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Edited Transcript of CPTA earnings conference call or presentation 6-Nov-18 1:30pm GMT

Q3 2018 Capitala Finance Corp Earnings Call

Charlotte, North Carolina Nov 19, 2018 (Thomson StreetEvents) -- Edited Transcript of Capitala Finance Corp earnings conference call or presentation Tuesday, November 6, 2018 at 1:30:00pm GMT

TEXT version of Transcript

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Corporate Participants

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* John F. McGlinn

Capitala Group - Director & COO of Raleigh

* Joseph B. Alala

Capitala Finance Corp. - Chairman, President & CEO

* Stephen A. Arnall

Capitala Finance Corp. - CFO

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Conference Call Participants

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* Christoph M. Kotowski

Oppenheimer & Co. Inc., Research Division - MD and Senior Analyst

* Christopher Whitbread Patrick Nolan

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

* Ryan Patrick Lynch

Keefe, Bruyette, & Woods, Inc., Research Division - MD

* Thomas Quinn Wenk

JMP Securities LLC, Research Division - 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 quarter ended September 30, 2018. (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 host for today's call are Capitala Finance Corp.'s Chairman and Chief Executive Officer Joe Alala; Chief Operating Officer Jack McGlinn; and Chief Financial Officer Steve Arnall. Capitala Finance Corp. issued a press release on November 5, 2018, 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 quarterly report on Form 10-Q. 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. - Chairman, President & CEO [2]

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Thank you, operator, and down in Berlin, Germany, but good morning to those in North America. Thank you for joining us today. Steve and Jack will be in the room in Charlotte as we discuss the results for the third quarter of 2018 that we announced yesterday.

In early 2016, we changed our investment focus to senior secured structures, moving away from second liens and subordinated debt. Since that time, we have invested approximately $227 million of debt investments, 87% of which are senior secured structures having a weighted average interest rate of 11.3%.

Investment activity during the third quarter of 2018 included 1 new investment and 2 add-on investments. All debt means senior secured debt. Our ultimate goal is to rebalance the portfolio to senior debt, reducing concentration of subordinated debt as well as equity.

As noted in our earnings release, senior secured debt now represents 51% of the entire portfolio, up from 36% at March 31, 2016. As we continue to reposition the portfolio through new originations, we continue to work on our existing lower middle-market credit portfolio.

Nonaccrual investments were at 2.9% of the portfolio on a fair value basis, down from a peak of 10.4% at June 30, 2017. In addition, we do anticipate an exit prior to year-end of our nonaccrual debt investment in Velum Global Credit Management, LLC.

During the third quarter, we exited our investment in Western Windows Systems, generating a $9.8 million gain from our equity investment. In addition, on October 29, Hibbett Sports announced that it has signed a definitive agreement to acquire our portfolio company City Gear, LLC, consisting of both the debt and equity. The deal is scheduled to close during the fourth quarter of 2018. We do anticipate other equity monetizations during this quarter, and we will announce them appropriately.

Liquidity for CPTA and for the firm overall will allow us to be active investors in the lower middle market. Our pipeline is currently very robust. Our focus will continue to be on senior secured structures, where we can invest between $25 million and $100 million across our platform, including the BDC. The BDC is coinvesting with Capitala Specialty Lending Corp., having closed 4 deals already, with several others pending.

Our underwriting and portfolio processes, as previously announced, have been refined with the addition of Peter Sherman as our Chief Risk Officer.

In summary, while we are disappointed with the decline in NAV per share, we continue to make progress on rebalancing our portfolio, reducing balances on nonaccrual and investing our dry powder into quality senior secured debt investments to enhance net investment income in support of our distributions.

At this point, I would like to ask Steve to provide some color on our third quarter financial results.

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

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Thanks, Joe. Good morning, and thank you for taking time to listen to our call today. Total investment income was $0.8 million lower in the third quarter of 2018 as compared to 2017. Interest and fee income increased by $0.7 million related to the impact of rising rates on our variable rate loans. PIK income decreased by $0.9 million for the comparable periods, resulting from continued efforts to earn and collect cash interest as opposed to PIK income, while dividend income was $0.5 million lower in 2018 compared to 2017 due to a onetime dividend from a portfolio company in 2017.

Total expenses for the third quarter of 2018 were relatively flat compared to the comparable period with no meaningful variances to report. Net investment income of $0.24 per share for the third quarter 2018 was slightly less than our distributions paid of $0.25. We fully understand the importance of consistent distribution coverage and are focused on providing such coverage on a quarterly basis.

Net realized gains for the third quarter of 2018 totaled $6.3 million or $0.39 per share. We realized a $9.8 million gain from our equity investment in Western Windows Systems, LLC, partially offset by $3.7 million loss from the exit of our recently restructured senior secured debt investment in Kelle's Transport Service, LLC.

Net unrealized depreciation totaled $22 million for the third quarter of 2018 compared to appreciation of $2.8 million in 2017. During the quarter -- third quarter of 2018, the company reversed $6.3 million of previous appreciation related to net realized gains, while the remainder of the portfolio collectively depreciated by $15.7 million, $12.1 million related to On Site Fuel Services, which was depreciated to 0 during the quarter.

The net decrease in net assets resulting from operations totaled $11.9 million or $0.74 per share for the third quarter of 2018 compared to a net decrease of $5.8 million for the comparable period in 2017.

Net assets at September 30, 2018, totaled $203.6 million or $12.71 per share compared to $13.91 per share at December 31, 2017. Stability and ultimately growth in net asset value per share remains one of our highest priorities.

At September 30, we had $50.5 million in cash and cash equivalents. During the quarter, we repaid $5 million of SBA debentures scheduled to mature on March 1, 2019, bearing a contractual interest rate of 4.62%. At quarter-end, we had an undrawn senior secured credit facility with $114.5 million available. Regulatory leverage at September 30, 2018, was 0.62x compared to 0.61x at year-end.

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, unless the company's shareholders approve the minimum 150% asset coverage ratio prior to the board's effective date.

Now I'll turn it over to Jack for an update on the portfolio and landscape.

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John F. McGlinn, Capitala Group - Director & COO of Raleigh [4]

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At September 30, 2018, our investment portfolio includes 42 investments with a fair value of $439.4 million and a cost basis of $411.7 million. First lien debt investments on a fair value basis at September 30 comprised 51.1% of the portfolio, while second lien represents 7.3%. Subordinated debt represents 18.3% and equity warrant investments represent 23.3%. On a cost basis, equity investments comprised 13.3% of the portfolio. And further as to Joe's point about our strategy shift mid-2016, senior secured loans represent 67% of the debt portfolio on a fair value basis at September 30, 2018, compared to 44% at June 30, 2016.

At quarter end, we have 3 portfolio companies on nonaccrual status with a cost basis and fair value of $12.7 million and $31.8 million, respectively. On a fair value basis, nonaccrual loans represent 2.9% of the portfolio at September 30 compared to 5% at December 31, 2017. During the quarter, we fully depreciated our investment in On Site Fuel Services. However, circumstances prohibit us from addressing specific questions you may have.

Lastly, as Joe mentioned, we anticipate an exit of our investment in Velum Global Credit Management, LLC prior to year-end.

Our investment pipeline as generated by our multioffice platform continues to be strong. We're actively working on several deals that are in various stages, most of which we hope to close prior to year-end.

At this point, we'd like to open the line for questions.

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Questions and Answers

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Operator [1]

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(Operator Instructions) Our first question is from Christopher Nolan with 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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On the higher leverage, you guys -- I don't see a proxy for a shareholder vote. Is there a plan to get shareholder vote on this?

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

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Chris, this is Steve. At this time, all we've got is board approval. So we do not have plans as of today to have a special shareholder meeting now.

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

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And Steve, what is the thoughts in terms of once assuming an approval or November 1, '19, comes by to taking the regulatory leverage level up, how high?

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

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Chris, that's a great question. I would say right now, it's just premature to really give you any guidance in that regard since it's a year away and a lot will change, the shape of the yield curve and there's just many factors that will be involved that will come into play as to how we'll handle that. We do -- in the short term, we're really focusing on the things we've talked about, which is trying to get our dry powder invested into senior debt investments and rebalance this portfolio. But it is just premature to get too specific now. We just approved it. We got a year of waiting period.

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

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Great. And a follow-up question would be for the exits on Velum and City Gear, are those close to your fair values?

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

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I would say, yes.

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

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Okay. So you have potential here for a gain on City Gear and neutral on Velum, I guess?

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Stephen A. Arnall, Capitala Finance Corp. - CFO [9]

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On realized, yes.

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Operator [10]

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Our next question is from Ryan Lynch with KBW.

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Ryan Patrick Lynch, Keefe, Bruyette, & Woods, Inc., Research Division - MD [11]

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I just want to pick up with what Chris was talking about the leverage, maybe to ask it in a little bit different way. As far as I know, you said you didn't want to talk about leverage range, but you guys are levered at 1.41x total GAAP debt to equity. Once this gets approved, are you guys looking to actually add on additional leverage? Or did you guys primarily approve this just to have increased flexibility to maybe protect on the downside? So are you guys planning on with -- passing leverage to actually increase the leverage? Or is that just increasing the flexibility?

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Stephen A. Arnall, Capitala Finance Corp. - CFO [12]

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I think it's the latter, Ryan. I mean, we really -- we think this is a good thing for the industry as a whole and for us. I think it allows us to have that flexibility. And in terms of specific plans of what we're going to do with that, it's just we don't have any right now. We just got this approved last week. And in terms of what we're going to do with it, we'll work with our board and management closely to figure out what makes the most sense. But having that flexibility, I think, is a good thing.

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Ryan Patrick Lynch, Keefe, Bruyette, & Woods, Inc., Research Division - MD [13]

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Okay. And then with the approval of this, are you guys shifting your strategy at all? Or is it going to continue to be the same strategy you guys have kind of run at with the last year?

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Stephen A. Arnall, Capitala Finance Corp. - CFO [14]

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Yes. I don't foresee a change in that strategy.

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Ryan Patrick Lynch, Keefe, Bruyette, & Woods, Inc., Research Division - MD [15]

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Okay. And then are there any covenants on your bonds or your credit facility that would have to be amended or anything for you guys to actually utilize the additional leverage or not?

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

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I don't believe so. I'm pretty sure on the bonds, there is not. On the credit facility, we'll work with them at the appropriate time. I don't believe so.

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Ryan Patrick Lynch, Keefe, Bruyette, & Woods, Inc., Research Division - MD [17]

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Okay. And then just last one, I know you guys said you can't comment on On Site Fuel Services specifically, so you may not be able to comment, but I guess, from that investment, I mean you got marked down from 1/10 of your cost to 0. I mean, I guess, what did you guys, I guess, learn from what happened here? And what steps can you just take to prevent this from happening with other investments kind of in the future?

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John F. McGlinn, Capitala Group - Director & COO of Raleigh [18]

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Yes. Again, it's difficult to answer it. I'll just say that it was a 2011 investment. It had been on nonaccrual for probably the better part of 4 years, if not longer. So it had been a troubled company for a long time and had gone through a couple of different iterations. So it was -- there are a lot of lessons to be learned and we discuss those internally. And again, it's not that investment, that structure of the investment is not what we're doing out of the BDC today as far as looking at the first lien unitranche-type deal. So I think the biggest thing is just that that's not our investment style as we go forward.

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Operator [19]

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Our next question is from Chris Kotowski with Oppenheimer.

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Christoph M. Kotowski, Oppenheimer & Co. Inc., Research Division - MD and Senior Analyst [20]

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I wonder, can you talk about the monetization of the Eastport Holdings? I'm not exactly sure how that worked and it was kind of a complicated description. And I mean, was it just a sale of a part of the $6-ish million of the fair value? Or -- and how does -- are there plans to monetize the rest of it? Just describe this transaction.

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

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Sure. I'll cover the first part at least. So during the quarter, the purchaser of that written call option exercised the option because it was set to expire in August. And so what happened is we received $1.5 million of cash for the option, which had a fair value at that time of $6.8 million. From an accounting standpoint, there really wasn't any impact on the income statement. On the balance sheet, what you saw was the fair value of the investment drop by $6.8 million due to really in effect our decrease in our equity ownership went from 33% down to 23%. And at the same time, you see all the liabilities decreased by the derivative being removed from the balance sheet. So net-net, it was a loss. At the end of the day, we received $1.5 million of cash. So now we have lower interest -- equity interest in that company and everything worked as it was supposed to.

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Christoph M. Kotowski, Oppenheimer & Co. Inc., Research Division - MD and Senior Analyst [22]

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Okay. And are there any other options on any of your remaining holdings there?

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Stephen A. Arnall, Capitala Finance Corp. - CFO [23]

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No.

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Christoph M. Kotowski, Oppenheimer & Co. Inc., Research Division - MD and Senior Analyst [24]

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So do you own that free and clear?

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Stephen A. Arnall, Capitala Finance Corp. - CFO [25]

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We do.

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Operator [26]

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Our next question is from Chris York with JMP Securities.

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Thomas Quinn Wenk, JMP Securities LLC, Research Division - Associate [27]

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Tom Wenk here in for Chris York. A quick question on leverage. We've seen a few BDCs change the fee structure in association with reductions in asset coverage. Do you guys expect to make any changes to your fee structure in the pursuit of additional leverage?

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Joseph B. Alala, Capitala Finance Corp. - Chairman, President & CEO [28]

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This is Joe. To answer that, we really haven't thought through the different strategies that come along with more leverage. We're really, like Steve mentioned, we're focusing on rebalancing the existing portfolio to get much more senior secured, less equity, less mezzanine, less sort of variable sort of underlying risky assets. But we would address the fees when we align the strategy with the new leverage.

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Operator [29]

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And I'm showing no further questions. I'd like to turn the call back over to Joe Alala for any further remarks.

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Joseph B. Alala, Capitala Finance Corp. - Chairman, President & CEO [30]

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Thank you, everyone, for participating in the earnings call. Steve is around most of the day. If you need me, shoot me an e-mail and I'll call you back over the next few hours, I'm on a different time schedule. But we thank you for your participation in this call, and we look forward to hearing from you. Everyone, have a great day.

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Operator [31]

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Ladies and gentlemen, thank you for participating in today's conference. This does conclude today's program and you may now disconnect. Everyone, have a great day.