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Edited Transcript of CPTA earnings conference call or presentation 5-Nov-19 1:30pm GMT

Q3 2019 Capitala Finance Corp Earnings Call

Charlotte, North Carolina Nov 22, 2019 (Thomson StreetEvents) -- Edited Transcript of Capitala Finance Corp earnings conference call or presentation Tuesday, November 5, 2019 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. - Chairman, President & CEO

* Stephen A. Arnall

Capitala Finance Corp. - CFO & COO

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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

* Kyle M. Joseph

Jefferies LLC, Research Division - Equity Analyst

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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 September 30, 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 host for today's conference -- the host for today's call are Capitala Finance Corp.'s Chairman and Executive -- Chief Executive Officer, Alala; and Chief Financial Officer and Chief Operating Officer, Steve Arnall. Capitala Finance Corp. issued a press release on November 4, 2019, 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 the call contains forward-looking statements that provide information other than historical information, including segments regarding the company's goals, beliefs, strategies, future operating results and cash flow. Although 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 section 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. Sir, please go ahead.

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Joseph B. Alala, Capitala Finance Corp. - Chairman, President & CEO [2]

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Thank you, operator. Good morning, and thank you for joining us today, everyone. I would like to offer a few comments related to our third quarter results, discuss some recent developments since the end of the quarter, and then turn it over to Steve to provide more insight into the quarter, and then we'll address any questions you may have.

Net investment income, $0.18 per share. Net asset value per share, $9.40. As we look at the risk in our portfolio at September 30, 2019, a couple of observations.

We currently have 2 credits with a risk rate of 3 and on a fair value basis are 6.9% of the total portfolio, the lowest level since our IPO in 2013. Nonaccrual balances, on a fair value basis, totaled $15.8 million or 4.3% of the total portfolio. Our portfolio team continues to actively manage the entire portfolio, focusing on reduction in watch loan credits.

Since we changed our investment strategy in 2016, the BDC has invested approximately $331 million in debt investments, 80% of which were first-lien structures, all of which are performing as expected.

We continue to rebalance our investment portfolio, focusing on senior secured debt investments and reducing mezzanine and equity investments. First-lien debt investments represent 59% of portfolio at September 30, '19 compared to 36% at March 31, '16.

We are confident that this strategy, long term, will produce a more stable net investment income in support of quarterly distributions and ultimately, a superior return on equity. Our equity portfolio represents 14.7% and 21% of the investment portfolio on a cost and fair value basis at quarter end. Part of the rebalancing of our portfolio is the need to continue to monetize additional equity holdings and redeploy the cash proceeds into senior secured debt investments.

We anticipate a significant reduction in our equity investments by the end of the year. Platform liquidity will allow the platform, including CPTA, to be active investors in the lower middle market. We have several deals under terms and expect to close them prior to end of year.

Subsequent to quarter end, we have had several announcements I would like to address: First, we hired an additional Business Development Officer based in Charlotte, excited to have Chris join us; second, we are in the market for additional resources across our platform as we prepare to be active investors in the lower middle market. We expect to hire many professionals across the platform over the next several months; lastly, we announced recently a strategic partnership with the Mitsui USA, where they have purchased a minority noncontrolling interest in the management company. This is a significant milestone for the platform and will benefit the BDC. Mitsui will provide the firm with substantial resources for growth of our credit and equity strategies, including Capitala Finance Corp.

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

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

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Thanks, Joe. Good morning, and thank you for participating in our call today. Total investment income was $10.1 million during the third quarter of 2019, $1.4 million lower than the third quarter of 2018. Interest and fee income declined by $2.2 million for the comparable periods, resulting from a decrease in our investment portfolio as well as the impact of 2 new nonaccrual investments.

Dividend income for the third quarter of 2019 totaled $1.2 million and included $0.3 million distribution from Capitala Senior Loan Fund II as well as $0.8 million for Micro Precision, LLC.

Total expenses for the third quarter of 2019 were $7.1 million, a decrease of $0.5 million from the third quarter of 2018. Interest and financing expenses decreased by $0.2 million, while base management fees declined by $0.3 million.

Net investment income of $0.18 per share for the third quarter of 2019 was below the $0.25 of distributions paid. Consistent distribution coverage will always be an important measure of our performance.

Since IPO, however, we have paid cumulative regular distributions of $138 million and never had a return of capital.

Net unrealized depreciation totaled $1.3 million or $0.08 per share for the third quarter of 2019 compared to depreciation of $22 million for the comparable period in 2018.

The net increase in net assets resulting from operations totaled $1.7 million or $0.11 per share for the third quarter of 2019 compared to a net decrease of $11.9 million for the comparable period in 2018.

Net assets at the September 30, 2019, totaled $151.9 million or $9.40 per share compared to $11.88 per share at December 31, 2018. At September 30, 2019, we had $62.8 million in cash and cash equivalents. In addition, we had 0 drawn and $114.5 million available on our senior secured credit facility priced at LIBOR plus 300 basis points.

Regulatory leverage at September 30, 2019, was 0.84 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.

We're in the final stages of amending our senior secured credit facility and will publicly announce the amended line once the process is complete. At September 30, 2019, our investment portfolio included 40 investments with a fair value of $371.4 million and a cost basis of $359.6 million.

During the third quarter, we invested $13.9 million across 2 companies -- 2 new companies and 4 existing portfolio companies. All of the investments were debt, 95% of which were first lien. The weighted average yield on the new debt investments during the quarter was 10.6%, while the weighted average yield of the entire debt portfolio at September 30, 2019, was 11.5%. First-lien debt investments on a fair value basis at September 30, 2019, comprised 59.3% of the portfolio, while second-lien and subordinated debt collectively represent 16.0%. Equity and warrant investments represent 21%, and our investment in Capitala Senior Loan Fund II represented 3.7%.

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

At quarter end, we have 4 portfolio companies on nonaccrual status with a cost basis and fair value basis of $25.8 million and $15.8 million, respectively. During the quarter, the subordinated debt investment in Vology, Inc. and the first-lien debt for CableOrganizer Acquisition, LLC were placed on nonaccrual.

Our direct origination platform is focused on generating quality senior secured opportunities that satisfy the return profile of the Capitala platform, including Capitala Finance Corp., and we expect several deals currently under terms to close prior to year-end.

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) It looks like our first question will come from the line of 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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What's the leverage outlook for the next couple of quarters, given the -- you've now past the 1-year mark?

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

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Chris, this is Steve. Until we get our line finalized and announced, I'm hesitant to give guidance. I think we're 0.84 at the end of September. Now that we've got a little bit of runway room there, we'll be very thoughtful as we use our line to fund new deals, but I'm hesitant to give you a guide until we get that finalized and announced.

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

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But do you think it'll increase?

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

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Possibly so, yes, from a regulatory perspective.

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

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Okay. And then on capital structure, most of your capital right now is fixed rate, given the change in the yield curve, any changes -- any thoughts in terms of how the capital structure might change?

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

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In the short term, no. I think as we look at -- potentially looking at SBIC subsidiary down the road, we may look at prepaying some of those debentures. But in the short term, I don't see any change in the makeup of the capital structure, no.

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

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Okay. And then finally, for Mitsui, what sort of resources for growth are they providing the external manager?

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Joseph B. Alala, Capitala Finance Corp. - Chairman, President & CEO [9]

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This is Joe. Yes, the resource is basically working capital at the manager level. We're on a significant acquisition of Talentnow hiring people, which we've already hired 1 business development person last month, and we're in the market for 6 to 10 professionals over the next few months to continue building out the investment team of the firm with this working capital investment.

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Operator [10]

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(Operator Instructions) Our next question comes from the line of Kyle Joseph with Jefferies.

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Kyle M. Joseph, Jefferies LLC, Research Division - Equity Analyst [11]

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Just wanted to get your sense on yields in the context of your new -- or not really, not new anymore, but your senior-focused strategy and combine that with where rates are, what sort of pressures are you seeing?

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Joseph B. Alala, Capitala Finance Corp. - Chairman, President & CEO [12]

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Well, I would say, on the yield side, it definitely -- even in the lower middle market where we operate, you've seen a compression over the last quarters on sort of first-lien or unitranche lending. What we have done to sort of enhance that is form this senior loan fund where we can bifurcate our own unitranche directly originated loans and sort of blend up our yields through the JV that we've -- that we have in place with Kemper. So that's how we've addressed sort of some of the yield compression, but we have definitely seen, in the lower middle market, some yield compression over the last several quarters, especially on equity sponsor activity. But as you know, we do both nonsponsor and equity-sponsor activity. The compression has not been that bad on the nonsponsor lending that we participate in. And also, I would say, even though there has been yield compression, we are still able to get the nice structures. So there hasn't been sort of a lapse in structure over those quarters to correlate with the lowering of the yield. So we're still finding good structures, but the yields are lower. And we're -- the best way we've been able to own balance sheet effect that is through our JV that we formed.

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Kyle M. Joseph, Jefferies LLC, Research Division - Equity Analyst [13]

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Got it. That's good color. Next question from me. We thought -- it sounds like 2 investments though on nonaccrual. I believe those are legacy strategy investments. But just stepping back, I wanted to get your sense of the broader portfolio and how things are performing? And how that compares to 3 months ago or a year ago, and essentially, to get your sense of where -- how the economy is doing?

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

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Yes. This is Steve, Kyle. I think if you look at where we are at September 30, one of the key measures where -- we try to share with everybody is where our risk rate reinvestments, which are kind of the watch loans. We had one upgraded through this period, Burgaflex. In September, we have 2 investments that are risk rated 3, and it's at the lowest -- that's the lowest point we've had since we went public back in '13. So we feel like, from that perspective, that's a good metric. While we've got 4 investments on nonaccrual, I think the portfolio group is actively working on all of those. And I think there's -- there will be some resolution to those prior to year-end. And we'll just share it with you when that becomes appropriate. But it certainly feels like, from a risk profile perspective, the portfolio is in a much better spot metrically than where it's been over the past several quarters and even several years, and that's a byproduct of what Joe mentioned, the investments that we've made -- the $330 million of debt investments we've made since we changed our strategy that are first lien, generally, first lien in nature, are performing as expected. So that trend is probably due to the rest of the portfolio, and we'll just continue to work through these legacy positions, as you mentioned, and it's just taking longer than we thought, but it feels like we're in a much better spot than we've been in previous periods.

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Operator [15]

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And it looks like we have a follow-up question from the line of Christopher Nolan with Ladenburg Thalmann.

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Christopher Whitbread Patrick Nolan, Ladenburg Thalmann & Co. Inc., Research Division - EVP of Equity Research [16]

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Steve, what percentage of the debt portfolio is floating currently?

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Stephen A. Arnall, Capitala Finance Corp. - CFO & COO [17]

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Portfolio is, I guess, that's where? 60%.

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Christopher Whitbread Patrick Nolan, Ladenburg Thalmann & Co. Inc., Research Division - EVP of Equity Research [18]

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And on the comments that you guys had in terms of a major realization in the fourth quarter -- major equity position, I mean, any color you can provide on that? Will there be an 8-K that goes up before the end of the quarter? I mean anything you can say on that.

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Stephen A. Arnall, Capitala Finance Corp. - CFO & COO [19]

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Yes, good question. Chris, I know you'd appreciate, we can't comment on that as it's in market. But clearly, when that transaction takes place, we will file a press release, possibly an 8-K to announce that, yes, for sure.

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Operator [20]

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And I am showing no further questions at this time. And I would like to turn the conference back over to Joe Alala for any further remarks.

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Joseph B. Alala, Capitala Finance Corp. - Chairman, President & CEO [21]

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Thank you, everybody, for your time today. Steve, I and Kevin are here all day, if you want to call with any follow-up questions, and we look forward to hearing from you. Have a great day.

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Operator [22]

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Ladies and gentlemen, this concludes today's conference. Thank you for participating, and you may all disconnect.