OFS Capital Corp (OFS) 2021 Q4 法說會逐字稿

Good morning, and welcome to the OFS Capital Corporation Q4 and Full Year 2021 Earnings Call. (Operator Instructions) Please note, this event is being recorded.

I would now like to turn the conference over to Steve Altebrando, VP of Capital Markets. Please go ahead.

Good morning, everyone, and thank you for joining us. Also on the call today is Bilal Rashid, Chairman and Chief Executive Officer of OFS Capital; and Jeff Cerny, the company's Chief Financial Officer and Treasurer.

Please note that we issued a press release this morning announcing our fourth quarter and fiscal year 2021 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 ofscapital.com.

Before we begin, please note that statements made on this call and webcast may constitute forward-looking statements as defined under applicable securities laws. Such statements reflect various assumptions, expectations and opinions by OFS Capital management 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 way beyond management's control, including the risk factors described from time to time in our filings with the SEC. Although we believe these assumptions are reasonable, any of those assumptions could prove 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.

Also during this call, we will be referring to non-GAAP financial measures. These non-GAAP measures are not prepared in accordance with generally accepted accounting principles. A reconciliation of the non-GAAP financial measures to the most directly comparable GAAP measures is available in the Investor Relations section of our website under the heading, Tax and Non-GAAP Information.

With that, I'll turn the call over to Chairman and Chief Executive Officer, Bilal Rashid.

Thank you, Steve. Good morning. I hope everyone is doing well. This morning, we are pleased to report an exceptionally strong quarter.

Some key takeaways. Our net asset value increased 7.2% from the third quarter to $15.18, a historical high for the company. This represents a 22% increase in our net asset value compared to its pre-pandemic level at the end of 2019. We increased our quarterly distribution to $0.28 per share, marking the sixth consecutive increase in our quarterly distribution. Net investment income was $0.33 per share compared to $0.24 per share for the third quarter. Adjusted net investment income was $0.47 per share, an increase of more than 41% compared to the third quarter. This also represents a historical high for the company.

We had no new loans on nonaccrual in the quarter. In fact, we have not placed any loans on nonaccrual for 6 consecutive quarters. We deployed $61.6 million in new portfolio companies and made $13.8 million in add-on investments with existing portfolio companies. The increase in our net asset value was primarily driven by improvements in the performance of our debt investments and strong gains on our equity investments.

One of our equity investments, TTG had a gross realized gain of $5.8 million, which was over 3.5x our initial equity investment. Our senior secured loan in this health care services and equipment company paid off at par as the company was sold in December. Also on prior calls, we have discussed our equity investment in Pfanstiehl, a global manufacturer of high-purity pharmaceutical ingredients. That investment continues to perform well and paid a significant cash dividend last quarter. While we primarily invest in senior secured loans, being able to make equity investments when we identify a strong opportunity like this helps us to maximize value for our shareholders.

Since our IPO, we have invested $39 million in the equity or received warrants in more than 38 portfolio companies. Today, we have net realized gains of approximately $23 million, which equates to a 1.95x multiple on invested capital. As of December 31, our net unrealized gain is approximately $55.4 million on the remaining invested capital of $15.1 million which equates to a 4.7x multiple. We believe that these metrics demonstrate the strength of our investment process.

An important factor in the growth of our net investment income is the reduction in cost of our debt. As you know, we refinanced $178 million of our bond debt last year at considerably lower rates, which are locked in until 2026 and beyond.

In terms of originations, the fourth quarter was one of our most active quarters ever. We made $75.4 million in investments, a 16.6% increase from the third quarter. For all of 2021, we invested a total of $269 million in new and existing portfolio companies, which is significantly higher than the $128 million invested in 2020 and $222 million invested in 2019 before the pandemic.

Even with this increase in origination activity, we remain highly selective. We believe that our disciplined approach before and during the pandemic, along with the strength of our balance sheet, has enabled us to deliver strong performance. We have relied on our long-standing investment process and the dedicated and experienced team of our adviser. As market conditions change, we continue to believe that we will benefit from this experience, which spans multiple asset classes and industries. Today, our adviser manages $3 billion across the loan and structured credit markets and has worked through multiple credit cycles and global economic disruptions over the past 25 years.

In this uncertain economic environment, which has been impacted by the effects of rising interest rates, inflation and geopolitics, we believe that we continue to be well-positioned, both in terms of our portfolio as well as our liabilities. We have been fundamentally focused on preserving capital while also thoughtfully growing our earnings. We believe that our portfolio remains defensively positioned both in terms of seniority in the capital structure and industry selection. As a percentage of fair value, approximately 95% of our loan portfolio was senior secured at the end of the fourth quarter.

Our portfolio is well diversified across multiple industries with significant exposures in health care, technology, business services and manufacturing. In addition, we continue to avoid highly cyclical industries such as oil and gas, metals and mining. We believe that we are well-positioned to benefit from increases in interest rates as our loans are largely floating rate and our financing is primarily fixed rate. Our financing continues to provide us operational flexibility. As of the quarter's end, more than 71% of our debt matures in 2025 or later, and over half of our debt is unsecured. In addition, our senior loan facility matures in 2024 and is non-recourse to the BDC. Our corporate line of credit is flexible with no mark-to-market provisions.

At this point, I'll turn the call over to Jeff Cerny, our Chief Financial Officer, to give you more details and color for the quarter.

Thanks, Bilal. Good morning, everyone. We continue to be encouraged by our overall performance. Last quarter, we generated a significant increase in net asset value from the prior quarter to $15.18, which is an all-time high. We, once again, posted strong net investment income per share and our adjusted net investment income per share was above any previous mark. The distribution was increased to $0.28, the sixth consecutive quarterly increase. To get into more specifics, our net asset value per share increased by 7.2% over the prior quarter and is 22% above our pre-pandemic level at the end of fiscal year 2019. This increase was primarily driven by higher fair value marks on our investments as was the case with our equity investment in Pfanstiehl and a realized gain on our investment in TTG. Once again, we had no new nonaccruals this quarter. We have not had a new nonaccrual since the second quarter of 2020. At fair value, we currently have 2.2% of the loan portfolio on nonaccrual.

Turning to the income statement. Total investment income increased to $15.3 million for the quarter, up approximately $4.8 million from the prior quarter. This was primarily due to an increase in interest income, an increase in cash dividends and an increase in fee income, including an increase in syndication fees. Total expenses of $10.9 million were up approximately $3.5 million from the prior quarter. This increase was primarily attributable to higher incentive fees and the accrual of a capital gains fee. Net investment income of $0.33 per share exceeded the $0.24 per share posted in the third quarter, an increase of 37%. Adjusted net investment income increased by 88% to $0.47 per share in the quarter from $0.25 per share in the last quarter.

As Bilal discussed, earlier this morning, we announced a distribution of $0.28, a 12% increase in the quarterly rate and the sixth consecutive quarterly increase. The Board approved this higher distribution based in part on our net investment income as well as our earnings expectations. We believe the strength of our platform and investment portfolio will continue to help drive healthy earnings. We remain focused on our liquidity and maintaining a healthy balance sheet. Additionally, our most recent bond offering has further optimized our capital structure.

During the quarter, we issued approximately $55 million of new lower-priced unsecured debt, which we anticipate will result in a reduction in our borrowing costs. 71% of our debt matures in 2025 or later and 51% of our outstanding debt at quarter end was unsecured. At quarter's end, we had approximately $70 million of outstanding SBA debentures compared to approximately $195 million in cash and investments at fair value within our SBIC fund. The fund started with approximately $75 million of equity which has grown to $125 million even after returns of capital. Furthermore, on Monday, we repaid another $19 million in debentures, reducing our balance to just $51 million. Excluding our SBIC debt, our debt-to-equity ratio was stable quarter-over-quarter at approximately 1.4x.

Turning to our investments. We are pleased by the continued strong performance of our portfolio companies. We continue to have confidence that our underwriting selectivity will increase the likelihood that the portfolio performs positively in the future. Several of our portfolio companies continue to identify opportunities for growth, for which we are evaluating incremental funding. These opportunities give us relationship and informational advantages in making investment decisions.

The vast majority of our investments are in loans. 95% of the fair value of our debt portfolio was senior secured. 92% of our debt portfolio consisted of floating rate loans. We had LIBOR floors on approximately 90% of our floating rate loan portfolio with a weighted average LIBOR floor of 95 basis points. Even in the current rising rate environment, this LIBOR floor continues to be a contributor to our earnings as it favorably compares to 3-month LIBOR of approximately 21 basis points at quarter end and still remains a contributor, although less so with 3-month LIBOR moving up to approximately 49 basis points earlier this week.

As a percentage of cost, our overall investment portfolio includes approximately 74% senior secured loans, 5% subordinated debt, 16% structured finance notes and 5% equity, of which approximately half of our equity was in preferred equity securities.

Our portfolio remains diversified. At the end of the quarter, the portfolio had investments in 87 companies totaling approximately $507 million on a fair value basis with an average investment in each portfolio company of $5.8 million or approximately 1% of the portfolio's total fair value. At the end of the quarter, the overall weighted average yield to cost on our performing debt and structured finance note investments was approximately 9.6%, remaining consistent with the prior quarter.

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

Thank you, Jeff. In closing, we had a great quarter to close out the year in a strong position. Our net asset value has continued to grow, driven by the performance of both our debt and equity investments. We increased our distribution for the sixth straight quarter, reflecting our view of our improved performance and our expected outlook for the quarters ahead.

Since the beginning of 2011, OFS has invested approximately $1.7 billion with a cumulative net realized loss of principal of only $34.5 million, which is just 2%, while generating attractive yields on our portfolio. We continue to increase our allocation to senior secured loans, which now constitute the majority of our loan portfolio. Our financing is primarily long term with 71% of our debt maturing in 2025 and beyond, and 51% of our outstanding debt was unsecured. We believe that this gives us operational flexibility to execute on our business plan.

Lastly, we believe the size, experience and reputation of our adviser has continued to benefit our business. With a $3 billion corporate credit platform within a $30 billion plus asset management group, our adviser has brought resources, including long-standing banking and capital markets relationships. It has gone through multiple credit cycles over the past 25 years, and it has a strong alignment of interest with a 22% ownership in the BDC.

Before we go, I would like to thank all of our employees for their continued hard work and dedication this past year.

With that, operator, please open up the call for questions.

(Operator Instructions) Our first question comes from Mickey Schleien with Ladenburg.

Bilal, can you give us a sense of how your portfolio companies are doing in terms of their revenues and margins? And how do you feel about their ability to service their debt down the road with what could be some meaningful rate increases later this year?

Great. Those are both very good questions. So as far as margins are concerned, I mean, they're certainly -- we're certainly seeing some wage inflation, some inflation in raw materials. But so far, our companies have been able to maintain the margins. They've been able to pass on some of those increases to the eventual customer. And so we, at least at this point, are not seeing any major impact on the margins. And again, as we mentioned on the call, a vast majority of our loan portfolio is senior secured and well-diversified across industries that we have confidence in. So if at some point, there is some margin erosion, I think we have structural protections in place that would mitigate that risk.

As it relates to the rising interest rate environment. So obviously, as it relates to the returns on the portfolio floating rate loans, we believe that as interest rates rise, the interest rate will go up. And so from a return standpoint, that's a good thing. But the point that you mentioned, which is how will the borrowers be able to withstand rising interest rates, I think there are a couple of things there. One, when we're looking at -- when you're looking at middle-market loans, the benchmark on that loan, so let's say it's SOFR plus 6%, 7%, the benchmark is a smaller percentage of the overall interest that the borrower is paying. So even though the benchmark is increasing on a percentage basis, that's not a very large increase as it relates to the interest -- overall interest. So I think that as opposed to some of the syndicated loans where you may have SOFR plus 3%. So interest rate going up significantly, you don't have as big of an issue.

But when we underwrite loans, we make sure that we are stressing the portfolio with respect to debt service coverage. And we -- as we underwrite these loans, we will look at various scenarios and in terms of the performance of the company, but also as it relates to interest rates and make sure that the company is able to withstand higher interest rate. And Mickey, as you may remember, we had this rising interest rate environment 3, 4 years ago and where -- at that point, LIBOR was going up, and we were able to navigate that scenario fairly well. So I think at this point, we feel that we are -- we feel good about the company's ability to withstand a rising interest rate burden.

Bilal, in thinking about this cycle versus the last one, perhaps one of the differences is the amount of private debt capital that's available today as these funds are disintermediating banks. Do you -- how do you expect spreads to potentially behave as short-term rates rise? In other words, do you think private lenders, like yourselves, will allow spreads to maybe contract a little bit? And keep yields at a certain level? Or do you expect to just pass that on to the borrower?

Yes. That's a good point. I mean, it's -- the part of the market that we are navigating in, which is what I would call the lower middle market, we see less of a competition there from banks. And so I think that as we look to the future and the part of the market that we play in, I would believe that we'll be able to pass on this rising interest rates to our borrowers as we did last time around.

I think a lot of the capital that has come into the market has been focusing on some of the larger part of the middle market, larger borrowers. So I think that's one of the reasons why we play in this part of the market. It's -- there's certainly competition but it's somewhat insulated from strong competition. So as far as the part of the market that we are in, I think that -- I believe that we should be able to pass the higher interest rates on to our borrowers.

Yes. Mickey, this is Jeff. I guess the other thing I would add is that the liabilities of these various funds, you need to consider that as well. And I think a lot of them to the extent they're applying leverage do have floating rate liabilities. And so I think they're going to be largely focused on maintaining that spread to make sure that the margins stay in sync, whereas, for our firm, we've got about 70%-ish of our borrowings that are fixed at this point. So I think we're going to benefit in the long run, but I do think funds are also going to be considered in the liability side of the balance sheet when considering that question.

That's a good point, Jeff. I appreciate that. My last question is just -- I haven't seen the portfolio yet for the quarter. But are there any companies with outsized risks related to the sanctions that are being imposed on Russia? I'm just thinking of companies that may be import or export to Russia and any companies that have outsized sort of risk related to commodity prices.

Yes. So Mickey, the answer to that is no. We don't have any direct exposure to Russia or Ukraine. And as we said in our prepared remarks, I mean, we try to stay away from companies that have exposure to commodity prices; oil and gas, metals and mining. So I think that we don't have really any outsized exposure to what's happening in Russia and Ukraine.

Our next question comes from David Miyazaki with Confluence Investment Management.

Congratulations on really making a lot of progress with your net asset value and restoring what your asset level and where you're at to a level that is -- I think your net asset value is the highest that I can recall since you've become public. So I mean that's really great.

Just kind of thinking about how you're positioned and what you're going to be doing going forward. Obviously, the pandemic had a pretty substantial impact on how you mark your assets as of the end of March in 2020 and in June in 2020. And the dividend was lowered by about, I think, by half, right, back then. And now bringing it back up towards at today, you're still below where you were pre-pandemic.

And I'm just kind of wondering how does the earnings power look for you going forward with your net asset value now higher than what it was before the pandemic started and your dividend level below that. Do you think that the earnings power going forward is going to be better than it was before the pandemic? And I assume that has a lot to do with asset shifts and how you manage your liabilities and what the floating rates are and what the spreads are. But how do you feel about the earnings power going forward relative to where you were before the pandemic?

Yes. Thanks, David. So I think that's a very good question. So as you mentioned, we've been slowly growing our net investment income and commensurate with that increasing the dividend. And I think that our hope and expectation is that we will continue to increase our originations and grow the net investment income with the existing portfolio mix that we have right now. I think that potentially floating rates rising would help. We've been also increasing -- sorry, decreasing the cost of debt over the last year or so, taking advantage of the tight market as it relates to the bond market last year.

So we've been taking all those steps. I think that we have some assets in our portfolio right now that are not interest-earning assets, one of them being Pfanstiehl and the few other equity securities that are -- particularly Pfanstiehl, which is a high-growth company, and we're very happy with its performance, but it's not an interest-earning asset.

So I think the thought would be that in addition to all the things that we've been doing over the last couple of years, I think monetizing some of those assets that are not interest-earning assets, but actually converting them at the right time and using those proceeds to invest in interest-earning assets, thereby increasing the net investment income and then continuing to grow the dividend. So I think that's -- that would be the longer-term plan.

In the short term, as I mentioned, we'll continue to do all the things that we've been doing with the existing portfolio mix, reducing costs, increasing originations and, hopefully, the rising interest rate environment will help as well.

Yes. I mean that's kind of a nice pathway where you have a lot of different levers to push and pull to help develop and grow your ROE over time. I'm curious that, obviously, being able to change over what's a pretty substantial equity exposure into something that can be interest earning is a real tailwind for you. Have you given any thought to moving out of having your structured finance investments on balance sheet? Because within the BDC industry, the exposure to CLOs and structured finance oftentimes attaches a discount to the valuation that publicly-traded BDCs trade at.

And so it seems to me like where you're at right now with your income and with the pathway forward that is, you have a lot of options, that there might be an opportunity for you to come out of that kind of investment. But when times are good, it creates a lot of income for you. How do you feel about that allocation?

We actually -- that allocation has really helped us a lot with the increasing the investment income. And we have a long-standing expertise in CLO management and also CLO investing. And so we feel comfortable with the exposure that we have. It's an asset class that has been around for a long time and has stood the test of time. And so I'm -- I think that the -- we have to just balance the impact on the net investment income with the potential perceived impact on the stock price.

So we like to make investments in things that we are very comfortable with and have long-standing expertise in. So we like that asset class and certainly have been helping a lot with the net investment income and has allowed us in a big way to increase our dividend as well over the last several quarters.

Right. And I appreciate that comment, and you wanting to utilize resources and capabilities of the manager to the benefit of the shareholders. I'm just thinking that it has a higher return profile, but it has the effect of also increasing the cost of your equity capital from the public -- for the public BDC. And so you can kind of wind up in a trap there, right, where you're earning a lot on the investment, but then your stock trades at a higher cost of capital, and you're kind of stuck with the discounted valuation.

So it might be just something to consider that although it will lower the return profile coming out of that allocation, it might lower the cost of equity capital for the public BDC as well.

Right, right. Yes. No, I think those are -- that's the push and pull there, but I think that that's something that we evaluate all the time.

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

Thank you all for joining the call today, and we look forward to speaking with everyone again next quarter. Operator, you may now end the call. Thank you.

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