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Edited Transcript of CPTA earnings conference call or presentation 3-Mar-20 1:30pm GMT

Q4 2019 Capitala Finance Corp Earnings Call

Charlotte, North Carolina Mar 26, 2020 (Thomson StreetEvents) -- Edited Transcript of Capitala Finance Corp earnings conference call or presentation Tuesday, March 3, 2020 at 1:30:00pm GMT

TEXT version of Transcript

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Corporate Participants

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* Joseph B. Alala

Capitala Finance Corp.

* Stephen A. Arnall

Capitala Finance Corp.

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Conference Call Participants

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* Christopher Whitbread Patrick Nolan

Ladenburg Thalmann & Co. Inc., Research Division - EVP of Equity Research

* Ryan Lan Carr

Jefferies LLC, Research Division - Equity Associate

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Presentation

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Operator [1]

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At this time, I would like to welcome everyone to Capitala Finance Corp.'s conference call for the quarter ended December 31, 2019. (Operator Instructions) Today's call is being recorded, and a replay will be available approximately 3 hours after the conclusion of the call on the company's website at www.capitalagroup.com under the Investor Relations section.

The hosts for today's call are Capitala Finance Corp.'s Chairman and Chief Executive Officer, Joe Alala; and Chief Financial Officer and Chief Operating Officer, Steve Arnall.

Capitala Finance Corp. issued a press release on March 2, 2020, with details of the company's quarterly financial and operating results. A copy of the press release is available on the company's website.

Please note that this call contains forward-looking statements that provide information other than historical information, including statements regarding the company's goals, beliefs, strategies, future operating results and cash flows. Although the company believes these statements are reasonable, actual results could differ materially from those projected in the forward-looking statements. These statements are based on various underlying assumptions and are subject to numerous uncertainties and risks, including those disclosed under the sections titled Risk Factors and Forward-Looking Statements in the company's annual report on Form 10-K. Capitala undertakes no obligation to update or revise any forward-looking statements.

At this time, I would like to turn the meeting over to Joe Alala.

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Joseph B. Alala, Capitala Finance Corp. [2]

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Thank you, operator. Good morning, and thank you all for joining us today. I would like to talk through actions taken by management in 2019 to position the company for improved financial performance in 2020. Then Steve will provide details on our fourth quarter performance, after which we will welcome everyone's questions.

Since we changed our investment strategy in early 2016, our portfolio mix has changed. First lien debt investments account for 81% of the total debt portfolio on a fair value basis at year-end compared to 46% at the end of 2015.

Since the first quarter of 2016, the BDC has invested approximately $390 million of total investments, 76% in first lien debt structures, 17% in second lien debt structures, 4% in equity and 3% related to our investment in Capitala Senior Loan Fund II.

Equity as a percentage of total investment is 17.6% at year-end and on a fair value basis compared to 20.5% the previous year-end.

During the fourth quarter of 2019, we partially exited our investment in Nth Degree, Inc. and realized a $25.9 million capital gain for CPTA. While it is our plan to continue to reduce equity as a percentage of total investments through normal exit, we will continue to make new equity investments as part of our normal underwriting and investing to provide NAV upside.

We ended 2019 with no, 0 that is, nonperforming loans. I'd like to thank our very talented portfolio management team for this accomplishment.

Credit quality is of the utmost importance in our focus on 0 secured debt securities. While senior secured debt securities have proved to be helpful in this regard, we are pleased to report that our class action lawsuit was officially dismissed during the fourth quarter of 2019 without a settlement.

Also, during the fourth quarter, we announced that Mitsui USA has purchased a minority investment in the external adviser, providing resources for growth of our credit and equity strategies, both focused on the lower middle market.

We are also actively pursuing an additional SBIC license within the BDC. The benefit of an additional license is access to low-cost, long-term fixed rate debentures that are exempt from regulatory debt ratios. This will provide additional dry powder for us to grow our investments and ultimately, our earnings. We will provide more information on this process as we move further along in it.

The BDC continues to benefit from being part of a larger credit platform by having the ability to co-invest in lower middle market unitranche deals ranging in size from $25 million to $90 million, where the BDC typically invests $5 million to $15 million per transaction.

We entered 2020 with significant liquidity across the platform. Our cash balances from recent repayments, coupled with our recently renewed line of credit, the company can remain active in the lower middle market, allowing our direct origination office to continue to source new opportunities. Our pipeline consists of a number of quality opportunities, and we expect to have a very solid first quarter of 2020.

At this point, I'd like to ask Steve to provide some color on our first quarter financial results.

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Stephen A. Arnall, Capitala Finance Corp. [3]

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Thanks, Joe. Good morning, everyone. Total investment income was $9.6 million during the fourth quarter of 2019, $1.7 million lower than the fourth quarter of 2018.

Interest and fee income declined by $1.5 million for the comparable periods, resulting from a decrease in debt investments outstanding, along with the decline in the weighted average yield on our debt portfolio, resulting from our continued first lien investment strategy.

Dividend income increased by $0.2 million for the comparable periods, while PIK income decreased by $0.3 million.

Total expenses for the fourth quarter of 2019 were $7.7 million, a decrease of $0.1 million from the fourth quarter of 2018. There are no material variances to report.

Net investment income for the fourth quarter of 2019 was $0.12 per share compared to $0.22 per share for the fourth quarter of 2018.

Consistent distribution coverage will always be an important measure of our performance. We're focused on deploying our dry powder in the lower middle market, first lien investments, debt investments and certain situations equity to help grow our net investment income and ultimately, our return on equity.

Net realized gains totaled $1.7 million or $0.07 per share for the fourth quarter of 2019 compared to net realized losses of $14.6 million or $0.91 per share for the same period in 2018.

During the fourth quarter of 2019, we realized a $25.9 million gain on the partial exit of Nth Degree, partially offset by realized losses on Vology, Inc., Portrait Studio, LLC, CableOrganizer Acquisition, LLC and American Clinical Solutions. I would like to note though that the net realized gains during the fourth quarter of 2019 did not have a material impact on our net asset value per share as realized amounts were in line with previously reported fair values.

Net unrealized depreciation totaled $3.1 million or $0.19 per share for the fourth quarter of 2019 compared to appreciation of $1.2 million for the comparable period in 2018. The net decrease in net assets resulting from operations totaled $0.1 million for the fourth quarter of 2019 compared to a net decrease of $9.2 million for the comparable period in 2018.

Net assets at year-end 2019 totaled $148.1 million or $9.14 per share compared to $9.40 per share at the end of September 2019.

At December 31, 2019, we had $62.3 million in cash and cash equivalents. In addition, we had 0 drawn and $60 million available on our senior secured credit facility priced at LIBOR plus 300 basis points. Regulatory leverage at December 31, 2019, was 0.86 compared to 0.72 at December 31, 2018.

On November 1, 2018, our Board of Directors approved that the company be subject to a minimum asset coverage ratio of at least 150% to be effective as of November 1, 2019. So that change is now effective. During the fourth quarter of 2019, we amended our senior secured line of credit, rightsizing our commitments to $60 million and giving us additional flexibility related to the change in asset coverage requirements.

At December 31, 2019, our investment portfolio included 43 investments with a fair value of $362.5 million and a cost basis of $353.9 million.

During the fourth quarter of 2019, we invested $29 million across 3 new companies and 5 existing portfolio companies. Of this amount, $27.4 million were first lien debt investments with a weighted average yield of 9.0%. The remaining $1.6 million were equity co-investments. The weighted average yield on our entire debt portfolio at December 31, 2019, was 11.5%. First lien debt investments on a fair value basis at year-end comprised 63.8% of the portfolio, while second lien and subordinated debt collectively represent 14.8%, equity and warrant investments represent 17.6% and our investment in Capitala Senior Loan Fund II represented 3.8%.

Please refer to our fourth quarter investor update on our website for additional information regarding the trends in our portfolio composition since we changed our investment strategy in early 2016.

At quarter end, we have no -- at year-end, we have no nonaccrual loans. Our portfolio management group has been active with the entire portfolio, with particular attention to underperforming credits. Our direct origination platform is focused on generating quality senior secured opportunities to satisfy the return profile of the Capitala platform, including the BDC, and we expect several deals currently under terms to close soon.

Lastly, we are in the process of developing a responsible lending policy for our platform, something we plan to roll out as soon as possible and will be included on our website.

At this point, we'd like to open it up for questions.

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Questions and Answers

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Operator [1]

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(Operator Instructions) Our first question comes from Christopher Nolan of Ladenburg Thalmann.

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Christopher Whitbread Patrick Nolan, Ladenburg Thalmann & Co. Inc., Research Division - EVP of Equity Research [2]

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The -- so is it correct that given the amendment of the bank facility that you guys are now cleared in terms of your covenants and so forth to increase your leverage -- your regulatory leverage ratio above 1:1?

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Stephen A. Arnall, Capitala Finance Corp. [3]

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That's correct.

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Christopher Whitbread Patrick Nolan, Ladenburg Thalmann & Co. Inc., Research Division - EVP of Equity Research [4]

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What's the plan in that respect? Is there a plan in 2020 to take it above 1:1? Or what's your thinking?

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Stephen A. Arnall, Capitala Finance Corp. [5]

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Chris, I would say, in the short term, I would say, let's move it up to about 1:1, and see how we're doing there. I would not forecast this to go too much beyond there in the short term.

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Christopher Whitbread Patrick Nolan, Ladenburg Thalmann & Co. Inc., Research Division - EVP of Equity Research [6]

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Okay. Great. And then in the quarter, you had lower dividend income Q-over-Q. I mean just curious what was affecting that?

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Stephen A. Arnall, Capitala Finance Corp. [7]

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Yes. Last year -- last quarter, we had a large dividend that was nonrecurring. So I think this quarter's dividend income looks a little more normal.

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Christopher Whitbread Patrick Nolan, Ladenburg Thalmann & Co. Inc., Research Division - EVP of Equity Research [8]

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Great. And then the resources that Mitsui is providing, what are those specifically beyond cash? I mean...

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Joseph B. Alala, Capitala Finance Corp. [9]

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Well, the resources other than investing in the manager and providing working capital to continue to expand the platform, as we've hired almost a dozen. Half a dozen or a dozen people since October, very skilled professionals that we've brought to the team. So other than the working capital to grow the team, they're helping us attract private pools of capital and best private pools of capital on the platform, and then also with their expansive -- yes, global investments in several 460 companies, they really help at the portfolio level with some industry expertise. And also, as you can imagine, some of these small businesses where we invest in, getting access to some of the larger companies on the Mitsui family and portfolio can have a material impact on the outcomes of their performance, too. So it's been a great partnership to date. And we look forward to many years of it.

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Christopher Whitbread Patrick Nolan, Ladenburg Thalmann & Co. Inc., Research Division - EVP of Equity Research [10]

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Right. Final question. Given the market turbulence over the last couple of months, can you give a little color in terms of what you're seeing in terms of deal terms for the lower middle market space from your perspective?

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Joseph B. Alala, Capitala Finance Corp. [11]

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As far as -- we continue to see somewhat of a compression in yield in the lower middle market. Especially sponsor activity is where we're seeing the most compression. However, what I do believe we do have in the lower middle market, which is maybe not as robust in other larger middle market and large syndicated loans, is we still have great covenants and structures.

I think our loan to values in our portfolio is still trended at 50% and under loan to values over the past many quarters and forecast this quarter, too. So we're seeing nice loan to values. They're on the lower side, typically 3 to 4 covenants per transaction. So these are not by any definition covenant-light deals. But we have seen a compression in pricing on the sponsor activity, but I will say on the non-sponsor activity, there's still some very attractive pricing. We pursue both sponsor and non-sponsor activity and we're trying to blend that to sort of keep yields up as we continue to see compression on the sponsor activity side. But the structures are very good. Our loan to values have actually been decreasing over the past many quarters, which, we believe, puts us in a great situation if a downturn hits this portfolio.

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Operator [12]

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Our next question comes from Ryan Carr of Jefferies.

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Ryan Lan Carr, Jefferies LLC, Research Division - Equity Associate [13]

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So yes, first question for you is related to portfolio growth. You -- in the fourth quarter this year, you hit -- your transition towards the first lien portfolio has largely come about above 80%. I'm just curious, in 2020, what's your outlook for portfolio growth? And when do you expect that to resume in the near term?

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Joseph B. Alala, Capitala Finance Corp. [14]

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Well, we did have a nice Q4. We expect to have a solid Q1. As I sort of mentioned, we've hired many professionals since October. We opened an LA office. We hired another origination partner with significant experience that's joined us. We opened the Dallas office last year and then continue to expand in the Charlotte office. So deal flow is actually increasing. We've put a lot of private vehicles on the platform. So we are able to hold much larger deals than ever before. We can go up to $90 million and arrange and lead those deals. We have never had that capacity before.

So we're excited. We think we're setting our internal forward goals at 3 to 4 investments per quarter. And we expect that to be the pace, and the BDC will have the right, obviously, to take its pro rata portion of all those deals. And I can't think of a deal that hasn't taken its pro rata right yet, but we do -- we have a lot of liquidity, although we're being very prudent. We're not giving on structures, we're not giving on covenants. We will move down in pricing because that's where especially the sponsor activity is, and we're helping to adjust the yield compression there with our Capitala Senior Loan Fund II, which is our JV with Kemper, where we're able to put a first allocation there and blend up our yields in the BDC.

So we're doing all the right things. We think this will be an active year. We do think that lower interest rates may happen. And so we're factoring that into all of our decisions, too. But we think this will be a strong year of deployments for the firm.

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Ryan Lan Carr, Jefferies LLC, Research Division - Equity Associate [15]

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And on the quarter-to-date investment activity, are you able to give any color on what that looks like into the quarter so far?

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Stephen A. Arnall, Capitala Finance Corp. [16]

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This quarter? No, it'd be premature to do that. I think to Joe's point, we do anticipate having several investments closed. But at this point, it's a bit premature to discuss any details.

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Ryan Lan Carr, Jefferies LLC, Research Division - Equity Associate [17]

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Okay. And then next question, obviously, with the rate environment, the yield outlook, it's a -- forward rate cuts are -- continue to be expected. With respect to your -- the structures of your loans, what percentage of them have LIBOR floors? And what are you -- what steps are you taking, really to address the rate cuts?

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Stephen A. Arnall, Capitala Finance Corp. [18]

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Yes, this is Steve. Most of our floating rate investments have floors in them. Looking to see from a variable -- so at the end of the year, 63% of our loans were variable rate so the remainder are fixed rate. And again, that goes back to our legacy roots from SBIC world.

So if you look at our sensitivity analysis in our 10-K, if rates drop 100 basis points, all things equal, I think it would reflect maybe a $0.05 to $0.06 impact to net income over the course of the year, again, all other things equal. So we'll keep an eye on that. We've identified all the assets that are variable rate and what that impact that a rate cut would do, but I think we'd be fine.

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Operator [19]

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(Operator Instructions) We have a follow-up from Christopher Nolan of Ladenburg Thalmann.

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Christopher Whitbread Patrick Nolan, Ladenburg Thalmann & Co. Inc., Research Division - EVP of Equity Research [20]

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Steve, did you indicate that there could be additional major equity realizations in the first half of '20?

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Stephen A. Arnall, Capitala Finance Corp. [21]

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I did not. I think we always anticipate in the normal course of business to have some repayments. But we did not say that. No.

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Christopher Whitbread Patrick Nolan, Ladenburg Thalmann & Co. Inc., Research Division - EVP of Equity Research [22]

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Okay. Great. Also, your investment yields for the portfolio were pretty steady Q-over-Q. I mean given the decrease in LIBOR, how are you guys maintaining your yields? And what's the strategy around that going forward?

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Joseph B. Alala, Capitala Finance Corp. [23]

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One thing we're doing is -- especially it's gotten more competitive in the sponsor activity is we do have a JV with Kemper in the BDC, our Capitala Senior Loan Fund II. We're able to take a reasonable allocation of that unitranche, call it, 25% on average, put in our JV, blend up our yields. So there's a little sort of own platform, financial engineering there that's helped to maintain yields. And also a big new component of our strategy is non-sponsored deals, where you can still get much higher spreads than you can on sponsored deals, and we're continuing to close and pursue non-sponsor activity. So we're proud that we've kept our yields higher in this environment.

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Operator [24]

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There are no further questions. I'd like to turn the call back over to Joe Alala for any closing remarks.

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Joseph B. Alala, Capitala Finance Corp. [25]

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Thank you, everyone, for your time. Steve and I are around all day. Please call us if you have any further questions, and we'll hope to be very responsive. And we'll talk to you next quarter. Everyone, have a great day.

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Operator [26]

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Ladies and gentlemen, this concludes today's conference call. Thank you for participating, and you may now disconnect. Everyone, have a great day.