get to bear the expense while the external manager gets clear indemnity and we all get stuck and saddled with a hefty lawsuit that we are defending and potential losses that could come as a result of it. Why do shareholders need to pay for that and not the external manager that has plenty of money to do so?

Good morning, Jon. Thanks for the question. Look, the litigation, as well as the shareholder claimer brought by shareholders of FSC and focused on FSC, the costs that we incurred in the quarter were accounting related and other professional costs associated with that, as well as our year-end audit, and those are costs that are appropriately born, we think, by FSC.

Okay. Fair enough. Shareholders fit the bill. I guess the next question that we would also ask is, when you look at the management fee construct -- and certainly the 1.75% base is an appropriate starting point that I think folks would like to look at in that it is at least downward. Please, Todd, your personal opinion matters. Do you believe it is appropriate to align the incentive fee with your shareholders in light of the fact that they just experienced an 8% decline in NAV?

Look, as I said, now I think a couple of times both in the script and in response to earlier questions, we feel like being at the median for the industry from a fee structure perspective is the right place for us to be. The situation, I think it is fair to say, is fluid, and we have taken a number of steps over the last year -- I won't list all of those again, but we have taken a number of steps over the course of the year, and I view the reduction in the management fee from 2% to 1.75% as a logical step in that progression.

As you think about the high watermark, there are a number of firms that have high watermarks. There are more that do not in the industry, including very few of the largest BDCs in the space. And we and, importantly, I think, the Board of Directors of FSC are going to continue to monitor the market and as it relates to this as well as other practices and make changes if and when we think that that is appropriate. I would just point out that, just to make sure the record is clear on this, our NAV decline was 6.5% in the quarter.

Excuse me. Sorry about that. 6.5% (multiple speakers).

That's okay. I just wanted to make sure the record is clear on that.

The record is clear. And what percentage of which was related to fundamental credit performance versus technical write-downs?

Yes, I will ask Steve to just comment on that.

Hey, Jon. Yes, we noted in the earnings release about 40% of the markdown was due to market fluctuations and not credit related, and the remaining 60% was -- and, as you can see on our schedule, investments very concentrated in a few names.

Particularly that $100 million loan. So understood that it sits in both the SLF as well as the balance sheet.

I guess another item that we are grappling with is, if you believe being close to the median range, Todd, is appropriate, and you and the board believe the median range of fees is appropriate and that there are several other BDCs that do not have look backs, would you put your overall performance on an NAV basis at that median level relative to those other BDCs or not?

Jon, look, what I would say is, honestly, we are disappointed in the NAV performance that we have seen. We are working to improve that, and we are cognizant that, not only for FSC, but for the industry as a whole, declining NAVs are a problem. And that is an issue that we and I think others is in the industry as well need to address.

I don't think our performance, though, is in any way an outlier in that regard. And, therefore, since you tied it back to the fee structure, we think it is appropriate for us to be right at the median for the industry.

Okay. And then, just as we see the lawsuits, as we see the potential for activism, as we see the proxy battles back and forth, one could argue that would it make sense to -- for the external manager to court a white knight? And I am curious, would you believe or do you believe strategic alternatives are appropriate for the external manager? And, if that is the case, is that an 8-K-able event if you guys believe it is?

Gosh. I am not going to comment on strategic matters like that. We will stick with what we disclosed publicly in that regard, and I'm not going to comment on those kinds of rumors.

Okay. No rumors. Just curious. Because if folks look at underperformance, typically that is the one way out. So with that said, thank you for taking my questions.

At this time, I am showing no further questions. I would like to turn the call back over to management for closing remarks.

Thanks, everybody, for joining us this morning, and we look forward to continuing our dialogue.

Ladies and gentlemen, thank you for your participation, and you may all disconnect. Everyone, have a great day.