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Edited Transcript of CPTA earnings conference call or presentation 6-Aug-19 12:30pm GMT

Q2 2019 Capitala Finance Corp Earnings Call

Charlotte, North Carolina Aug 13, 2019 (Thomson StreetEvents) -- Edited Transcript of Capitala Finance Corp earnings conference call or presentation Tuesday, August 6, 2019 at 12:30:00pm 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

* Ryan Patrick Lynch

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

* Troy Lee Ward

Ares Management Corporation - MD & Portfolio Manager

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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 the Capitala Finance Corp.'s conference call for the quarter ended June 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 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 August 5, 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 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'd 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. Good morning, everyone, and thank you for joining us today. Yesterday, we released our results for the second quarter of 2019. Steve and I will give you some insight into the quarter and address any questions you may have.

Before we get into the specifics related to the current quarter, I want to remind you of our change in investment strategy. Early in 2016, we made the decision to adjust our investment strategy, focusing on senior secured debt investments and moving away from mezzanine debt. After 3 years, we have successfully rebalanced the debt portfolio. First lien debt investments are 78% of the total debt portfolio at June 30, '19 compared to 46% at June 30, '16 on a fair value basis. Net investment income for the second quarter was $0.25 per share, in line with our quarterly distribution. I'd like to point out that since the IPO, we have paid $142 million in regular distributions and have never had a return of capital.

Net asset value was significantly impacted by several factors. During the quarter, we realized a $20.4 million loss on our mezzanine investment in AAE Acquisition, LLC. Several investment bankers were interviewed to sell the business and had given similar ranges of expected sales price, which supported our prior fair value mark. Ultimately, no buyers transacted in the ranges provided by the investment banks. The senior bank has since taken over responsibility for the company at this point. This was not the outcome we foresaw earlier in 2019.

US Well Services equity value declined by $3.8 million during the quarter. This is a publicly traded stock with shares under lockup -- with our shares under lockup until November of this year. It is our belief that this decline is temporary. Also, we recorded $9.2 million of unrealized depreciation collectively on portrait studios, CableOrganizer Acquisition, LLC, mostly related to the equity valuation resulting from declines in TTM EBITDA.

As we look at the risk in our portfolio at June 30, 2019, a couple of observations. We currently have 4 credits within a risk grade of a 3, and on a fair value basis, are 9.8% of the total portfolio, the lowest level since our IPO in 2013.

Nonaccrual balances on a fair value basis totaled $8.7 million or 2.2% of the total portfolio. Our portfolio team continues to actively manage the entire portfolio, focusing on the reductions in (inaudible) loans credits. Since we changed our investment strategy in 2016, the BDC has invested $281.6 million in debt investments, 88% of which were first lien securities.

As stated earlier, we continued to rebalance our investment portfolio, focused on senior secured debt investments and reducing mezzanine and equity investments. We are confident that this strategy will produce a more stable net investment income in support of quarterly distributions, and ultimately, superior return on equity through lower realized and unrealized gains and losses, resulting on a lower level of equity investments. Our equity portfolio represents 14.2% and 19.1% of the investment portfolio on a cost basis and a fair value basis at quarter end.

During the quarter, we recognized gains from our equity investments in US Bath Group, LLC, and Navis Holdings, Inc. Part of the rebalancing of our portfolio is the need to continue to monetize additional equity holdings and redeploy the proceeds into senior secured debt investments. We expect a significant reduction in our equity investments during the second half of 2019 resulting from normal exits and sales. In summary, while we are not satisfied with the decline in NAV, we are very optimistic about future earnings results from a more senior secured debt portfolio and anticipate equity monetizations later in 2019.

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. - CFO & COO [3]

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Thanks, Joe. Good morning, everyone. Total investment income was $11.6 million during the second quarter of 2019, $0.3 million lower than the second quarter of 2018. Dividend income for the second quarter of 2019 included $0.4 million distribution from Capitala Senior Loan Fund II, LLC. PIK income decreased by $0.2 million for the comparable periods and were 6.2% of total investment income for the current period, the lowest level since the fourth quarter of 2014.

Total expenses for the second quarter of 2019 were $7.6 million, a decrease of $0.1 million from the second quarter of 2018. Incentive fees, net of the waiver, increased $0.2 million for the comparable periods. Net investment income of $0.25 per share for the second quarter of 2019 was in line with our quarterly distribution. Consistent distribution coverage will always [be an] important measure of our performance.

Net realized losses for the second quarter of 2019 totaled $15.1 million or $0.94 per share. We realized losses related to AAE Acquisition and J&J Produce Holdings, partially offset by realized gains from US Bath Group and Navis Holdings. Net unrealized depreciation totaled $17.4 million or

$1.08 per share for the second quarter of 2019 compared to appreciation of $22 million for the comparable period of 2018.

The net decrease in net assets resulting from operations totaled $29.1 million or $1.81 per share for the second quarter of 2019 compared to a net increase of $4.9 million for the comparable period of 2018. Net assets at June 30, 2019, totaled $153.9 million or $9.55 per share compared to $11.88 per share December 31, 2018.

At June 30, 2019, we had $43.5 million in cash and cash equivalents. In addition, we had $5 million drawn and $109.5 million available on our senior secured facility priced at LIBOR plus 300 basis points. Regulatory leverage at June 30, 2019, was 0.86 compared to 0.72 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%, effective as of November 1, 2019. We do not anticipate a special shareholder meeting but have begun planning for the reduced asset coverage ratio to be effective in the fourth quarter of this year.

At June 30, 2019, our investment portfolio included 41 investments with a fair value of $391.1 million and a cost basis of $378 million. During the second quarter, we invested $13.8 million across one new company and 5 existing portfolio companies. Debt investments totaled $13.4 million, where first lien structures had a weighted average yield of 9.8%. The weighted average yield on the entire debt portfolio at June 30, 2019, was 12.2%.

First lien debt investments on a fair value basis at June 30, 2019, comprised 60.1% of the portfolio, while second lien and subordinated debt collectively represent 17.3%. Equity and warrant investments represent 19.1%, and our investment Capitala Senior Loan Fund II represent 3.5%. At quarter end, we had 2 portfolio companies on nonaccrual status with a cost basis and fair value of $13.3 million and $8.7 million, respectively.

Lastly, 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 an active second half of the year in that regard.

At this point, operator, we'd like to turn it over for questions.

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Questions and Answers

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Operator [1]

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(Operator Instructions) And our first question comes 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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The -- I saw an increase in the last -- first lien last out, is -- what sort of portfolio yield are you guys targeting? Because I know it's 12% or so, which is a little bit higher than what you normally see for first lien first out. And I guess that was my question.

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

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Yes, I'm not sure specifically what you're asking, Chris. I mean this is part of our overall unitranche facility program, where we've got Capitala Senior Loan Fund I taking the first out and then other Capitala entities taking the last out piece. The first out will be priced differently clearly so that the other Capitala entities are benefiting from a higher yield in that regard. So I think we're expecting to see double-digit yields for Capitala Finance Corp. when it participates in this unitranche facilities.

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

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Okay. So it's just a function of the SLF really?

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

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Most of the time, that's correct. Yes.

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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 my follow-up is on leverage. Do you guys anticipate, given that you can start increasing your regulatory leverage after November, what is the plan in terms of your regulatory leverage ratios beyond that?

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

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Yes, good question, Chris. So look, our total leverage is 1.8 and regulatory 0.86 at the end of the quarter, the difference being our exempt SBA debentures. As we work with our bankers, we're certainly going to be mindful of how any future increases in our total regulatory leverage impact our ability to deliver stable net asset value per share. So we're going to continue to move towards making senior secured debt investments, move it away from mezzanine and equity, and that should help support higher leverage. But in the meantime, 0.86, there's not a lot of room there. So we'll continue to, again, work with our bank and try to move towards that higher level as our Board has approved and becomes effective November 1 of this year.

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

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Final question, what's a more normalized cash-basis balance sheet cash for you guys?

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

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It varies greatly. We have pretty active investment activity coupled with repayments. So I would say where we are at the end of the quarter is not unusual. We've got a fair amount of liquidity that we can put back to work, and that's pretty normal, actually.

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Operator [10]

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

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

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Joe, I just wanted to touch base on the sales process you talked about in the quarter that impacted NAV. How do we think about how that impacts NOI going forward? Was that investment on nonaccrual or accrual? And is there anything left of it on your books?

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

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Kyle, this is Steve. I'll take that one. It was on accrual status because it has been current. But going forward, it should not have a meaningful negative impact on [NII] as we continue to put repayments and cash back to work. We've kind of restocked that. But that investment is off of our schedule investments. We took the full write-off on that at June 30. So it's no longer billed under active investment.

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

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Got it. And then one follow-up from me. If you could just talk about the -- any changes in the competitive dynamic in the industry. Obviously, the rate outlook has been shifting. We've seen the industry been able to increase its leverage. But just sort of -- since we last spoke, any sort of changes you're seeing in the industry?

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Joseph B. Alala, Capitala Finance Corp. - Chairman, President & CEO [14]

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This is Joe. I mean it's very similar to prior quarters in that it's still a competitive industry, but the lower middle market seems to be trending on the less competitive side as some entrants have left or in the process of leaving. We've been able to generate some really nice loans over the last 3 years in our new first lien strategy. The leverage on those loans are very reasonable, we think. The average is less than 60% loan-to-value. And the average yield as right -- as Steve mentioned earlier, on all those first lien loans are right around 10%, some a little lower, some a little higher and some -- and most of those loans are either -- they're all first lien, first outs, or if we do have a first out piece, we're taking a very small first out position to our captive senior loan fund of around 25%.

We're not very active in the market doing unitranche loans, where we're behind 50% to 70% of a first lien structure that's third-party. So we really do believe our unitranche loans are structured correctly. And we just still generate those type of yields. Our LIBOR has gone down a little bit with the recent cut. We were proactive when we structured a lot of these loans over the past 3 years, and we have -- actually have higher floors than we expect our competitors do. Those often became negotiating points in each specific deal. So we feel good about the ability to find these deals in lower middle market. And we think having the amount of liquidity and the size of the team we have, and we expect to start growing more this fall, that we're in a good place when it comes to lower middle market credit.

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Operator [15]

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And our next question comes from Ryan Lynch with KBW.

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Ryan Patrick Lynch, Keefe, Bruyette, & Woods, Inc., Research Division - MD [16]

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First one, I just wanted to follow back up on AAE. So it sounds like that, that was in a process, the sales process, and some bankers [were] -- give you guys some quotes. The question was, it seemed like that company was still paying you guys interest income. It was still on accrual status, and it still had a pretty high fair value mark in the prior quarter. So was the whole basis of the mark that you guys had based on them being able to complete the sales process? Or was there anything else driving that because it's just a pretty extreme mark to go from 85 to exit it at a 0.

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Joseph B. Alala, Capitala Finance Corp. - Chairman, President & CEO [17]

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Yes, that's a great question. We've been trying to monetize or improve our risk 3 assets actively over the past few years. We actually did sell one that we haven't talked about. We sold J&J Produce over the same last quarter. It was a risk 3 asset. It was in a process that we got 91% cost.

AAE, the size of the company actually had interest from many investment banks. We ran a full investment bank interview process. Most of those investment banks had a range -- a tight range on the hiring and enterprise value that we believe they could achieve, they believe they could achieve. We -- obviously has our independent valuation team involved in this entire process. It went to market. And we actually received bids in that range. So we did have third-party bids in the range that the bankers believe. And then post diligence, the offers did decline. And they declined to the point -- we were mezzanine in this particular transaction, that it's declined to the point -- the bank has really taken over this operations and other responsibility of this company. We were no longer involved. We do believe the bank would transacted something that gets them out hold but would not grant much more than that to try to take care us. So we did impair to 0. But we believe the process was not the outcome we wanted. We were very confident in the banks and the bank that we chose, and they ran a good process. It just did not transact at the original offers that were made for the company.

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Ryan Patrick Lynch, Keefe, Bruyette, & Woods, Inc., Research Division - MD [18]

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Okay. And then you mentioned you guys expect exit some of your equity positions in the second half of the year, reduce that concentration in your portfolio. I know that's been a goal for at least the last several quarters, maybe the last several years, to kind of reduce your guys' exposure that is fairly high. What gives you guys confidence that you'll be able to further reduce your equity portfolio in the second half of the year? Are there companies that are currently in the M&A process or the bid process? Or is there active markets for some of your investments?

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Joseph B. Alala, Capitala Finance Corp. - Chairman, President & CEO [19]

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Yes, that's another great question. Equity continues to perform well. But if you look at what we're sort of focused, is really the top 3 names that we published on our equity holdings. One of the publicly traded company, US Wells Services (sic) [US Well Services], we talked about earlier, the stock has declined meaningfully over the past period of time, but it's -- you can track that as publicly traded or lockups, as we mentioned, to expire over time. So that when you can publicly just track how that would affect our equity valuations. Then we have 2 more large ones. One of the 2 large ones has already hired a banker. They're in process. We have been communicated, so I'm very optimistic. Fall from that process in the early stages.

We do believe that company transacts between now and the end of the year. It is a larger asset that's held by other BDCs, too. So we're excited that, that one may monetize in the fall. And then the other larger one -- it's been on books for a while. We believe they will go to market in 2020. And then -- so you're looking at 6 months into 2020 for a process on that one. But really, it's US Wells (sic) [US Well] to track and then also our larger one that's in market right now that's owned by other BDCs too that should monetize in the fall, and that really would make a meaningful conversion of equity to cash, which we need to take it out, put it into these first lien yields. And that's where our earnings -- we're really optimistic about our earnings on that conversion.

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Stephen A. Arnall, Capitala Finance Corp. - CFO & COO [20]

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And Ryan, this is Steve. Remember, on US Well, that we're still under lockup. And so once we get to November, all other things equal, we're free to trade.

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Operator [21]

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And our next question comes from Troy Ward with Ares Management.

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Troy Lee Ward, Ares Management Corporation - MD & Portfolio Manager [22]

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Joe, I just had a real quick question on AAE, following up from Ryan's question. You talked about how your value was based on the takeout. I have a couple of questions. First, are there any other fair values in your portfolio that hinge almost solely on the value of a takeout?

And second, how long were you in that investment? And as an owner, as an investor, shouldn't -- your knowledge of that underlying fundamentals in that transaction should have been higher than any buyer. So what was found in due diligence that surprised the buyers that lowered their bids but also surprised you to wiped out your fair value?

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Joseph B. Alala, Capitala Finance Corp. - Chairman, President & CEO [23]

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Yes. Let me sort it -- It's sort of a multiple part question. Let me sort of dissect in a few parts. The first part is familiarity with this investment. In fact, this investment, we entered it the first time, I think, 2003, back when we were private fund, we entered it, we sold it, very successful investment. We got back in it. So we've been familiar with this investment for almost 15 years now, very familiar with it, very active in it. This company did have earnings. This was not a company that -- this company is a [rental] company that has a lot of assets and equipment. But it does have earnings. So it's not as if the bankers in our process was basing anything on this (inaudible) transaction value. It was a multiple of trailing EBITDA that everyone was basing their valuation on. I think from what we understand happened in the process is the third-party buyers believed the CapEx needed to refurbish some of the fleets -- some of that equipment was much greater than we believed and management believed. So they sort of reduced their bids accordingly.

And then my opinion is the bank just got frustrated because they saw a path to where they could get much more recovery and not worry about the junior debt in the capital scenario. And once they see that path, they do have that right, that they can -- unless we want to take them out, unless the mezzanine lender wants to take them out, they have the right to start performing their remedies, which they did. So we were removed from the process, but -- and the equity sponsor, obviously, was completely [impaired in]. But -- so we have familiarity with the deal, but it was not a transaction that we thought that was -- it was based on EBITDA. It was based on equipment values and EBITDA. We did have multiple banks in the same range, but it was just a failed process at the end.

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Troy Lee Ward, Ares Management Corporation - MD & Portfolio Manager [24]

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I see, so it was much more to do with -- about your position in the capital stack and seniors' ability to just run over you if you couldn't buy them out.

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Joseph B. Alala, Capitala Finance Corp. - Chairman, President & CEO [25]

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Yes. And then the only -- you mentioned another question about if there is anything else in the portfolio sort of valued-own a pending sale, it is not. And that goes -- both to the ones that are performing, the ones that are overperforming and the ones that underperforming.

So we have optimistic views on to it. Some of these equity monetizations will occur at a value that's hopefully better than what we think is the multiple of EBITDA.

And really, that happened in our last quarter with US Bath. So yes, we had a great return on that. It was a huge multiple on invested capital. Unfortunately, all the good things that we did last quarter sort of take second focus and the bad things that happen related to NAV. But we do believe that we're much further along on this rebalancing of the portfolio that started in 2016. And that when you look at assets deployed over the past 3 years, it really confirms the change in strategy in underwriting and portfolio management of those successful performing assets.

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Troy Lee Ward, Ares Management Corporation - MD & Portfolio Manager [26]

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Okay. And then one last question for me and it relates to SBIC. Can you speak to what -- or how many of the assets that have been impaired and caused us a 17% write-down in NAV in 3 months were SBIC? And what has your conversations with the SBA been, seeing how that's such an important part of your ability structure?

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Joseph B. Alala, Capitala Finance Corp. - Chairman, President & CEO [27]

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I'm going to have Steve dig in over here and try to get the answer on what's in the SBICs. I will just say on a broad relationship with the SBA. We have a lot of communications with them. We do have a private SBIC funds in addition to these BDCs. What you're referring to is also referred to as READ: retained earnings available for distribution. It's a very -- much a big focal point for SBA and the thing about READ that's unique is its cost-based accounting versus fair value accounting. So they really focus on it. We have had some of these monetizations happen, like I just mentioned, US Bath, where we made 9x our money on the equity on that one happen last quarter. Those things have helped READ over time. Our READ is not to the point where SBA has communicated to us any concern over negative READ.

And in fact, we do believe that we will have some more positive READ advance, meaning monetizations of the equity this fall. Because you've got to remember, we keep -- if this is SBA accounting, not -- we keep fair value books and SBA books. The SBA books, you keep all your equity positions at cost. So if we have a cost of like in US Bath, $500,000 is our cost. It was on our books for $500,000 until we sold it last quarter for $4.5 million. So once you monetize and realize it, then you book the appreciated asset. So that's how the recalculations in general work in SBA valuations. But we have -- we're in constant communication with them. We've been in the program since 1999. So we value the relationship, and we do believe that our READ outcomes by the end of '19 will be very favorable.

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Operator [28]

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And we have a follow-up here from Christopher Nolan with Ladenburg Thalmann.

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Christopher Whitbread Patrick Nolan, Ladenburg Thalmann & Co. Inc., Research Division - EVP of Equity Research [29]

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My question's answered. Thank you.

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Stephen A. Arnall, Capitala Finance Corp. - CFO & COO [30]

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This is Steve. I want to come back in and finish the last of Troy's questions related to which one for SBIC investments. From a realized perspective, AAE was an SBIC investment. So that will have a variant there. On the unrealized side, certainly, US Well Services is not. But the other 2 that we mentioned, Portrait Studios and CableOrganizers, they are in the SBIC program. But those -- again, those are unrealized at this point, just fair value declines due to softness in earnings.

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Operator [31]

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

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Joseph B. Alala, Capitala Finance Corp. - Chairman, President & CEO [32]

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We'd like to thank everyone for participating today. Steve and I are around most of the day, all week, answering any more questions. Steve has sent some of the analysts a little summary. So if you want to follow-up on that, we're more than happy to do that. We're around all day. Thanks for your participation and look forward to next quarter.

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Operator [33]

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Ladies and gentlemen, thank you for your participation in today's conference. This concludes the program. You may now disconnect. Everyone, have a great day.