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Edited Transcript of OFS earnings conference call or presentation 8-Nov-19 3:00pm GMT

Q3 2019 OFS Capital Corp Earnings Call

Rolling Meadows Nov 10, 2019 (Thomson StreetEvents) -- Edited Transcript of OFS Capital Corp earnings conference call or presentation Friday, November 8, 2019 at 3:00:00pm GMT

TEXT version of Transcript

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Corporate Participants

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* Bilal Rashid

OFS Capital Corporation - Chairman & CEO

* Jeffrey A. Cerny

OFS Capital Corporation - CFO, Treasurer & Director

* Stephen Altebrando

OFS Capital Corporation - VP of IR

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Conference Call Participants

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* Mickey Max Schleien

Ladenburg Thalmann & Co. Inc., Research Division - MD of Equity Research & Supervisory Analyst

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Presentation

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Operator [1]

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Good day, and welcome to the OFS Capital Corporation Third Quarter 2019 Earnings Conference Call and Webcast. (Operator Instructions) Please note, this event is being recorded.

I would now like to turn the conference over to Mr. Steve Altebrando, Investor Relations. Please go ahead.

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Stephen Altebrando, OFS Capital Corporation - VP of IR [2]

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Good morning, everyone, and thank you for joining us. With me today is Bilal Rashid, Chairman and Chief Executive Officer of OFS Capital; and Jeff Cerny, the company's Chief Financial Officer and Treasurer. Please note that we issued a press release this morning announcing our third quarter results. This press release was subsequently filed on Form 8-K with the SEC. Both documents can be obtained under the Investor Relations section of our website at ofscapital.com.

Before we begin, please note that the statements made on this call and webcast may constitute forward-looking statements as defined under applicable securities laws. Such statements reflect various assumptions, expectations and opinions by OFS Capital management, concerning anticipated results are not guarantees of future performance and are subject to known and unknown risks, uncertainties and other factors that could cause actual results to differ materially from such statements. The uncertainties and other factors are in some way beyond management's control, including the risk factors described from time to time in our filings with the SEC. Although we believe these assumptions are reasonable, any of those assumptions could prove inaccurate. And as a result, the forward-looking statements based on those assumptions also could be incorrect. You should not place undue reliance on those forward-looking statements. OFS capital undertakes no duty to update any forward-looking statements made herein, and all forward-looking statements speak only as of the date of this call.

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

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Bilal Rashid, OFS Capital Corporation - Chairman & CEO [3]

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Thank you, Steve. Good morning, and welcome. Our net investment income per share was $0.36 for the third quarter, again, above our $0.34 quarterly distribution. We have now declared 28th straight quarterly distributions of $0.34 per share since our IPO in late 2012. In addition, we have declared $9.38 per share in distributions over this time, including $0.37 per share of special dividends. And over the last 5 years, our total net investment income has exceeded our total regular distribution. We believe that maintaining our distribution and outearning it over this period of time puts us in select company within the BDC sector.

We made significant progress in the quarter, ramping up our senior loan subsidiary. We invested $41.3 million in the quarter, of which $22.7 million was in the senior loan subsidiary. Jeff will provide more specifics on our investment activities in this quarter later in the call. We believe the senior loan subsidiary will increase our ROE while further improving the overall risk profile of the BDC. The flexibility and incremental leverage permitted under the Small Business Credit Availability Act enables us to invest in loans that previously did not meet our return targets. We believe that we have an advantage in this part of the market since our adviser has been investing in these types of loans for 25 years and currently has approximately $1.5 billion invested in these types of loans through other funds. We believe this new subsidiary is able to capitalize on one of the core competencies of our adviser. As we have mentioned on several of our previous calls, we have been gravitating toward more senior loans based on how we view the private loan market, and we expect that this subsidiary will accelerate that trend.

Given the nature of the loans we are investing in this subsidiary, we continue to be comfortable with consolidated leverage exceeding 2.25x debt-to-equity. Notably, the regulatory leverage is expected to be well below 2x given that the SBIC debt does not count toward the leverage test.

It is also important to reiterate that while the debt of the subsidiary is consolidated on our balance sheet for GAAP purposes, the debt in this facility is nonrecourse to the rest of the BDC. This is similar to other nonconsolidated facilities in the industry.

Our net asset value per share at the end of the quarter was $12.74 compared to $12.95 in the prior quarter. The quarterly decline was largely due to unrealized losses related to fair values determined at the end of the quarter. For the fifth consecutive quarter, we had no new nonaccruals. Jeff will also provide more commentary on the performance of the portfolio.

Turning to the broader lending environment. Over the last year, loan prices have been soft relative to their peaks in October 2018. We believe that this is related in large part to a supply-demand imbalance. Over the last year, there have been 12 straight monthly outflows from retail funds aggregating approximately $50 billion. We believe that this imbalance in the broader market has begun to shift the balance in favor of the lenders. We believe that over the last quarter, lenders have become more discerning in the larger market, pushing back on loan structures, leverage and pricing. We have observed that in many cases, they have been disproportionately penalizing even slight underperformance, which is reflected in lower prices. We believe that this dynamic has begun to create some interesting opportunities in the larger loan market. As such, we continue to be vigilant and cautious about our portfolio construction. 90% of our loan portfolio is senior secured as a percentage of fair value. This compares to 76% 2 years ago. We expect to continue to concentrate on senior secured loans and avoid highly cyclical industries. While we still believe that we are in the late stages of the current credit cycle, the U.S. economy remains in growth mode, although a slow growth.

In terms of deal flow, we continue to see attractive opportunities across the loan market. In the fourth quarter, we took advantage of the decline in interest rates by closing on an approximately $54 million 7-year unsecured bond offering at 5.95%. This was a significant improvement in rate from a similar bond offering that we executed a year ago at a rate of 6.5%. Proceeds from the bond offering were primarily used to repay our revolving line of credit, further enhancing the strength of our balance sheet.

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

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Jeffrey A. Cerny, OFS Capital Corporation - CFO, Treasurer & Director [4]

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Thanks, and good morning, everyone. It was another strong quarter for our net investment income, which continued to exceed our distribution. As Bilal mentioned, we made significant progress ramping up our senior loan facility. We believe this entity is attractive for our shareholders by increasing our focus on lower-yielding first lien senior secured loans to larger borrowers, which we believe will improve our ROE.

In connection with this new financing facility, the company's investment adviser has agreed to waive a portion of its base management fee. It has agreed to reduce its base fee to 1% from 1.75% on assets held in the senior loan subsidiary when statutory leverage is above 1x debt to equity.

We deployed approximately $41.3 million in the third quarter, consisting of $13.4 million to existing portfolio companies and $27.9 million in 5 new companies. The new investments consisted mostly of floating rate senior secured loans to larger companies funded through our new financing facility and our SBIC.

Turning to the financials. Starting with the income statement. Total investment income for the quarter was approximately $13.9 million, approximately a $1 million increase over the second quarter. This increase was driven by a higher overall invested balance during the quarter, partly offset by declining LIBOR.

Total expenses of $9 million increased $1 million compared to the prior quarter. This increase was driven by interest expense due to higher outstanding line of credit balances used to fund our investments and management fees due to more dollars invested during the quarter.

Resulting net investment income per share of $0.36 remained stable. Again, this was above our $0.34 distribution. Net unrealized depreciation approximated only 0.6% of the overall cost of our investments.

Turning to our balance sheet. We had approximately $8 million of uninvested cash at the end of the quarter compared to $9 million last quarter. Of the $8 million of cash on our balance sheet, $4 million of that cash was in our SBIC. As Bilal mentioned, shortly after quarter end, we priced and closed a $50 (sic) [$54] million 7-year bond offering at 5.95%, which we used to pay down our PacWest line of credit. As of earlier this week, we have approximately $1.6 million of cash, $100 million of undrawn commitment on our PacWest line of credit and $102.8 million of undrawn commitment on our new senior loan facility.

Please note that cash on our loan facilities varies based on the asset mix and the amount of cash we deploy as equity.

Our debt-to-equity ratio at the end of the quarter was about 1.2x, excluding our SBIC debt, and 2.1x, including the SBIC debt. As previously mentioned on this and prior calls, the SBIC does not count toward the leverage test. As also mentioned, we would be comfortable increasing our leverage further in order to invest in senior secured loans of larger companies, which will primarily be done through our new senior loan subsidiary.

Our net asset value was $12.74 per share compared to $12.95 in the prior quarter. The decline was largely due to net unrealized depreciation related to fair values determined at the end of the quarter.

I would like to discuss in further detail the reason for the net unrealized depreciation of fair value this quarter. A substantial portion of the unrealized depreciation related to Constellis, a portfolio company that provides security, operational and risk management support to government and commercial clients. I want to note that the company is current on its payments. And based on discussions with management, they have stressed that they have adequate liquidity to fund operations. The company has a growing backlog and expects sequential performance improvement. The sponsor has substantial amount of cash invested in this business, and we expect continued focus from the sponsor.

As Bilal mentioned, in this environment, we believe that certain loan prices have been disproportionately penalized even for slight underperformance, which is reflected in lower loan bids and trades that negatively impact fair value. The broader lending environment has had softness. And over the last year, loan prices have been soft relative to their peaks in October of 2018. We believe this is, in large part, related to supply-demand imbalance resulting from 12 straight monthly outflows of cash from retail funds that invest in loans. More recently, we believe that this imbalance in the broader market has begun to shift the balance in favor of lenders who have more influence on loan structures.

Turning back to our portfolio. As Bilal mentioned, we had no new nonaccruals this quarter. At fair value, we currently have only 0.1% of the portfolio on nonaccrual. At cost, we currently have only 2.5% of the portfolio on nonaccrual. This is the fifth consecutive quarter with no new nonaccruals.

Looking at the overall health of the portfolio, we saw the majority of our borrowers exhibit a quarter-over-quarter increase in revenue. We continue to watch our portfolio closely, and we are not seeing any significant sector concerns in our portfolio.

As far as our investments, at the end of the quarter, we had investments in 73 companies totaling approximately $502 million on a fair value basis. As a percentage of cost, our investments were approximately 78% senior secured loans, 11% subordinated debt, 4% structured finance notes and 7% equity, approximately 2/3 of which is in preferred equity securities. 90% of our loan investments were floating rate.

Our portfolio remains diversified with an average investment in each portfolio company of approximately $6.8 million or 1.4% of the portfolio's total fair value. The overall weighted average yield to cost on our performing debt investments was approximately 10.8% at September 30 compared to 11.4% at June 30. As expected, most of that decrease was driven by our focus on loans to larger companies, many of which are in the new senior loan subsidiary.

Before I turn the call back to Bilal, we would like to highlight one of our investments from the quarter, New York Bariatric Group. We made a $10 million investment in a floating rate senior secured term loan. Founded nearly 20 years ago, New York Bariatric Group is one of the largest providers of bariatric surgery and weight management solutions in the U.S. The 5-year facility has a full covenant package. The last dollar of debt leverage at closing was approximately 3.8x, and the pricing stands today at 7.1%.

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

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Bilal Rashid, OFS Capital Corporation - Chairman & CEO [5]

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Thank you, Jeff. In closing, our net investment income once again covered our distribution in the quarter while we continue to ramp up our senior loan subsidiary. We have been steadily increasing our allocation to first lien loans and remaining selective. We are proud that since the beginning of 2011, OFS has invested approximately $1.2 billion with a cumulative net realized loss of principal of only $900,000 or just 0.07% while generating attractive yields on our portfolio.

Looking ahead, we remain confident in our earnings power. We have attractive long-term financing in place. We believe this financing will provide us the operational flexibility we need to weather a potential economic downturn. In addition, we believe our portfolio, consisting primarily of senior secured loans, positions us well for the current economic environment.

In addition, by taking advantage of our higher leverage allowance, we believe that we can increase the ROE of the BDC while improving its overall risk profile by investing in senior secured loans of larger companies.

With 3 rate cuts this year alone and growing economic uncertainty, investors are increasingly focused on long-term capital preservation by relying on an experienced manager. Our adviser oversees a $2.2 billion corporate credit platform, and its long-standing investment platform has gone through multiple credit cycles over the last 25 years. We believe our low loss track record demonstrates both our experience and alignment of interest since our adviser is the largest shareholder in the BDC, with more than 22% ownership.

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

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Questions and Answers

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Operator [1]

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

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Mickey Max Schleien, Ladenburg Thalmann & Co. Inc., Research Division - MD of Equity Research & Supervisory Analyst [2]

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In your prepared remarks, you mentioned the stress in the more liquid loan markets. And clearly, as you said, some of that weakness is due to fund outflows due to declining LIBOR. But I think the market is also realizing that deal terms, in some cases, have been too aggressive and fundamentals are deteriorating, especially for company -- companies whose business models may have been dislocated by the Internet or those that have been too acquisitive and maybe optimistic on their synergies. There's also increased bifurcation between good credits and those perceived to be weak. So can you be a little more specific on what areas of the more liquid markets are most interesting to you? And where do you think the market is mispricing those credits?

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Bilal Rashid, OFS Capital Corporation - Chairman & CEO [3]

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Thanks, Mickey. I think that's a very good commentary and good question. I think generally, you're seeing a lot of negative press in the market regarding the broader leveraged loan market. And I think you're absolutely right. I think over the last few years, you have seen some deterioration in terms of structures, leverage. Pricing has been compressing. And so I think that certainly has been a way out there.

I think where the opportunities arise are situations where people are throwing the baby with the bathwater, so to speak, where there are certain sectors that are getting beaten up. For example, retail is one sector that has been beaten up quite a bit. But there are some places within the retail sector, certain companies, that are actually doing well. Then on the health care side, within the pharma area, you're seeing there as well with some of the hangover from the opioid crisis. Certain companies are getting beaten up more than their share, even though the performance, in fact, has been pretty good.

So I think generally speaking, there's the overall negativity around the leverage -- broader leverage loan market, which is creating some interesting opportunities across different sectors. But I think within certain sectors, it's -- the market has a negative view of the overall sector, and even though there are certain companies within those sectors that are very -- that could be interesting based on their performance. And so -- and then as I was mentioning, and I think Jeff mentioned in his remarks, situations where the company is a long-term good performer and has maybe one quarter of bad results, and certainly, you're seeing, because of the anxiety in the market, that the loan price drops by 5 points, 3 points, 7 points on the day. And even though that company is actually -- is a good long-term performer and is going to be, in our opinion, fine in the long run, and I think that those situations also create some interesting opportunities in the market.

So I think we are watching it vigilantly. And I think as those opportunities arise, we will take advantage of those. As we said earlier, we managed $2.2 billion of assets, and about $1.5 billion are in some of those larger loans.

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Jeffrey A. Cerny, OFS Capital Corporation - CFO, Treasurer & Director [4]

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Mickey, I guess I would also add that the practical reality is that CLOs are a very large holder of loans in this sector. We have seen, as we mentioned, the retail fund outflows. But as Bilal mentioned, as you see a fundamentally sound company that has 1 or 2 quarters of poor performance, and the trading prices react very quickly, the managers of CLOs are reacting to collateral buckets and concentration limitations. So they're selling, in some instances, very quickly, which we think puts undue downward pressure on the price of these. So they're managing to a vehicle, which creates opportunities for others that have more flexibility.

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Mickey Max Schleien, Ladenburg Thalmann & Co. Inc., Research Division - MD of Equity Research & Supervisory Analyst [5]

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Actually, Jeff, I wanted to ask you about CLOs. And even though we don't have the Q in front of us, I think you mentioned you're still holding some CLO investments. That market is practically frozen right now due to the fears of those CLOs tripping their CCC buckets. So how do you feel about the outlook for cash flows to CLO equity? And to the extent there's liquidity, which I know right now is really limiting factor, how do you feel about increasing your CLO allocation at OFS Capital?

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Jeffrey A. Cerny, OFS Capital Corporation - CFO, Treasurer & Director [6]

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Yes. Mick, I would say that right now, it accounts for less than 5% of our investment portfolio. We expect it to remain a very small part of that portfolio. It is an asset class that we know very well. As you know, we are -- we manage CLOs. We also invest in CLO equity and debt. And we don't expect to really meaningfully increase our exposure to CLOs.

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Mickey Max Schleien, Ladenburg Thalmann & Co. Inc., Research Division - MD of Equity Research & Supervisory Analyst [7]

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All right. And Jeff and Bilal, given that you manage a lot of money, and you've been at this for a while in the more liquid markets. Just at a 30,000-foot level, when you see a market like this where fear is impacting what you would consider generally good credits, does that -- is that some sort of a signal of a bottom of the market? Or is it too early to tell?

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Bilal Rashid, OFS Capital Corporation - Chairman & CEO [8]

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Yes. I think it's too early to tell right now. I think there is a decent amount of uncertainty in the market with respect to what's happening with the trade war with China and just the overall global economic outlook softening. And then you have other political exogenous events like Brexit, et cetera. So I think it's too early to tell at this point, in my opinion.

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Operator [9]

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Thank you. At this time, I would like to return the floor to Bilal Rashid for any closing comments.

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Bilal Rashid, OFS Capital Corporation - Chairman & CEO [10]

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

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Operator [11]

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