OFS Capital Corp (OFS) 2015 Q4 法說會逐字稿

Good morning and welcome to the OFS Capital fourth-quarter and full-year 2015 earnings conference call.

(Operator Instructions)

Please note this event is being recorded. I would now like to turn the conference over to Steve Altebrando, Vice President, Investor Relations. Please go ahead.

Good morning everyone and thank you for joining us. With me today is Bilal Rashid, our Chairman and Chief Executive Officer; and Jeff Cerny, our Chief Financial Officer and Treasurer.

Please note that we issued a press release this morning announcing our fourth-quarter and year-end 2015 results. This press release was subsequently filed on Form 8-K with the SEC. Both documents can be obtained under the Investor Relations section of our website at www.OFSCapital.com.

Before we begin, please note that the 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 risks, 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 SEC.

Although we believe theses assumptions are reasonable, any of those assumptions could prove inaccurate, and as result, the forward-looking statements based on those assumptions could also be incorrect. You should not place undue reliance on those forward-looking statements. OFS Capital undertakes no duty to update any forward-looking statements made herein. All forward-looking statements speak only as of the date of this call.

Our comments may reference adjusted net investment income, a non-GAAP measure. Please refer to our earnings press release for a reconciliation. With that, I will turn the call over to our Chairman and Chief Executive Officer, Bilal Rashid.

Thank you Steve. Good morning and welcome. Closing out a successful 2015, we had a particularly strong fourth quarter with adjusted net investment income, a non-GAAP measure, of $0.46 per share, which is significantly more than our $0.34 distribution. This increase in net investment income was due to strong interest income, higher prepayment fees and an acceleration of origination fees. We view income from these types of fees as a recurring part of our business. However, this quarter the fee income was higher than normal.

Overall for 2015, our adjusted net investment income was $1.47 per share compared to our $1.36 per share distribution. Our net asset value increased 2% compared to the third quarter and 4% from the prior year. In the fourth quarter, we realized a gain of approximately $658,000 or $0.07 per share related to our warrant position. This was well above our previously reported fair value. This was the second quarter in 2015 that we had a significant realization on a warrant. The net asset value also increased due to our net investment income being well in excess of our distribution.

In an environment of deteriorating asset values among credit portfolios, we believe that an increase in our net asset value is a real testament to our underwriting standards. We had just one loan on non accrual, representing less than 1% of the portfolio at fair value. As we have mentioned before, we do not have any investments in the oil and gas sector, which has been a major source of deterioration in net asset value of other credit portfolios.

As you are aware, the broader credit and equity markets have been volatile over the last several quarters. So far, the lower middle market has been relatively insulated from this volatility. We will continue to focus on the lower middle market, especially the non-sponsor part of the market, an area we have been focusing on due to its strong risk adjusted returns and relative stability. In addition, we are carefully observing the broader loan market and are well positioned to take advantage of the dislocation in that market due to our external manager's broad investment platform. We believe we hold a competitive advantage due to the strength of our external manager, which has a $1.7 billion credit platform. Our manager has weathered multiple credit cycles since its founding in 1994, and our team has the size and breadth of expertise across all parts of the leveraged loan market. This provides us with considerable economic and capital markets intelligence in addition to expertise across industries.

Through the first two months of 2016, the base of deployment of capital has been relatively slow as we carefully consider new investments, leaving us with considerable dry powder. Our significant investment capacity and the strength of our balance sheet puts us in a strong position to take advantage of the growing number of investment opportunities in the market. As always, we will only invest where we see the best risk adjusted returns. Because of our building cash position, we would expect first-quarter net investment income to be lower compared to the fourth quarter. We believe being patient in the short-term will create greater value for shareholders in the medium to long-term.

Continuing into 2016, we intend to maintain our focus on our core tenets. One, maintaining our strict underwriting standards. This has resulted in low non-accruals and an avoidance of portfolio companies in the highly cyclical oil and gas sector. Two, being responsive to our borrowers' needs by providing flexible capital solutions. This has led to repeat business, a reputation as a reliable partner and good quality deal flow. Three, always focusing on the best risk adjusted returns for the longer term instead of short-term gains. Being a long-term shareholder with 30% ownership, the external manger's interests are aligned with those of the other shareholders.

As the last several quarters have shown, we have been rewarded for being thoughtful and deliberate in the investments we make. We have also been rewarded for our expertise in the non-sponsor part of the lower middle market. Our seasoned team has long-standing sourcing relationships, allowing us to see a broad array of potential transactions and to be highly selective in making investments. Our portfolio benefits from the heavy emphasis our investment team places on companies with strong management teams, high barriers to entry, and strong free cash flow characteristics.

Looking ahead, our portfolio is positioned to benefit from a meaningful increase in interest rates. A majority of our loan assets are floating rate while our debt is 100% fixed rate. We have $150 million in fixed rate SBA debentures with our rated average interest rate of 3.18%. We have no maturities until 2022.

At a time when capital may be constrained for others, we are in the fortunate position of having significant capital resources in an increasingly favorable investment environment. As of year-end, we had several potential sources of available capital. Number one, we had $32.7 million in cash. Number two, we had $24.6 million invested in the senior club loan portfolio that can be redeployed in higher-yielding investments. Number three, we have ability to raise additional capital in the bank loan or the bond market. As a reminder, SBIC debt does not count towards the BDC leverage test, so we have not tapped any of our available statutory leverage. Lastly, our second SBIC license was submitted last year. If approved, we would have access to additional capital in SBA debentures. We don't have an update regarding its timing and status, but we continue to have an ongoing dialogue with SBA as our portfolio continues to perform.

Going forward, our primary focus remains the same: to generate long-term value for our shareholders through strong current cash flows and stability in the long-term value of our portfolio. As we have done so far, we will continue to finance the company in a thoughtful manner. We will only raise additional capital if it is accretive. As a 30% owner of the Company, the interest of our external manager are aligned with those of our shareholders. At this point, I will turn the call over to our Chief Financial Officer, Jeff Cerny, who will provide more details on the financials.

Thank you, Bilal. We're very happy with our fourth-quarter results, and we continue to focus on enhancing our yield and net investment income. We have 23% of our net asset value in cash, giving us flexibility in a tough capital raising environment.

As Bilal mentioned, we continue to focus on optimizing our capital base with higher-yielding lower middle market loans as we believe the relative value opportunity remains strong in this market. This strategy helped to maintain our net investment income above our distribution for the quarter. Due to macro issues and widening spreads over last several months, we believe other areas of the loan market are beginning to offer attractive relative value opportunities, and we continue to look at those opportunities.

This quarter we had 39 companies in our investment portfolio totaling $257.2 million on a fair value basis equating to 102% of cost. The debt portfolio is at 98.9% and the equity portfolio is at 130% of cost. Our fair value marks this quarter declined overall for the loan portfolio, largely due to widening credit spreads, while the equity portfolio increased in fair value. As a percentage of fair value, our investments were approximately 62% senior secured loans, 25% subordinated debt and 13% equity. As a percentage of cost, our equity investments are just under 10%.

Our average investment in each portfolio company was $6.6 million at fair value or 2.6% of the total portfolio. The overall weighted average yield to fair value on our debt investments continues to move in a positive direction. It increased 19 basis points since last quarter to 12%.

At the end of the quarter, 59% of our loan portfolio consisted of floating rate coupons. All of our floating rate loans have LIBOR floors. Non-accruals consist of a single loan, Phoenix Brands, with a fair value of only $798,000. This loan went on non accrual during the third quarter of 2015.

As far as deal activity in the fourth quarter, we closed five transactions in new portfolio companies with an aggregate invested amount of $42.8 million. These investments included senior secured loans and equity investments.

We derived approximately $8.9 million in total investment income in the fourth quarter compared to $7.7 million last quarter. This quarter-over-quarter increase was largely due to the 19 basis point increase in the weighted average yield to fair value which I previously mentioned and increased acceleration of original issued discount and prepayment fees due to several investments paying off.

Expenses totaled $4.6 million for the quarter compared with $4.1 million for the prior quarter. The $500,000 increase in expenses was largely driven by an increase in incentive fee expense due to higher net investment income and increasing administrative fees and an increase in interest expense due to $22.6 million an outstanding SBA debentures that were pooled in late September.

Net investment income for the fourth quarter was approximately $4.3 million or $0.44 per share, which exceeds our prior-quarter net investment income of $0.38 per share. On an adjusted basis, which is a non-GAAP measure, fourth-quarter net investment income was $0.46 per share. As Bilal previously mentioned, we more than fully covered our distribution this quarter with net investment income.

We still have capacity to invest with approximately $33 million of cash as well as $22 million remaining in lower yielding assets. We have made good progress in deploying capital and optimizing our portfolio, and we will continue to prudently deploy capital and generate liquidity on a timeline that allows us to maximize our interest income. We intend to sell lower-yielding assets or otherwise raise capital when we believe it is accretive and can be deployed in a timely manner. With that, I will turn the call back over to Bilal.

Thank you Jeff. To summarize, our strong 2015 results demonstrate the strength of our investment platform and our increased brand awareness among borrowers. The recent stress in the credit markets and the deterioration of fundamentals in certain sectors of the economy have brought to fore the strength of our underwriting capabilities and the long-term alignment of interest between the BDC and our external manager. Our external manager has extensive experience working through multiple credit cycles and in all parts of the leverage loan market. We have strong value added origination capabilities.

Our focus and our strength has been the lower middle market, especially the non-sponsored transactions where we continue to find attractive risk adjusted returns compared to other parts of the middle market. Our teams' underwriting expertise and sourcing relationships have allowed us to successfully participate in that part of the middle market.

We have attractive long-term fixed rate financing through the SBIC program that positions us well for an expected increase in interest rates. Finally, in a sector that has seen other participants struggling to raise capital, we have sufficient capital available to take advantage of growing opportunities in the market. Despite the recent challenges in the credit markets, our net asset value has increased 4% from the prior year. We think that this is a credit to our methodical and time-tested underwriting process, patience and long-term thinking.

OFS Capital remains committed to providing long-term value to all of its stakeholders including both shareholders and borrowers. As a lender, we remain focused on being responsive to the needs of our borrowers and providing them flexible capital solutions. With that, operator, please open the call for questions.

Thank you. We will now begin the question and answer session.

(Operator Instructions)

Our first question is from Mickey Schleien from Ladenburg.

Good morning, Bilal, and congratulations on an excellent quarter. Bilal, could you perhaps remind us how the BDC works with the rest of the OFS platform? Not just the credit business, but the overall platform in terms of originating deals and how that differentiates you from other BDCs?

Sure. That's a good question and thank you for your compliment earlier. So, as we mentioned, OFS itself has $1.7 billion of assets under management, and the external manager is focused on corporate credit, specifically leveraged loans. So the size and scale of OFS itself is much larger then the BDC itself. The BDC has about $300 million of assets and benefits from that broader platform.

In addition to that, OFS is actually -- the manager itself is part of a much larger group of affiliated managers that include managers that focus on real estate private equity, infrastructure private equity, the corporate private equity platform. And so, OFS really benefits from being part of a much larger group of affiliated managers.

We benefit from the legal compliance, HR, IR, technology infrastructure, certainly capital markets activity. So we get the attention from outside parties like banks, and other capital providers, which is much greater than the size of OFS by itself.

So from that standpoint, I think OFS Capital, when you look at it as a $300 million BDC, it benefits greatly from OFS Capital Management, the external manager that manages credit assets of about $1.7 billion, which is -- the way we benefit there is that we have -- we invest in other parts of the lower market, syndicated part of the lower market. Separately we have strong industry expertise there, especially in this environment where we have seen turmoil in that sector. We got a lot of intelligence as to what is happening in the broader credit markets that I mentioned.

We have strong industry knowledge there and expertise. So that's one thing there, and just reiterating the fact that we're part of a much broader affiliated -- we're part of a much broader group of affiliated managers that benefit from each other in terms of just shared infrastructure, but also shared knowledge and expertise and intelligence that we get from the market.

Thank you for that, Bilal. That is really helpful. I wanted to ask just a couple more questions. Your base management fee is 1.75% We have seen some other BDCs lower their fees to 1.5%. Look back seems to be coming commonplace and best in class. Is management discussing with the board a revision of the external management agreement to bring it more in line with some other -- the newer structures?

Well I think the -- some of the guys out there who are reducing their management fees, certainly may be doing -- I'm not an expert in -- on that side. But because they are having some pressure in terms of earning their dividends because of some pressure on their spread income, and there may be some non-accruals arising there and assets that generated income may be going down.

In our case, as you've seen, we been earning a dividend now for the last several quarters, this quarter certainly. We covered the dividend by a huge margin. And so, we -- what I would say it changes for the investment management fee is not front and center because we haven't felt that pressure. But certainly, we always evaluate what is going on in the market. And we continue to discuss that internally here among ourselves, but also with the board.

All right. My last question is just housekeeping, when can we expect you to file the 10-K?

Yes, we would expect to file that early next week.

Okay. Thanks for your time this morning. I appreciate it.

Definitely. Thanks.

Our next question is from Terry Ma of Barclays. Please go ahead.

Hey guys. You guys mentioned that the first two months of 2016, you saw slower originations. Can you maybe just contextualize that a little bit, whether or not it is from lower deal flow or are you guys being a little more selective because you're seeing riskier structures and whatnot?

Yes, I mean I would say Q1 generally is a slower quarter. Certainly when we started the quarter, January was a slow month, and we started seeing some good deal flow coming to us towards the middle to end of February. And as you know, these deals take some time to actually close. So some of that deal flow will go into the second quarter. So I think the deal flow was slow. And I think generally we've seen that right after the new year, you have people coming back and getting back into the groove of things. So it's sometimes related to that, the slowness of the deal flow.

And we are always cautious in terms of underwriting, and I think as you look at our NAV and look at the performance, you look at the fact that our non-accruals are so low and we don't have any investments in the oil and gas sector, I think that's a testament to that. I would say we are being a little more cautious than usual. So certainly, we are keeping everything in mind here as we move through these current markets.

All right. Got it. And if I just think about your NAV walk from quarter to quarter, you guys had the $0.07 benefit from a warrant position, out earned your dividend by about $0.10. There's probably another $0.06 or $0.07 with accounting for that difference?

Well, we did have a slight decline in the loan portfolio as I mentioned, but our equity portfolio performed quite well. We had an unrealized gain on an asset called Health Fusion and as well as, another realized gain and then earnings from the quarter.

Okay. What is actually driving the markups on the equity positions?

What you're going to see is about realized and unrealized equity increase of almost $3 million, and the majority of that is of public knowledge and has since been realized. So we had an offer on one of the companies, and that has since closed. It was purchased by a public company.

Got it. And can you just quantify how much the loan book was marked down?

On an apples to apples -- it's always tough to come up with this number, but the asset side existed at 9/30 versus the assets that still exist at 12/31, it was about a half a percent.

Got it. And on the $1.3 million of fee income, was that all from prepayments and acceleration of OID? And how should we think about that going forward?

You said $1.3 million of -- say it again.

The $1.3 million of fee income.

That, as Bilal mentioned, that was a little higher than normal this quarter, but it is a recurring part of our business. If deals repay, most of our deals have prepayment fees. We recognize closing fees. We have OID acceleration when something pays off. It is a little bit higher this quarter than normal, but it is a recurring portion of our ongoing business.

Okay, got it. Was there anything one time in the interest income line of $7.6 million?

Let me -- no. No, I don't think so.

Okay. Got it. That's it for me. Thanks.

Thanks Terry.

Our next question is from Matthew Howlett from UBS. Please go ahead.

Hey guys. Congrats and thanks for taking my question. Bilal, when you look at optimizing the balance sheet, I know you have cash and you have the floating rate liquid portfolio.

But you have a lot of options, you could go tap the bank lending side, I guess you could tap the baby bond market or another form of financing. Could you walk us through what you're thinking about permanent financing in place and what do you think is open or will be open to you in the next 6 to 12 months?

Yes. I think that's a good question, Matt. So I mean, we certainly, as we said we have a decent amount of capital and dry powder available here. So we first will obviously rely on that.

As a relates to permanent financing, you certainly as we mentioned, we have the bank loan market available to us. And so that's one option. We have very good relationships with all the major banks that provide that financing. And as I mentioned, we are part of a much larger affiliated platform here, so that gives us access to some good bank financing. So we are definitely evaluating that.

The second piece of the bank -- is the baby bond market, and that is certainly available as well to us. The way I compare these two is that the bank loan market is a market where you are getting shorter-term financing, when you're talking about four- or five-year financing. It secured, it has covenants, and it has some criteria or investment criteria that you have to follow. So there is some operating inflexibility there. But it is cheaper. You're talking more about LIBOR plus 350 type or range, maybe 375 or 325 range. So it is cheaper, but it has less flexibility. It shorter-term compared to the baby bond market and has covenants.

So, then you compare that to the bond market, which is longer term, it's unsecured, there are really no major covenants there, and it's -- it gives you the ultimate flexibility in terms of what types of assets you can put in there. But it is expensive. You're talking about high fixed [100] or high 6% to low 7% range. And that depends on it being a five-year bond, seven-year bond, ten-year bond, et cetera So it is more expensive, but you're able to put assets in there with a lot more flexibility. Perhaps you can make up for the increased cost by putting assets that are high-yielding there.

So that's something we are evaluating and constantly evaluate. And again on that side, we have very strong relationships with investment banks and banks like yourselves as well where we can certainly use one of those to tap that market if we decide to do that.

And then really, the third option obviously is the SBIC license. We have applied for that. As you know, we applied for it about a year ago. That process is still ongoing. As we said, we don't have an update on timing of that if we are able to receive that. But that's a third option that could be available to us if we are approved by the SBA.

Right now I feel really good about the amount of capital we have, and I feel really good about the opportunities we have in the market. And beyond that, when we need to raise capital, we have several options that we can avail ourselves of. As you mentioned earlier on, and you know that the SBIC leverage that we currently have does not count toward the leverage test. So for us to raise additional capital, if we have to, we can tap the debt market as opposed to doing any dilutive equity offering.

Yes exactly, and that was my next question just on the flexibility you have. You can fully fund the existing SBIC with cash and liquid securities and loans you have, and perhaps you can fund a second one. I wanted to ask you on what is going to through Congress right now to go up to [$350 million] in debt potentially. I mean, a lot of this we would again -- a lot of this stuff can be done without tapping the equity market. I'm assuming you wouldn't have any interest in doing that below your NAV at this point.

Yes, I think that's correct. We don't have any interest in doing dilutive equity offerings. As you know, the external manager owns more than 30% of the outstanding shares. So there is clear alignment of interest there between the manager and the shareholders.

So I think we will -- I think we are in a lucky position of one, having a decent amount of capital already, but then when we have to go and raise capital, we can do it in the debt markets as opposed to doing equity offerings. I feel very good about that.

Great. I was -- I guess to follow up on the dividend policy. I know the board meets, clearly you have a lot of room -- things going well -- to increase that. I mean how, with trading this much below NAV, how important is it to increase it [to pass]? It seems like you're not getting credit certainly for your balance sheet or your diversification or performance relative to the group, which is trading below NAV. So what's the thinking around increasing the dividend, at this point?

We certainly have an ongoing dialogue with the board about that. But, we haven't really made any definitive decision on that front. But certainly think about it and consider it on an ongoing basis.

Great. Thanks, Bilal. I really appreciate it.

Thanks, Matt.

(Operator Instructions)

I'm showing no additional questions. This concludes our question and answer session. I'd like to turn the conference back over to Bilal Rashid for any closing remarks.

Thank you all for joining the call today and for your questions. We look forward to speaking with everyone again on our next call. Operator, you may now end the call. Thank you.

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