OFS Capital Corp (OFS) 2014 Q1 法說會逐字稿

Good morning, and welcome to OFS Capital Corporation's First Quarter 2014 Earnings Call. It is my pleasure to turn the call over to Ms. Mary Jensen, VP of IR. Ms. Jensen, you may begin.

Thank you. Good morning, everyone, and thank you for joining us. With me today is Glenn Pittson, our CEO, and Bob Palmer, our CFO. Please note, our earnings announcement was released this morning and can be accessed via the IR section of our website at ofscapital.com. We will plan on filing our 10-Q 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, 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. The uncertainties and other factors are in some 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 as of the date of this call.

A replay of this call will be available until May 30 beginning approximately two hours after we conclude this morning. Alternatively, the webcast will be available for the next 30 days. To access either replay, please visit our website at ofscapital.com.

With that, I will turn the call over to Glenn.

Thanks, Mary. Good morning, and welcome to our quarterly earnings call. During our call, we'll be addressing three main topics - first, the reduction of our management fee, second, our dividend, and third, investment expectations for the balance of 2014.

As we described over time, the process of completing the acquisition of our drop-down SBIC Fund took longer than we would have liked. This delay hampered our ability to fully implement our business plan, mainly in terms of being able to leverage the potential of the SBIC Fund. This vehicle is a critical driver of profitability for OFS Capital, both through the capacity to fund investments, which are expected to generate double-digit returns on average, as well as access to favorable financing.

After assessing the impact of this protracted delay on our shareholders, the investment advisor unilaterally decided to reduce the base management fee by two-thirds for the remainder of 2014. The net result of this reduction is a halving of the base management fee for all of 2014 from 1.75% back to .875%.

At the time we went public, the investment advisor agreed to lower the base management fee by 50% for approximately one year. Its purpose was to ease the burden of management fees on the earnings of the Company while we worked toward adding higher yielding investments to the portfolio. A guiding principle of our investment advisor is that a manager should never profit from its investors. The manager should always profit alongside of its investors. As you may also be aware, the advisor is controlled by the largest shareholder of OFS Capital, which owns more than 30% of our outstanding shares. This unilateral action to cut the base management fee is being taken to reaffirm the alignment of interest among all stakeholders and demonstrates confidence in our ability to deliver superior returns over the long-term by providing capital to middle-market companies across the United States.

All of the pieces are in place to put our capital to work and direct investment opportunities. On our last earnings call, we mentioned our target run rate of about $10 million per month in SBIC Investments, and so far this quarter we are at pace and remain confident that we will continue to do so over the long-term. As we announced this morning in our earnings release, OFS Capital's Board of Directors approved a $0.34 distribution for the second quarter, payable on June 30 to shareholders of record as of June 16. Last year, our second distribution was paid on April 30, 2013. I am calling this out as it is a change from the schedule we followed last year. It is our expectation to continue to make future distributions at the end of each calendar quarter, consistent with other BDCs.

Now, before providing some color about our backlog, I'll turn the presentation over to our CFO, Bob Palmer.

Thanks, Glenn. Our investment portfolio totaled $228 million on a fair value basis as of March 31, equating to 97.9% of cost. The portfolio was comprised of 56 companies, 47 in the Senior Loan Fund and nine in the SBIC Fund. At quarter-end, our investments were comprised of senior secured debt investments and 54 borrowers, with an aggregate fair value of $210.9 million, subordinated debt investments in two borrowers with an aggregate fair value of $9 million, and equity interest in eight of the SBIC Fund's nine portfolio companies, which had an aggregate fair value of $8.1 million.

At March 31, the 56 companies in our portfolio were diversified across 18 industries. Our largest portfolio company investment accounted for 6.5% of the aggregate fair value of our investment portfolio at March 31, and investments in our five largest names accounted for just under 19% of the portfolio's total fair value. Our average portfolio company loan size was approximately $4.1 million at March 31, and the weighted average yield to fair value on our debt investments was 8.35%, including 6.89% on debt investments in our Senior Loan Fund and 13.23% on debt investments in the SBIC fund. The 8.35% overall figure compares with 8.53% as of December 31, 2013. A number of our portfolio companies completed credit agreement amendments in the first quarter of this year that involved reductions in pricing. We are seeing that trend continue thus far in the second quarter. The leverage loan market remains competitive, including in the middle and lower middle market segments in which we participate.

Floating rate loans comprised 84% of our loan portfolio at the end of the first quarter of 2014 as all of the loans in the Senior Loan Fund are at floating rates while seven of the nine loans in the SBIC Fund carried fixed rates. All of our floating rate loans contain LIBOR floors.

We had one non-accrual at March 31, our debt investment in Strata Pathology, which had a fair value of $1 million and which has been on non-accrual since the first quarter of 2013. In the quarter, we closed a senior secured debt investment in one new portfolio company with a face amount of $3 million, and we made a $.8 million add-on loan in an existing portfolio company. We made both of those investments through our SBIC Fund. Thus far in the second quarter, we've closed two debt investments, both through the SBIC Fund, with an aggregate principal balance of $13 million.

We derived approximately $5 million in total investment income from our portfolio in the first quarter of this year compared with $4.5 million in the fourth quarter of 2013. Approximately $3.3 million of this quarter's total was derived from our senior loan fund, while $1.7 million came from our SBIC Fund. Expenses totaled $3.6 million for the three months ended March 31 compared with $3.1 million for the prior quarter. Included in the $3.6 million in first quarter expenses were approximately $1.3 million in management fees, which included $0.2 million to MCF Capital Management for its role with respect to the Senior Loan Fund and $1 million in base management fees to our investment advisor.

As Glenn discussed a few minutes ago, earlier this week, our investment advisor reduced the effective base management fee from 1.75% to 0.875% for fiscal year 2014. The $1 million in base management fees in the first quarter were calculated on an annual rate of 1.75%. In order to achieve the reduced effective base management fee rate of 0.875% for the entire fiscal year 2014, the base management fee for the remaining three quarters will be approximately 15 basis points per quarter.

Net investment income for the first quarter was approximately $1.4 million, or $0.15 per share, compared with just under $1.4 million, or $0.14 per share in the fourth quarter of 2013. During the first quarter, we recorded $0.7 million in net unrealized gain in investments comprised of $0.9 million of unrealized gain on non-control, non-affiliated investments, $0.5 million in unrealized gain on affiliate investments, and $0.8 million of unrealized loss on our control investment in Tangible Software Inc. For the three months ended March 31, we had net increase in net assets of $2.1 million, or $0.21 per share, compared with $1.2 million, or $0.12 per share in the three months ended December 31, 2013.

With respect to liquidity, we had $37 million in cash and cash equivalents as well as $14.7 million in borrowing availability on the Senior Loan Fund's credit facility at March 31. As of May 7, we had $21.7 million in cash, including $18.9 million in the SBIC Fund and $15.4 million in borrowing availability on the Senior Loan Fund's credit facility. At this time, the SBIC Fund has leverage commitments of $61.4 million from the SBA and $26 million of outstanding SBA guaranteed debentures, leaving incremental borrowing capacity of $35.4 million under SBIC regulations. Between its $18.9 million in cash and the $35.4 million in borrowing capacity, the SBIC Fund currently has approximately $54.3 million with which to make investments.

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

Thanks, Bob. Our investment pipeline is beginning to show real results, and we are encouraged by our present backlog that includes nine potential investments totaling $87 million. The definition of backlog is investment opportunities where, in my opinion, there is a greater than 50% chance of closing. The backlog includes add-on investments, balance sheet refinancings, change of control transactions, and dividend recapitalizations. We are working with private equity firms, independent sponsors, and management owners. I am very pleased with the investment opportunities being generated by our expanded team and the diverse sourcing of these transactions.

Looking ahead, our plan is to complete the necessary steps to fully capitalize the SBIC Fund, which should provide us with access to the full $150 million in SBA guaranteed debentures. We believe we are well positioned, going forward, and have a strong investment team that is delivering attractive underwriting opportunities.

With that, Operator, you can now open the phone lines for questions.

(Operator instructions.) JT Rogers from Janney Capital Markets.

Hey, good morning, guys, thanks for taking my question. First question, just on the operating expense line, saw that went up by -- or specifically the administrative expense line that went up by $200,000 associated with an increase in salaries and bonus accrual. [Just] wondering if that is a one-time or a seasonal event, or if $475,000 is a new run rate for administrative expenses.

Hey, JT, thanks. That is seasonal, one time a year, and what it reflects, JT, is the bonus payments that happen in the spring of the year for employees whose time is allocated under the services agreement.

Okay. and then, I think last quarter [you] talked about there being -- in the fourth quarter there was $200,000 of legal and accounting expenses related to the SBIC drop-down, and some of that would be going away in the first quarter. It didn't look like there was a significant drop in the professional fees. Just wondering if -- what's the run rate on professional fees, if there was another sort of one-time issue in that line item.

There were some one-time line items. There were carryover expenses relating to the drop-down that was completed in January. We consummated and paid the money in December, and there were legal and accounting expenses related to that that carried through into the first quarter. We do expect to be discussing meaningful reductions in the professional fees, going forward.

Can you quantify that? Is that $50,000, $500,000, just try to get a range of the magnitude?

My expectation is that it should approach $100,000.

In savings?

In savings.

Okay, great. And then, it looked like there was a big decline in the fair value of Tangible. Just wondering what's going on there and what your all's view is to the forward outlook for that company.

Sure. JT, it's a government contractor. And as you may be aware, a number of the government contractors have experienced headwinds of late. And we're in active discussions with the company and its backers. We're not in a position at this point to give you more color on that, but we hope to be able to do so in the relatively near-term future.

And just -- obviously in discussions, but just looking at Sub, if I do my math right, sort of a mark at about a 30% discount to par. Would that indicate the potential for this company moving to non-accrual?

There's always that potential. All payments are current with that name, and there was a meaningful excess cash flow payment made during the first quarter.

Okay, great. And then, just looking into (inaudible) a little bit, I think you all said that you were close to receiving the final capital certificate from the SBA. I assume you all have received that?

Still going through it with them, JT.

Okay. All right. It looks like the backlog is good. I think you mentioned there is some pressure on margins. But, in terms of that, Glenn, I think you said it was an $87 million backlog. What's sort of the yield on that piece of the -- on that backlog, and maybe what are the IRRs expected from those investments?

I won't address IRRs, because it's a blend of -- on average, I mean, because there's a blend of equity investments and whatnot in there, so it's hard to really make a public statement on that. But, if you look at the investments -- the actual coupons on those investments, we're probably close to 11% in cash yields on those, probably closer to 3% in [PIC] on average out of that $87 million for all of the interest-bearing securities we're looking at. So, that kind of brings us into a 13% to 14% yield on those types of investments. There are $5 million-ish of potential equity investments that we're looking at, an add-on and a new transaction. So, a nice blend of deals, certainly a good mix of senior and second lien transactions, uni-tranche type deals. But, I think the coupon, as I mentioned, is looking like it's at 10.8 cash yield, 3.1 in the PIC side on the interest-bearing securities that we have, (inaudible).

Okay, great. Thanks a lot, Glenn. I'll get back in the queue.

And the only other statement I'd make on that is all these term sheets are evolving, which makes me confident that we're continuing to negotiate through them. But, that's how the Group seems to be building.

Okay, great. Thank you.

[Terry May] from Barclays.

Hey, thanks for taking my questions. Can you maybe just talk at a high level about how you go and source deals for your investment pipeline for the SBIC Fund?

We have a direct marketing group. We've built that out over time. The SBIC team, the principals that came on board had an existing program. We've augmented that with incremental hires, and we've been expanding that. It's basically a broad, direct marketing process, but we also work through intermediaries. We're not -- and we also try to diversify that with working with partners in the BDC space in the SBIC Funds. So, we have some material relationships with other parties in the markets. We try to get a blend of transactions out of the market, both direct and working with other people. Some of our direct transactions, we try to share with our partners, the other BDCs and the SBIC Funds.

So, we try to hit as many places as possible in order to generate as big a volume of looks as possible in order that we can make good quality decisions on investment opportunities. The one thing I would mention is that we do meet weekly, Mondays, and review our pipeline report, which is much larger than this backlog I spoke about, and I've been quite pleased about the number of looks we have and how large that report is at this current time. Our meetings used to take -- let's say a year ago maybe 30 minutes to get through everything. It's taking us an hour and a half to look at these deals, start to work through them and determine which ones we want to put resources against.

Sounds good. That's great. Obviously it's going to be lumpy from quarter to quarter. I think you guys said you closed one investment so far. But, how confident are you that you can maintain this $10 million a month run rate?

That's why I took the time to kind of break this down and give you that $87 million number, because I sat down and took a really good look at what we had out there in the market. Now, when that $87 million closes, I just couldn't tell you, but it looks like that's within a three-month time horizon. A couple could be done in the next several weeks, so it's -- but a lot of these transactions are direct investments working with management teams that don't close these types of deals. It's just not what they do. They actually manage companies, so those take a little bit longer. And a couple of transactions in my backlog are actually deals that are fairly well baked that we're working with other SBIC Funds and BDC Funds, and accordingly, those may come in a little bit quicker.

So, as I tried to illustrate in the earnings call, in our scripted remarks, I feel good about the blend there. I think this portfolio hopefully will be coming in [at] a fairly consistent basis over the coming months.

And just to clarify, Terry, we had one new investment and one add-on in the first quarter, and two so far this quarter.

Okay, got it. Thanks a lot.

Chris Kotowski from Oppenheimer.

Yes, good morning. Obviously we'll readjust our model for the fee waivers and all that, but even with that, it just doesn't seem likely that the net investment income would cover the dividend any time soon. And I wonder, what is the philosophy or thought about maintaining a dividend that's so far above the base level of earnings? Do you have a thought on how long that continues, or whether that's a desirable state? I guess just what's the philosophy of having such a gap between the dividend and the actual investment income?

Well, in our prepared remarks, we described in detail how we're seeing improvement in the pipeline and the greater diversity in sourcing. We're also confident in our ability to translate these opportunity into transactions that will -- it'll enhance our ability to fully cover our distributions and grow the Company.

Now, doing some quick math on this backlog of transactions, trying to translate it into some kind of EPS number, it could have the impact of $87 million of transactions along the parameters that I described to you, could easily double our run rate in earnings, I mean, if you just simply do the math. So, we've took a good look at the beginning of this year [at] where we are, what happened and why it happened, and it led us to the conclusion that, at this point, we shouldn't be burdening the shareholders with a cut in the dividend, that the managers should be bearing that expense in order to create enough room for us to build this dividend.

It really -- with the team we have in place, we really don't need a lot of transactions to create the level of income and to create the level of run rate to bring the earnings up to support the dividend substantially. So, right now, our job is just to work and get these investments done and producing some real income. There are no excuses at this point [in any] time. Everything's in place, and I feel really confident that we're going to be able to pick up that pace of earnings.

Okay, thank you.

But, Chris, the one thing I would tell you is our absolute priority is to make sure we fully fund the SBIC equity portion of the capital structure in order that we can access the full leverage right now. So, everything we will do will probably be driven, to a large extent, by whether or not that becomes at risk by following the continuing dividend policy.

Okay. And funding the SBIC, I mean, do you use liquidity from the senior portfolio, or do you draw down the credit facilities you have? How do you do that?

Well, we physically have cash in the SBIC Fund right now, which we've talked about in the course of the dividend, and then the balance of that would always be used, either a mixture of cash out of earnings, hopefully [will be], but to a large extent we'd be relying on the availability under our line of credit with Wells Fargo.

Okay, great. Thanks.

This will conclude our question and answer session. I would like to turn the conference back over to Mr. Glenn Pittson for any closing remarks.

I appreciate everyone taking the time to sit in on the call, look forward to talking at length about what occurs with this backlog in the next earnings call. Thanks for all your time, and we'll be talking to you in a month.

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