OFS Capital Corp (OFS) 2013 Q3 法說會逐字稿

Good morning, and welcome to OFS Capital Corporation's earnings call for the quarter ended September 30, 2013. It is my pleasure to turn the call over to Miss Mary Jensen, Vice President of Investor Relations. Miss Jensen, you may begin.

Thank you. Good morning, everyone, and thank you for joining us. With me today is Glenn Pittson, our Chief Executive Officer; and Bob Palmer, our Chief Financial Officer. Please note our earnings announcement was released this morning and can be accessed via the investor relations section of our website at OFScapital.com. We plan on filing our 10-Q later this evening.

Before we begin, please note that statements made on this call and webcast may constitute forward-looking statements within the meaning of the Securities Act of 1933 as amended. Such statements reflect various assumptions by OFS Capital concerning anticipated results and are not guarantees of future performance and are subject to known and unknown uncertainties; uncertainties and other factors that could cause actual results to differ materially from such statements. Uncertainties and other factors are, in many ways, beyond management's control, including the risk factors described from time to time in our filings with the Securities and Exchange Commission. Although we believe these assumptions are reasonable, any of those assumptions could prove to be inaccurate, and, as a result, the forward-looking statements based on those assumptions also could be incorrect.

You should not place undue reliance on these forward-looking statements. OFS Capital undertakes no duty to update any forward-looking statements made herein, and all forward-looking statements speak only of the date and time of this call.

A replay of the call will be available until November 18, 2013 beginning approximately two hours after we conclude this morning. Alternatively, the webcast will be available for the next 90 days. To access either replay, please visit our website at OFScapital.com.

With that, I'll turn the call over to Glenn.

Thanks Mary. Good morning, and thank you for joining us as we discuss our results for the fiscal quarter ended September 30, 2013. I hope you had an opportunity to review our third-quarter earnings announcement, which, as Mary mentioned, was distributed a few hours ago and is available in the investor relations website.

One year ago today, we made our public debut and rang the opening bell on the NASDAQ. It was a culmination of a busy month that included receiving permission from the SEC to launch our IPO and traveling around the US to meet many of you during our road show.

At that time, we discussed both the macroeconomic environment and the growing demand for middle-market credit as well as the specific opportunities at OFS Capital offered shareholders.

A year has passed and we have faced some challenges in realizing these goals, both in terms of our results and finalizing all the steps in the process of implementing our business plan. However, we feel good about where we are in the process and believe we are at the threshold of fully implementing our strategy, which would position us for meaningful growth.

We have diligently pursued the two investment objectives outlined during our IPO process. First, to make prudent investments in both the senior loan fund as well as the SBIC fund. And second, the most important goal was to convert our investment in the SBIC fund into a wholly-owned, drop-down subsidiary. As you may recall, during the summer, we concluded negotiations with the other limited partners in the SBIC fund, enabling us to submit applications with both the SBA and the SEC. As we indicated before, this was done with the intention to materially expand our financing forces.

During the negotiations with the other limited partners, we obtained a purchase option set to expire December 6, which provided us with ample time to complete the transaction. Despite the burden of the federal government 16-day shutdown in October, a time when our application was in for review with the SBA, we remain confident that we will be able to complete the SBI drop-down on time and before the purchase option expires.

In addition, the SEC has been highly responsive to our exemptive relief application; and accordingly, we are optimistic that the SEC will, in the near term, grant us exemptive relief similar to that obtained by other SBIC applicants.

As we sit here one year later, we appreciate that our investors have remained supportive, given the hurdles involved in completing this process. We recognize this challenge, and we determined that the right thing to do for all shareholders was for the external manager to assume the significant cost of the IPO as well as cut the base management fee in half for the first year.

The managers assumed those costs in order to develop a long-term source of equity capital to invest in middle-market companies. As you know, management continues to have a significant stake in OFS Capital, which ensures our alignment with all shareholders.

Turning to our third-quarter results, frankly, they were not what we would like them to be. However, there were some positive takeaways. The senior loan fund continues to perform and is substantially invested. And despite the delays in the drop-down process, the SBIC fund continues to make new investments.

Now, I will turn the call over to Bob to discuss our third-quarter financial performance.

Thanks, Glenn. Our investment portfolio totaled $219.3 million on a fair-value basis as of September 30. It consisted of 56 portfolio companies and was comprised of first-lien senior secured debt investments and 55 borrowers with an aggregate fair value of $208 million; as well as our limited partnership investment in the SBIC fund, which had a fair value of $11.3 million.

The weighted average yield to fair value on our senior secured debt investments was 7.21% as of September 30, and the average portfolio of Company loan size was approximately $3.9 million. All of the loans and the senior loan funds are at floating rates; all contain LIBOR floors; and we've had just one nonaccrual at September 30, a debt investment with a fair value of $2.1 million.

During the third quarter of 2013, we closed two senior secured debt investments totaling $7.5 million, comprised of a $3 million investment in a new portfolio company and a $4.5 million investment in the refinance of an existing portfolio of company's credit facility. We were fully repaid on senior debt investments totaling $9.3 million in 2 companies that were in our portfolio at June 30. In addition, we had repricing amendments during the quarter on 5 portfolio companies within the senior loan fund, which had $18.4 million in aggregate principal balances outstanding at September 30, including the aforementioned $4.5 million refinance transaction.

The SBIC Fund ended the quarter with debt investments in 5 portfolio companies with $25.9 million in aggregate principal balance outstanding and equity investments of $4.9 million at fair value in the same 5 portfolio companies. Thus far in the fourth quarter, the SBIC fund just made senior secured debt investments totaling $10.8 million in two new portfolio companies and obtained equity stakes in each new portfolio company at an aggregate cost of $500,000.

On the senior loan fund portfolio, we derived approximately $4 million of investment income in the third quarter of this year; almost all of the investment income came from interest income on our debt investments. During the third quarter of this year, we incurred approximately $2.6 million of expenses, compared with $2.8 million in the second quarter and $2.9 million in the first quarter of this year. Included in the third-quarter expenses were $821,000 in interest expense on the senior loan fund credit facility; $856,000 in general and administrative expenses, professional fees, and administrative fees; $744,000 in management fees, which included $497,000 in base management fees and $247,000 to MCF Capital Management for its duties with respect to the senior loan fund credit facility; and $168,000 in amortization of deferred financing closing costs on the senior loan fund credit facility.

Included in $850,000 in third-quarter 2013 general and administrative expenses, professional fees, and administrative fees were approximately $50,000 in legal fees relating to our efforts to obtain drop-down approval from the SBA and exemptive relief from the SEC. That figure compared to approximately $250,000 in the second quarter. Although we will incur additional legal expenses until the conclusion of the drop-down and exemptive relief processes, such expenses, which have totaled in excess of $300,000 so far this year, are nonrecurring in nature.

Net investment income for the quarter was approximately $1.4 million, or $0.15 per share, consistent with the $0.15 per share in net investment income we earned in each of the first two quarters of this year. Net unrealized loss of investments totaled $1.1 million for the quarter ended September 30, comprised of $1.5 million in net change and unrealized [depreciation] on non-affiliate investments -- that is, investment assets held in the senior loan fund; and $400,000 in net changing unrealized appreciation on affiliate investments -- that is, our limited partnership investment in the SBIC fund.

Approximately 60%, or $900,000, of the $1.5 million in unrealized depreciation in the senior loan fund related to a decrease in the fair value of our debt investment in Strata Pathology, which remains our only nonaccrual credit. We had net increase in net assets of $400,000, or $0.04 per share, for the three months ended September 30; and we made a $0.34 per-share distribution on October 31.

We estimate the tax characteristics of our distribution to shareholders on Form 10-99 after the end of each fiscal year. However, if the tax characteristics of that distribution were determined for the quarter ended September 30, we estimate that $0.19 per share would've been characterized as a return of capital to shareholders.

As to our liquidity, we had $6.8 million in cash and cash equivalents as well as $49.9 million of borrowing availability on the senior loan funds credit facility at September 30. As of November 4, we had approximately $51.2 million of borrowing capacity. We are currently in negotiations with our lender to extend the reinvestment period on our credit facility, which is set to expire on December 31.

With that, I'll turn the call back over to Glenn.

Thanks, Bob. With respect to the middle market, we continue to see strong demand by companies seeking capital, and we have been successful in keeping the senior loan fund invested. In reference to the smaller end of the middle market -- in other words, the current and prospective clients of the SBIC fund -- demand is particularly vibrant after taking into account the continued but slow expansion of the economy. Further, the SBIC team has been increasing the pace of business development through direct calling efforts as well as expanding its network of like-minded SBIC funds and other BDCs. And we are pleased with the quality and quantity of deal flow within the SBIC fund. Since our IPO, our senior loan fund has remained substantially invested, and we continue to see attractive new opportunities in this asset class.

In summary, our short-term focus is to complete the SBIC drop-down process and accelerate the pace of SBIC fund investing. Our long-term focus is to create shareholder value through quality earnings growth as well as stable, uninterrupted dividends. We look to achieve this through prudent investments that ensure a balanced risk/reward equation, and we will continue to be patient in growing our investment portfolio while remaining focused on preserving capital.

With that, we would be happy to take your questions.

(Operator Instructions) Mickey Schleien, Ladenburg.

Good morning. My question relates to the SBIC. I was hoping you could perhaps describe their origination team and process and also the size of their backlog and pipeline.

Right now, we have a team of about -- we've been hiring a bit lately. So we have four -- we have 11 people devoted completely to the SBIC fund right now, including people coming on board as we speak. As far as the pipeline goes, our meetings that we have on a weekly basis have been extending -- running quite long. I'm sitting with a nice little stack of proposals and term sheets that we've been offering out into the market as far as new transactions. So we've been slowly taking our foot off the brake here as we get closer to the date of the possible approval of the drop-down. Because, as you're aware, Mickey, we will end up doubling the size -- over-doubling the size of the fund, and that would put us in a position to make a little larger commitment to these transactions and put us in a little better shape as far as doing a little larger transaction size with that. But we feel pretty good about the flow of business; I think a lot of that has to do with the fact that we're just pressing harder into the market right now that we're developed a certain amount of confidence related to getting this drop-down buttoned up.

What sort of channels does that team count on to originate business? Is it meetings with business brokers and conferences like that or something else?

Well, it's definitely business brokers and conferences. We try to work our way through most of the major conferences out there. Deal directly with CPA firms. Hired someone specifically on the West Coast who had a small-business investment background; a lot of his work was with mezzanine transactions associated with supporting bank lending activities. So we've gone directly to banks; we've worked with CPA firms, accounting firms, legal firms as far as estate planning goes. Also, we've been also just actually reaching more heavily into our Rolodexes now that we have a much clearer story as to what we can present to people.

Up until today, it's been -- up till now, it's been somewhat unusual to be trying to describe exactly the affiliation between Tamarix and OFS. So we've actually been able to start speaking with a little more clarity to these people. So it's been a lot of the intermediaries, it's been a lot of the guys who have M&A shops with one or two people in it in different cities throughout the country. Some of the smaller towns. It's been more of a direct calling effort. We've also been trying to work directly with companies that we might know. It's a little closer to maybe a private equity business development effort than it would just be in terms of calling it just a sponsor group or whatever. But actually, we do work with a lot of what people now call -- I guess, what do they call them? What do the call sponsors with no money? (multiple speakers) Fundless sponsors. That's so crazy. So we see a lot of guys who don't have a dedicated fund but are out there trying to put together transactions.

Would you be in a position to give us some sense of the trajectory of the SBIC once this is all concluded in terms of the size of the portfolio?

I think -- when I was out on the road show, we were talking in terms of trying to run the SBI fund at roughly $8 million to $10 million a month in originations, giving you $20 million to $30 million a quarter. We are still working toward that number. We're still trying to build the platform in order to deliver that type of business origination activity. So I think that's the run rate we're working toward as of now with the backlog we have. Hopefully, we'll be able to start speaking in future earnings calls specifically to those types of numbers.

Very good. Thanks for your time this morning.

Thanks for your questions.

JT Rogers, Janney Capital.

Thanks for taking my question. I guess, first just on the on balance sheet stuff, was there any fee income in the top line interest income?

No. I mean, it's interest income, and in a [NOID], there's no dividends coming through on that because all of that is in the SBIC fund, JT.

Okay, well, I guess my question was is the topline run rate just for the William Fund? Is that a good run rate? In terms of going forward, is that something we'd expect on the interest income line?

Yes, it's been pretty consistent, JT, over the last three quarters. $4 million to $4.2 million a quarter on the top line.

Okay. Thanks for the detail on the $300,000 of associated legal fees associated with the SBIC drop-down. Question, are there any startup-related SG&A costs that are maybe one-time that might disappear in coming quarters? And then I was wondering if you could -- if you roughly had an idea what kind of -- what percentage of SG&A is fixed and could potentially be leveraged as you grow the portfolio?

There is a certain amount of SOX-compliant expenses, JT, that should recur in much smaller numbers after we get through the first year, since we will be SOX-compliant at the close of this year. For the first half of this year -- well, for the last two quarters, that's totaled about $80,000, and you'll see that running through professional fees.

The SBIC-exempt really has been drop-down stuff we've already talked about. The fixed fees, I think you've seen administrative expenses over the last three quarters in the $180,000 to $200,000 range for the last two quarters, which is down meaningfully from the first quarter, where it was about $280,000. So we feel like we're getting pretty good controls over our SG&A, but we'll give you more clarity over time, JT. Is that helpful?

Yes, that's helpful. And obviously -- I mean, the big item here, I think, is Tamarix, and it sounds like we're getting closer to the finish line there. When is drop-down -- what does the hold size grow to?

Right now, we've been working along the lines of, I think, on average -- I've been kind of thinking hard about going above $5 million. I think once we get the drop-down done, $10 million-ish is definitely not that concerning to us, taking into account our capital base and whatnot. So that's kind of the range we're working in, although we're debating a $15 million investment right now, whether or not that fits properly in there.

And the other judgment we'll be making as we look at the size of holds is whether or not -- what is it? Is it a preferred stock investment? Is it a mezz B sort of -- is it further up in the capital structure, senior debt fees, where even in default situations your capital is pretty well protected? So all of those would enter into a decision as far as size; but on a larger size credit, where senior type credit [activity] is getting close to 10% of equity maybe but not more than that. But I would say our average would still stay a little bit below $10 million in most of the new deals we are working with.

And there's a lot of demand right now out there for transactions, unitranche-type transactions. As we said, we've been trying to work a bit with the other like-minded SBIC funds and BDCs, and we like to share business with them in order to build a diversified book here. But the good thing about that is they always send transactions back your way to take a look at, so it kind of helps keep the flow alive and builds a little more diversification into our portfolio, which we think serves us well.

Okay, great. Thanks. And then just in terms of new deals, I mean, it sounds like you're looking at a number of different options. But I was wondering if you just had sort of a typical deal that you all look at in the lower middle market, sort of what kind of yields are you getting? And then what kind of leverage are we seeing? This could be for the unitranche or for junior debt capital.

Okay. Well, our senior loan fund is very much different than the activities we engage in in the SBIC fund. The senior loan fund -- I think we talked about this in the past, your average size of operating profit, EBITDA, whatever metric you like to use, is $10 million to $20 million range of type of borrowers. A little larger size there. I would think that most of those transactions don't really get much past three times leverage against that number, maybe drift a little bit above it depending on the rates of return we get on that. And that's all usually always floating rate coupon with usually a floor. So that's the senior loan fund size.

On the SBIC fund, I don't think we go much beyond 3.5 times in leverage. Even when we permit -- make a small revolver or a small bank-oriented term loan in front of us, we try to stay above that 3.5 times leverage point against cash flow. And if we do end up going beyond that, you probably will see it likely in the form of maybe a piece of CREF stock or whatever because maybe we believe the rates of return are just high enough where it warrants putting a little bit of paper in there like that.

But our goal is to always build a portfolio of current income-producing assets. First question we have -- and every time I look at the portfolio, I'm always making sure that all of our assets are producing current income in order to -- since we're a dividend-paying vehicle, we need to stay focused on that and not drift too far from that goal. Does that make sense?

Yes, yes absolutely. I guess the question more is -- so, on the income-producing side, what are the typical yields of loans that you're seeing in the market right now? Is it 13% to 15%, 15% to 16%, 10%?

On the senior loan fund side, what we're seeing is the same kind of yield we've been getting, which is in the [7%-ish] range. Kind of look over at other sources, more [broadly] syndicated size of the middle market. That yield seems to be coming out. And the assets that we would think about that are called middle-market and kind of single B rated, the yields on those seem to be 3% to 3.5%, 1% floor. So you're talking 4% to 4.5%. So we don't find those very attractive. We look in there every once in a while, but we never seem to find anything that's interesting.

On the SBIC fund side, we're competing in the range of 11% to 12% in current cash coupons. Maybe 1% to 2% in PIC-type instruments. And then either a direct investment in the equity, depending on how we feel about the play there, for some type of warrant component to that. I think as we mentioned on multiple occasions, we try to work around structuring the unitranche-type deals to obtain a yield in the range of 20% IRR for the fund, but that is kind of just a single data point. We'll take less risk and let that IRR shrink, or we might even take a little more risk and less IRR. But the single data point we use when we start structuring something is usually around why is it not a 20% IRR, or why is it that number, or why is it more or why is it less? But that's kind of a central discussion point when we sit down and think about committing capital to these smaller companies. And these smaller companies will be in the $3 million to $15 million EBITDA range, so much smaller entities, dealing with much different situations at hand. Generally, there is no sponsor involved. Or, as we were saying earlier, a fundless sponsor involved; someone trying to put together a deal. So is that more on point as far as what you are asking?

Yes, absolutely. And then just for clarification, how'd you get from the 12% to 14% current coupon to the 20% IRR? What's the warrant coverage that you would get in a typical deal like this?

It really depends on -- we'll get -- we -- I think our ownership stakes range from 5% up to -- are we in the 40%s on one of them, Bob?

No, in the 20%s in the SBIC. (multiple speakers)

Maybe it's one of the new deals. So we'll be moving into the equity along that whole spectrum depending on what we can negotiate, how much value we're bringing to the situation at hand, the financing opportunity at hand.

Okay, great. And just one last question, if I could. Do you have the weighted average yield of the Tamarix portfolio right now and maybe average leverage?

Not in hand, but the yields are typically between 12% and 16%, including PIC. I think we've got a 12% cash with 4% PIC. So they're in that range. And leverages, as Glenn said, are typically below 3% through that portfolio.

And since it's a private fund, we've still been somewhat sensitive to the other investors as far as the amount of disclosure we want to make to related to that pool. Hopefully, during the next period, we'll be in a position to give you a lot more information, as hopefully as the assets are consolidated onto the balance sheet as we convert this into a drop-down.

Okay. Thanks for taking my questions.

This concludes our question-and-answer session. I would like to turn the conference back over to Glenn Pittson for closing remarks.

Thanks, everyone, for your time. Thanks for all the questions, and then we look forward to speaking to you hopefully with a much different story on our next call. Thanks everybody.

The conference has now concluded. Thank you for attending today's presentation. You may now disconnect.