Q4 2023 Gladstone Capital Corp Earnings Call

Participants

David John Gladstone; Chairman & CEO; Gladstone Capital Corporation

Michael Bernard LiCalsi; General Counsel & Secretary; Gladstone Capital Corporation

Nicole Schaltenbrand; CFO & Treasurer; Gladstone Capital Corporation

Robert L. Marcotte; President; Gladstone Capital Corporation

Kyle Joseph; Equity Analyst; Jefferies LLC, Research Division

Mickey Max Schleien; MD of Equity Research & Supervisory Analyst; Ladenburg Thalmann & Co. Inc., Research Division

Robert James Dodd; Director & Research Analyst; Raymond James & Associates, Inc., Research Division

Presentation

Operator

Greetings, and welcome to the Gladstone Capital Corporation Fourth Quarter Earnings Conference Call. (Operator Instructions) As a reminder, this call is being recorded. It is now my pleasure to introduce your host, David Gladstone, Chief Executive Officer. Please proceed, sir.

David John Gladstone

Okay. Thank you very much. Latoria, this is what the tenth time we've talked with you on there. This is very nice. This is David Gladstone, Chairman, and this is the earnings conference call for Gladstone Capital for the quarter end and also the fiscal year-end of September 30, 2023. Thank you all for calling in. We're always happy to talk with our shareholders and the analysts that follow us and welcome an opportunity to provide updates with regard to the corporation.
And now we hear from our General Counsel, Michael LiCalsi, who will make a statement regarding certain forward-looking statements. Michael?

Michael Bernard LiCalsi

Thank you, David. Good morning, everybody. Today's report may include forward-looking statements under the Securities Act of 1933 and the Securities Exchange Act of 1934, including those regarding our future performance. These forward-looking statements involve certain risks and uncertainties that are based on our current plans, which we believe to be reasonable. Many factors may cause our actual results to be materially different from any future results expressed or implied by these forward-looking statements, including all risk factors in the Forms 10-K, 10-Q and other documents we file with the SEC to find them on the Investors page of our website that's gladstonecapital.com.
While you're on there, you can also sign up for our e-mail notification service. You'll find the documents on the SEC's website as well, www.sec.gov. Now we undertake no obligation to publicly update or revise any of these forward-looking statements whether as a result of new information, future events or otherwise, except as required by law. And just a reminder, today's call is an overview of our results, so we ask that you review our press release and Form 10-K both issued yesterday for more detailed information. Again, go to the Investors page of our website to find them. Now I'll turn the call over to Gladstone Capital's President, Bob Marcotte.

Robert L. Marcotte

Thank you, Michael. Good morning, and thank you all for dialing in this morning. I'll cover the highlights for last quarter and the fiscal year ended September 30 and conclude with some commentary as we look forward into fiscal '24. Before turning the call over to Nicole Schaltenbrand to review the details of our financial results for the period. So beginning with the last quarter results, originations last quarter below trend and totaled $27 million mostly to existing portfolio companies as we enter the quarter closely managing our overall leverage and with a cautious view on investment leverage levels in the face of slowing price escalation and elevated interest rates. Prepayments have been modest this year. However, we did have one sizable prepayment from Encore Dredging, which combined with the portfolio amortization resulted in a $13 million decline in our ending investment balance as of September 30.
Short-term [Zopa] rates increased 30 basis points on average over the quarter and were the primary reason, the weighted average yield on our investment portfolio rose to 13.8%. The average earning assets for the period also increased 3.7% and the 2 combined to increase total interest income by 6.7% to $23.3 million for the quarter. Borrowing costs rose slightly as average bank borrowings declined with the proceeds of the lower-cost GLADZ baby bond issuance in August. As a result, our net interest income rose $1.3 million to $17.1 million for the quarter. Deal closing and advisory fees fell with the modest originations and management fees rose by $1.5 million given the reduced fee credits to $5.6 million for the period. Despite the $2.1 million decline in fee income in deal closing and advisory fee credits, net investment income came in at $11 million or $0.28 a share for the quarter, which was down $700,000 from the prior quarter.
The net realized and unrealized gains on the portfolio for the period totaled $2.1 million which lifted our ROE for the quarter to 13.7% and 11.9% for the last 12 months. Consistent with our outlook for significant growth of private credit within the lower middle market over the next couple of quarters, we elected to capitalize on significant investor demand into our common stock ATM program and issued 4.9 million shares last quarter, which generated proceeds of $48.3 million and increased our NAV to $409 million or $9.39 per share.
With respect to the portfolio, the portfolio continues to perform well with senior debt representing 73% of the portfolio, and we ended the quarter with only one non-earning asset, representing $6.1 million in cost or 0.4% of assets at fair value. We continue to prioritize our portfolio monitoring in areas where revenue headwinds appear to be most prevalent, which seems to be mostly consumer-facing sectors, which is a small portion of our overall investments. And thankfully, our couple of exposures to the auto segment were relatively unaffected by the recently settled strikes.
Appreciation for the quarter of $2.1 million was driven by the equity appreciation of our position in a manufacturer of defense-related electronics, which was partially offset by the depreciation of a handful of senior debt positions, most of which are private equity sponsored with significant underlying equity support. In reflecting on our 2023 performance and outlook for what is now our fiscal '24, there are a couple of comments I'd like to leave you with. While 2023 deal activity has been volatile, we've been able to grow our investment portfolio by 10% to over $700 million, while still maintaining our focus on investing in growth-oriented lower middle market companies and broadening our private equity network in the process.
Today, our portfolio is comprised of over 50 companies, and our core portfolio represents companies with an average EBITDA of approximately $11.7 million. We've maintained our underwriting rigor and are fortunate to have our portfolio heavily weighted to senior secured loans with relatively low PIC and nonearning assets. With the expectation of the continued growth opportunities inside the portfolio, and the growth of private credit market more broadly across the lower middle market, we've ended the quarter with a very conservative leverage position at just 74% of NAV, and ample availability under bank credit facility.
So we are very well positioned to grow our earning assets as the primary driver of our net interest income growth and shareholder distributions in the coming year. And now I'll turn the call over to Nicole Schaltenbrand, the CFO for Gladstone Capital, to provide more details on the fund's financial results for the quarter.

Nicole Schaltenbrand

Thanks, Bob. Good morning, everyone. During the September quarter, total interest income rose $1.5 million or 6.7% to $23.3 million based on the increase in short-term rates and an increase in earning assets. The weighted average yield on our interest-bearing portfolio rose 30 basis points to 13.8% with the increase in floating rates on the 89% of the investment portfolio that carries floating rates. The investment portfolio weighted average balance increased to $668 million, which was up $24 million or 3.7% compared to the prior quarter. Other income declined to $500,000 and total investment income rose $900,000 or 4.1% to $23.8 million for the quarter.
Total expenses increased by $1.6 million quarter-over-quarter as net base management fees rose $1.7 million with the reduced deal closing and advisory fee credit. Net investment income for the quarter ended September 30 was $11 million, which was a decrease of $700,000 compared to the prior quarter or $0.28 per share, which exceeded the $0.2675 per share dividend paid. The net increase in net assets resulting from operations was $13.1 million or $0.33 per share for the quarter ended September 30, as impacted by the realized and unrealized valuation depreciation covered 5 months earlier. With respect to the full fiscal year, total investment income for 2023 was $86.4 million, which represented an increase of $23.3 million or 37% over the prior year.
The year-over-year increase was primarily due to the 21.2% increase in the weighted average principal balance of our interest-bearing investment portfolio and the increase in the weighted average yield from 10.4% during the year ended September 2022 to 13.3% during the year ended 2023. Expenses increased $14.5 million or 47.1% in 2023 as compared to the prior year. This increase was primarily due to a $7.9 million increase in interest expense on borrowings and a $3.2 million increase in the net incentive fee.
Net investment income for the year ended September 30, 2023, was $41 million, an increase of $27.1 million as compared to the prior year or $1.10 per share. The net increase in net assets resulting from operations was $42.7 million or $1.14 per share for our fiscal year ended 2023 compared to $19.9 million or $0.58 per share for 2022. The current year increase was driven by net investment income and $12.7 million in net realized gains, partially offset by $11 million in net unrealized depreciation.
Moving over to the balance sheet. As of September 30, total assets declined to $720 million, consisting of $705 million in investment at fair value and $15 million in cash and other assets. Liabilities declined to $311 million, and consisted primarily of $253 million of senior notes, including the $57 million of 7.75% GLADZ baby bond due September of 2028, which we closed during the quarter and advances under our $223 million line credit declined to $48 million as of the end of the quarter.
As of September 30, net assets rose by $50.7 from the prior quarter end with the net proceeds from common share issuance under our ATM of $48 million and our undistributed earnings. NAV rose from $9.27 per share at the end of the prior quarter to $9.39 per share as of September 30. Our leverage as of September 30 declined with the common stock issuance and debt reduction to 74% of net assets. And subsequent to September 30, we closed an $11 million secured for lien debt and preferred equity investment and quality environmental. With respect to distribution, in October, our Board of Directors declared monthly distributions to common stockholders of $8.25 per share per month for October, November and December, which is an annual run rate of $0.99 per share. Board will meet again in January to determine the monthly distribution to common stockholders for the following quarter.
At the current distribution run rate for our common stock and with the common stock price at about $9.98 per share yesterday, the distribution run rate is now producing a yield of about 9.9%. And now I'll turn it back to David to conclude.

David John Gladstone

Well, thank you, Nicole. Nice presentation, and Bob, another good year. Michael did a nice job too, presenting things that will help our analysts and stockholders understand who we are and what we've been up to. In summary, it was another solid quarter and a solid fiscal year for Gladstone Capital. For the year, the company delivered some impressive results, 25% growth in average earning assets, 27% growth in net investment income, 11.9% return on equity and 22% increase in the common stock distribution rate.
Very nice numbers. While the fiscal year 2023 results were good, the company also is very well positioned for the coming year as the portfolio is in good shape and modest leverage and very low nonperforming assets. As a strong balance sheet today to support further growth, and I think we'll get good growth for this new year, fiscal year 2024. In summary, the company continues to stick with its strategy of investing in growth-oriented at low middle market -- lower middle market businesses with good management. Many of these investments are in support of midsized private equity funds that we have been friends with for many years.
And they are looking for an experienced partner to support their acquisition and growth of that business, which they've invested in. This gives us an opportunity to make attractive interest-paying loans to support our ongoing commitment to pay cash distributions to shareholders. We live to pay dividends, and I love that since I'm a shareholder and I'm going to turn it back over to our -- the lady who is handling this, Latoria, and we'll get sort of the operator telco as how they can ask for questions.

Question and Answer Session

Operator

(Operator Instructions) Our first question comes from Robert Dodd with Raymond James.

Robert James Dodd

Congratulations on the quarter and a good year. Bob, can you give us some color about pipeline or anything like that? I mean you sound very confident and positioned the balance sheet to capitalize on some significant onboarding of new builds potentially. So can you give us any color about is that hopeful? Or is it actually already showing up in the pipeline and what kind of deals given that Q3 was pretty light, obviously?

Robert L. Marcotte

Thank you for calling, Robert. I guess, a couple of observations. We went through last quarter with almost $30 million of core growth in existing portfolio. So we're finding our existing businesses that we feel good about are certainly looking for solutions to continue to grow. I would expect over the near term to see -- continue to see a significant investment on that front.
Secondly, we've been very judicious in pursuing new activities. We've already closed one this quarter, and there are definitely a few on the horizon. I will say, not all of those are necessarily private equity buyout situations. The complexion of the marketplace today is -- there are lenders and investors that are withdrawing from the market given the capital limitations and the availability of capital more broadly. So we're finding businesses that the existing lenders are not able to step up and support the growth of the businesses as well as certainly some selective buyout activity.
But at current marginal rates, there's no doubt that the overall volume of private equity buyout activity has come down a bit. So I think the idea of seeing flow and picking up from where we were in Q2, when we frankly took on no new assets is part of why I'm relatively bullish. The unknown, Robert, is prepayments. Our portfolio continues to mature. We have roughly a little more than 50% of the portfolio with EBITDA north of $10 million. And so depending upon where interest rates are and how the liquidity returns to the market, we may see a pickup in prepayment activity, but that's a tough one to call at this point.
I think our view is rates are staying high and the banks currently aren't aggressively pursuing refinancing activities. So we're seeing those assets probably stick around longer. A number of our portfolio companies have considered refinancings and been somewhat challenged based on the market reception. The last thing that I would also say is consistent with that private equity market is businesses are not selling and private equity is not necessarily raising a ton of new funds today. So a lot of portfolio companies and sponsors are looking to extend the life of their investment horizon.
So you're seeing a tremendous amount of continuation funding, dividends and recapitalization activities because they can't necessarily sell the assets at the multiples they expected given the current interest rate environment. So overall, we feel like the market's there. It's just slightly different pockets of activity. It's not all buyout activity. It's coming in a variety of different forms and I think the idea of us being able to put out an average of roughly $50-plus million a quarter, which is what we've been averaging for the most part on a normalized quarterly basis is the reason why we've created the capacity we have on the balance sheet, just for round numbers, we need to put out another $100 million in order for us to get to close to 1:1 leverage.
That's currently what I would say is the target. And if we can do that over the course of the next 2 to 3 quarters, I think that's really the plan of why our balance sheet is currently as strong as it is.

Robert James Dodd

That was really helpful color. Second one, if I can, on credit quality. I mean, to your point earlier, I think one other call, the only thing the consumer -- you mentioned consumer headwinds in the consumer sector, where you don't have a lot of exposure. Any other areas where maybe margins are moving the wrong way or anything like that where there's an emergence of perhaps credit concerns? Or is it just the consumer like that?

Robert L. Marcotte

I will say we're going into year-end. And in the past couple of years, year-end has been a market where some of the industrial companies, we are in a middle bending, middle processing, precision manufacturing business, their end customers will be large industrial manufacturers. Order visibility and order momentum is a little soft.
Nobody wants to be stuck with year-end inventory more than they otherwise would, given the current rates and the current liquidity profile in the marketplace. So we're definitely seeing a tick down in some order flows for those. We tend to look at those as year-end related matters. It happened last year. It's happened in the prior years. I think at this point, the businesses are solid. They're not looking to source it overseas. They're not chasing alternative suppliers. This is not about pricing. This is about managing their order flows and maybe getting a little leaner. So some of the metal processing industrial businesses, I think, are going to be down single digits in their revenue profile over the course of Q4 and we'll have to see what the beginning of Q1 next year looks like.

Robert James Dodd

Really, really helpful. And I mean, kind of following on to that avenue this year-end. I mean have you heard preliminary -- you've gotten any feedback from portfolio companies about expected budgets for 2024 or maybe it's too early in that cycle? I mean, by the sound of it with the industrial, is that's what you're hearing. Any other general expectations? I mean, are people budgeting for a recession next year or just a more moderate economy?

Robert L. Marcotte

I don't think anybody's budgeting recession. For most of our businesses, it's about has the market moved where do they need to be going, diversifying their underlying customers. As you may appreciate, when you start at a lower middle market business, you tend to have a limited set of core customers that drive the business. And depending upon the selection of customers you've got or the diversity, there may be sectors that are not as robust. And so part of the challenge is broadening the horizon to grow the underlying business.
At this point, I would say I think people are cautiously optimistic. I think they know they're going to have to work harder. They know they're going to have to diversify more. They're going to have to broaden the funnel of deal opportunities to build on to '24 volume. But we're still focusing on the core. Most domestic businesses are still reshoring. They are still looking for capable, lower middle market or middle market businesses that can support and be more flexible in their supply chain on fulfilling their production needs.
And so we don't feel like the market is moving away from us, and it's certainly not about pricing. It's about diversity and stability of the customer base, and we feel pretty good about that. It's not about price for the most part. I was down visiting one of our smaller companies in the electronic printed circuit board business. And they've had the biggest quarter they've had in the last couple of years, last quarter because people don't want to be dealing with foreign suppliers and it's created a resurgence and flexibility for those folks that are capable and responsive to their underlying customers.
So at this point, it's not a recession horizon. It's about continuously improve the business and diversify the businesses that we're most focused on.

Operator

Our next question comes from Mickey Schleien with Ladenburg.

Mickey Max Schleien

Yes. Bob, I realize these are not particularly large investments, but I wanted to ask you about the prospects for DKI ventures and 8th Avenue Food, just asking in relation to their valuation.

Robert L. Marcotte

Taking them in reverse order. 8th Avenue Food is a large syndicated position in a buyout business that is in the grain and commodity processing. It is affiliated with what used to be the old post foods. It had a tough couple of quarters, but it has consolidated its manufacturing and is reasonably solid in the food service business.
As a second lien loan in this marketplace, things don't trade very well. And I think that one is probably trading at a relatively low point compared to its enterprise value. I -- frankly, I'm not terribly worried by that. That is actually a position that is owned by Apollo, and they have significant capital invested in that business. So I -- food service tends to go through some cycles, but it tends to have a long-term horizon to grow. That's one that don't really spend a ton of time on and give you a little color on that one.
In terms of DKI, DKI is a -- it's an environmental kind of a restoration company kind of like a bow 4 type of business where it deals with events such as flood storm damage, fire restoration type of obligations. The business has gone through a bit of a transition. It used to be a franchise business with local operations. That franchise platform is morphed to a services, more of a TSP platform. They recently hired some additional resources to expand and grow its network of property owners and managers that they service.
The business has a core supply GPO underlying it, which also produces a fair bit of profitability. Because of the current events, whether it's climate change or otherwise, we seem to have plenty of occasions for that kind of support. And then given what's going on in the property market, we see large property managers desperately in need of a consolidated outsourced provider to service those particular incidents when they arise in their managed properties. So the underlying performance of the business has probably trailed what I think is the broader marketplace.
We've repurposed the marketing side of the business and feel like it's in pretty good shape. And the underlying sponsors in this case and the founders of the business are continuing to fund money into the business to support the transition that's ongoing. So it's a business we are working hard on, but we think the long-term fundamentals supporting the business and the equity ownership is supportive of the business and feel like it's a small business that has a reason to continue to grow and come out of the situation soon.

Mickey Max Schleien

Bob, just a follow-up to that explanation. Does quality environmental, the new investment you made operate in the same space?

Robert L. Marcotte

It actually does not. Quality environmental is an asbestos abatement firm focusing on certain segments of the health care and the educational sectors. So it's more about curing environmental problems that exist, not fixing problems that have occurred, unfortunately.

Operator

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

Kyle Joseph

Yes. Just wanted to pick your brain. Obviously, the portfolio has seen some good yield expansion on rates, but kind of give us a sense for what spreads has been doing and the outlook for yield into '24, given the forward curve?

Robert L. Marcotte

The rates are a tough one, Kyle. Thanks for the question there. When you look at current market, the SOFR 7 type pricing puts rate at 12 -- low 12s. That starts to sound like traditional mezz or subordinated debt. And what's happening is there's a little bit of a convergence and blurring of the categories. If it is a good solid business, you'll tend to get a little bit more pricing compression, and we've seen good sized businesses attract large capital sources and maybe that -- what might have been in the high 6s and the spread over SOFR can be bid down to maybe 6 over.
So there's been about 50-plus basis points of compression for the better credits. And so they're clearing probably closer to the -- in the 11s as opposed to other places where it might have been a recapitalization and it might have been a slightly wider. So I think what's happening today is buyouts of good credits, good companies are getting a little bit more aggressive if they're of size. And so what we're finding is we wouldn't expect spreads to widen from where they are today. In fact, I probably suspect they will start to contract slightly, and we'll see less of that in the lower middle market.
It's the large funds where they've got capital on the balance sheet that they need to be put to work where we're seeing the most amount of price compression. And that's not the average for us. What we're seeing is for us is it's still in the SOFR 7 range for us. So I would not expect that compression to hit us. Some of our larger credits, we do have a fair number that I said, average over 10%. We may see some compression, but we'll see significant upside in those situations.
So if somebody -- if one of our credits happens to be very lowly leveraged because of growth, if we want to recapitalize that business or fund an acquisition, we may see that compression come through slightly. But we'll get the upside associated with the additional volume. So in the lower middle market, I think you're going to see slight compression in the larger credits. I think we're seeing at least 50 basis points in tightening just because of competition.

Operator

Mr. Gladstone, there are no further questions at this time. I'd like to turn it back to you for closing comments.

David John Gladstone

Okay. Well, thank you all for calling in. We certainly appreciate those questions from the analysts. They help us continue to go forward and explain where we are and what we're doing. But we'll stop for now, and we'll see you again next quarter. That's the end of this call.

Robert L. Marcotte

Thank you.

Operator

Thank you. This does conclude today's teleconference. You may disconnect your lines at this time. Thank you for your participation, and have a great day.