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BlackRock Kelso Capital Corporation (NASDAQ:BKCC)

Q4 2012 Earnings Call

March 07, 2013 16:30 ET

Executives

James R. Maher - Chairman and Chief Executive Officer

Laurence D. Paredes - General Counsel

Michael B. Lazar - Chief Operating Officer

Corinne Pankovcin - Chief Financial Officer and Treasurer

Analysts

Richard Shane - JPMorgan

Greg Mason - KBW

Arren Cyganovich - Evercore Group

Douglas Harter - Credit Suisse

Operator

Good afternoon. My name is Ginger, and I will be your conference facilitator today. At this time, I would like to welcome everyone to the BlackRock Kelso Capital Corporation Investor Teleconference.

Our hosts for today's call will be Chairman and Chief Executive Officer, James R. Maher; Chief Operating Officer, Michael B. Lazar; Chief Financial Officer, Corinne Pankovcin; and Secretary of the Company and General Counsel of the Advisor, Laurence D. Paredes. All lines have been placed on mute to prevent any background noise. After the speakers' remarks, there will be a question-and-answer session. [Operator Instructions].

Thank you. Mr. Maher, you may now begin your conference.

James R. Maher

Thank you. Welcome to our Fourth Quarter Conference Call. Before we begin, Larry will review some general conference call information.

Laurence D. Paredes

Thank you, Jim. Before we begin our remarks today, I would like to point out that certain comments made during the course of this conference call and within corresponding documents contain forward-looking statements subject to risks and uncertainties. Many of these forward-looking statements can be identified by the use of words such as anticipates, believes, expects, intends, will, should, may and similar expressions.

We call to your attention the fact that BlackRock Kelso Capital Corporation's actual results may differ from these statements. As you know, BlackRock Kelso Capital Corporation has filed with the SEC reports, which lists some of the factors which may cause BlackRock Kelso Capital Corporation's results to differ materially from these statements. BlackRock Kelso Capital Corporation assumes no duty to, and does not undertake to, update any forward-looking statements.

Additionally, certain information discussed and presented may have been derived from third party sources and has not been independently verified. Accordingly, BlackRock Kelso Capital Corporation makes no representation or warranty with respect to such information.

Please note that we have posted to our website an investor presentation that complements this call. Shortly, Jim and Mike will highlight some of the information contained in the presentation. At this time, we would like to invite participants to access the presentation by going to our website at www.blackrockkelso.com, and clicking the March 2013 Investor Presentation link in the Presentations section of the Investor Relations page.

With that, I would now like to turn the call back over to Jim.

James R. Maher

Thanks Larry. Good afternoon and thank you for joining our call today. It has been a busy 2012 for BlackRock Kelso Capital. We are pleased with our performance. Our adjusted net investment income of $1.08 per share compared with dividends of $1.04 per share. During the year, we invested $317 million across six new and several existing portfolio companies. Sales, repayments and other assets totaled $315 million. With that total, investments made during the fourth quarter was $79 million, while assets during the period totaled $111 million.

We worked very hard to keep our total assets where they were one year ago. We are pleased that we are able to accomplish this without lowering our average yields or substantially changing the risk profile of our portfolio. This effort was a big challenge in a bull credit market, in which many of our successful investments were repaid or exited. In other words, a lot of work to stay even.

The US credit markets continue to be driven by reaching for yield. This environment of sustained near zero interest rates has fueled continued and increasing demand for higher yielding assets and for risk assets more generally.

As for the supply side of the equation, new private equity transactions remain slower than we had anticipated. As a result, supply of capital exceeded demand. This excess supply has been directed to other types of transactions, such as issuer-friendly opportunistic loan repricings, upsizings and dividend recapitalizations with higher leveraged levels and weaker credit protection. We operated in a difficult market, which we expect to continue.

In 2012, LBO purchase price multiples tracked by S&P averaged over the 9 times EBITDA, on average deals greater than $500 million; but less than 8 times for transactions less than $500 million. The ratio of debt-to-EBITDA averaged 5.5 times for larger deals, and 5.0 times in the middle market. In other words, the middle market remains relatively attractive.

Given the current market conditions, and our focus on capital preservation, we continue to be very selective. We have avoided transactions where deal structures are weak, leverage is too high, and returns are not adequate to appropriately compensate us for risk.

In the fourth quarter, our aggregate portfolio size was reduced by $32 million. Our leverage stood at 0.5 times at December 31, a slight reduction from 0.55 times at the end of the third quarter.

We have plenty of debt capacity to grow our portfolio, without needing to issue additional equity capital. At quarter end, we had more than $203 million available under our existing revolving credit facility and during the quarter we received commitments to increase and extend the maturity of a revolving credit line. In addition, we closed a $150 million convertible notes offering, which Mike will describe in a few more minutes.

As always, we remain focused on our dividend coverage. For the quarter, we had net investment income of $0.27 per share adjusted for pro forma incentive fees. Yesterday, our Board of Directors declared a quarterly dividend of $0.26 per share, payable on April 2 to stockholders of record on March 19. For the year 2012, we produced adjusted net investment income of $1.08, related to dividends of $1.04 per share.

While there is certainly a challenge in today's environment, we remain confident that we will be able to continue to earn net investment income that supports our [dividends].

Mike will now discuss our results in more detail.

Michael B. Lazar

Thank you, Jim. Good afternoon and thanks for joining our call today. I am pleased to have the opportunity to talk about some of our financial results, and to discuss portfolio strategies. In advance of the conference call, we posted our quarterly investor presentation through our website. The financial section of the presentation starts on page 8.

With respect to the operating details, our portfolio generated investment income $37.9 million for the fourth quarter, compared to $40.7 million for the quarter ended September 30th. This brought total investment income to $147 million for all of 2012, this is a 12% year-over-year increase compared to 2011. The average balance of our total investments at cost, was over 7% higher in 2012 than 2011. The higher average earning asset base, as well as the slightly higher weighted average yields on the comparative portfolios, are contributors to the increase in investment income over the prior year. The weighted average yields of the debt and income producing securities in our portfolio, on a cost basis, was stable at 12.2% at year end.

Fee income for the fourth quarter was $4.4 million, and $20.7 million for all of 2012. That compares with $21.9 million for the year that ended December 31, 2011. The current portfolio provides us with a stable base of net investment income, regardless of new investment activity, and regardless of associated fee income. Fee income also tends to be relatively consistent over time for the business, although it can be somewhat lumpy when examined from quarter-to-quarter. We earn fees not only for prepayments, but for new transactions, amendments and other fees as well.

Adjusted to remove the effects of [fees] in each quarter, our total investment income for the fourth quarter was $33.5 million, up from $31.7 million in the third quarter. Included in fourth quarter net investment income is $2.5 million cash dividend relating to our investment in M&M Holdings.

Excluding all of our fee income, our fourth quarter preincentive fee net investment income was $0.29 per share, or $0.25 per share, when dividends received during the quarter are also excluded.

Total expenses for the three months ended December 31, 2012, were $29.6 million, while total expenses for the third quarter were $16.8 million. Of those totals, for the fourth quarter $5.6 million was related to base fees, versus $6 million in the third quarter. The largest quarter-to-quarter difference was related to incentive fees. Total GAAP incentive fees for the fourth quarter were $17.3 million. With respect to incentive fees based on income, $17 million was earned in 2012, versus $11.9 million for 2011.

The increase is largely due to higher overall portfolio returns, which moved from 11.4% to 12.8%. Of those GAAP incentive fees, $2.5 million in the quarter and $5.5 million for 2012 represent management fees, incentive management fees that are accrued, based on a hypothetical capital gains calculation, which GAAP requires. Should be noted however, that capital gains fees, if any, are neither earned nor [joinable] until the end of the annual measurement period.

Now on the other hand, pro forma incentive fees for the fourth quarter were $5.6 million, up slightly from $5.0 million for the third quarter. An illustration of the net investment income, is takes into account each of these items can be found on page 17 of our investor presentation.

Turning to the investment portfolio itself, during the three months ended December 31, 2012, we invested $78.6 million across two new and several existing portfolio companies. The new portfolio company investments include $20 million invested in the senior secured notes of American Piping Products, which is a distributor of specialized, heavy valve, seamless steel pipe and fittings, and we invested $21 million in the senior subordinated notes of Higginbotham Insurance agency, which is a generalist insurance broker, placing property and casualty and life insurance, as well as providing risk management services. We also purchased $1.5 million of equity, representing just under 1% ownership of the company.

Some of the more significant investments made in existing portfolio companies, included $17 million of par amount in additional borrowings under the second lien loan made to MCCI, that supports a transaction where Humana made a significant investment in the company. $15 million of par amount in an upsizing of our existing first lien loan at [Madelia] was also made during the quarter.

Exits totaled $111.3 million during Q4. Significant repayments included two first lien loans, and two second lien loans. The first lien loans were $44 million to Volume Services, and $24.6 million to Grocery Outlet. The second lien loan that hadn't been repaid during the quarter included $20 million of par amount to Renaissance Learning and $15 million to Potters Holdings. For each of these, all four of these transactions, we produced a cash-on-cash return on IRR in excess of 13%.

We had no investments on nonaccrual at year end, compared with [multi] investment on nonaccrual at September 30. Since year-end, we have been actively engaged in the restructuring of two portfolio companies, at least one of which we anticipate will result in a nonaccrual, as of the end of our current first quarter of 2013. The weighted average rating of our portfolio of companies at year end was 1.20, up slightly from 1.17 on September 30.

Since year-end, we have experienced some portfolio repayments, which have contributed to a slight net reduction in our overall portfolio so far this quarter. Given our current investment pipeline, our expectation is for another slightly negative quarter overall for a net new investment.

As Jim mentioned, we have undertaken two transactions during the first quarter of 2013, that improve our access to debt capital and extend our debt maturities. First, we closed an offering of $115 million in aggregate principal amount of 5.5% unsecured convertible senior notes that are due in February of 2018. Also this week, we finalized commitments for an extension of our revolving credit facility to March of 2017. The revised revolver will be $350 million of commitments, versus $275 million today. Borrowing costs on the new revolver are lower at LIBOR plus 2.5%, compared with LIBOR plus 3.25% previously.

With that, I'd now like to turn the call over to Corinne, to review some of the GAAP financial information for the fourth quarter.

Corinne Pankovcin

Thanks Mike, and hello everyone. I will now take a few moments to review some of the other details of our 2012 year-end financial information. Continuing our positive earnings momentum, net investment income totaled $8.3 million and $73.7 million or $0.11 per share and $1 per share respectively for the three months ended and year ended December 31, 2012. Our portfolio continues to produce a stable amount of interest and dividend income, relative to its price, and an income based incentive management fee, continues to be concentrated in the fourth quarter, producing an uncharacteristically low net investment income per share, relative to that for the entire year.

The percentage of our portfolio comprised of senior loans and notes has remained somewhat stable at 70%. Of this 70% senior debt total, 25% senior notes and loans were secured by first lien, 49% were secured by a second lien, and 26% for senior notes.

In addition, 16% of the portfolio was invested in unsecured or subordinated debt securities. 13% in equity investments, and 1% in cash and cash equivalents. Our average portfolio company investment at amortized cost, excluding investments below $5 million was approximately $26.9 million at December 31, 2012, versus $24 million at this point in the prior year.

For the year ended December 31, 2012, the net increase in net assets from operations was $67.4 million or $0.78 per share compared to $76.9 million or $1.05 per share, for the year ended December 31, 2011. Our net asset value was $9.31 per share at year end. Removing incentive management fees for the current year, our December 31 net asset value per share has relatively (inaudible) prior three quarters at $9.61. At year-end we were in compliance with regulatory coverage requirements, with an asset coverage ratio of 295%, and we are in compliance with all financial covenants under our debt agreement.

In May 2012, our repurchase plan was extended through June 30, 2013, with approximately 1,331,000 shares remaining authorized for repurchase. There are no purchases under the plan during the year ended December 31, 2012. Since inception of the repurchase plan through December 31, 2012, we have purchased approximately 1,425,000 shares of our common stock on the open market for $9.5 million, including brokerage, commission.

At December 31, 2012, we had approximately $9.1 million in cash and cash equivalents, $346.9 million in debt outstanding, and subject to leverage and volume based restriction, $203 million available for use under our senior secured multicurrency credit facility. Relative to our $1.1 billion dollar portfolio at fair value, we continue to have sufficient debt capacity to grow our business.

With that, I would like to turn the call back to James.

James R. Maher

Thanks Corinne. We are proud of our fourth quarter and full year performance. As we look into 2013, we remain optimistic. We are focused on continued prudent portfolio growth adhering to our conservative investment philosophy, focusing upon preservation of capital. On behalf of Mike, Corinne, Larry and myself, I'd like to take this opportunity to thank our investment team for all their efforts and thank you for your time and attention today.

Operator, will you now please open the call to questions? Thank you.

Question-and-Answer Session

Operator

[Operator Instructions]. Your first question is from Rick Shane from JPMorgan.

Richard Shane - JPMorgan

Hey guys, thanks for taking my question. When we look back in the history again, a lot of this is a function of timing. But there has been a series of realized losses on the portfolio over the last couple of years. Have you been able to, over the last three years, put money to work in a much more attractive environment? Do you think we are now approaching the inflexion point, where that [you will go to and] start to generate some realized gains going forward?

Michael B. Lazar

Sure. Hey Rick, it's Mike.

Richard Shane - JPMorgan

Hey Mike.

Michael B. Lazar

I think -- hey. It's obviously very difficult to forecast gains, and separately, as we have discussed from time to time, within the boundaries of what's allowable under tax, we tend to be as aggressive as we can to realize taxable losses or tax losses, to shield the income from taxation as we make distribution to shareholders. So whether you are considering this a timing question for BDC generally, or more specifically to us. With respect to us, we tend to take losses as early as we can, as aggressively as we can. Usually, and we have a pretty good history of having written down the investment prior to taking the loss, and you know we have been through that before.

At the moment, because we have done that, because we have gone through that active process, we actually have appreciation, net appreciation of the small amount in our portfolio. So, while this is just a hypothetical, based on a hypothetical liquidation of the portfolio at 12/31, based on the valuations, that would suggest that there would be some gains embedded in the portfolio at that point.

James R. Maher

I think adding to that, we have a number of equity positions that do have significant gains in them, and in terms of the timing of realizing those gains, we are not, in most cases, in control of the timing. There are a number of situations that could, I underline could, be realized during the course of 2013.

Richard Shane - JPMorgan

Got it. You are right in terms of marking to market, it is interesting, there have been substantial realized losses, but over -- the book was marked over flat [debt] a long time ago, and so it has not continued to impact NAV. It's just a question, I mean, what -- it's a cyclical business, we understand cyclically why investments that you made -- '06-'08 timeframe would be investments that you will be existing, realizing losses on, now as you start to enter a period where hopefully you will enter your harvesting post crisis really incredibly stringently underwritten investments that you could see the other part of that cycle?

James R. Maher

I think in some ways you are more likely to see it from that period, from the earlier period of time, where companies were restructured and we ended up with some significant equity, and that's what you will most likely see the significant gains.

Richard Shane - JPMorgan

Got it. That makes sense too. I haven't even thought of that.

Michael B. Lazar

To add on to Jim's point, we often use our investment at ECI as an example of that. We have realized long ago. We realized, not only related to (inaudible) and fair market value, but realized a loss on ECI, but we continue to hold the securities. We realized the loss, because for tax purposes, we were able to shield income in that period. We reduced our basis in the asset. However, we still have the asset, and in fact, the fair market value of it today exceeds what the initial price was that we paid for the debt investment in the first place.

Richard Shane - JPMorgan

Got it. I should jump back in queue, because I am sure there are other folks who have questions as well. Thank you guys.

James R. Maher

Sure.

Operator

Your next question is from Greg Mason from KBW.

Greg Mason - KBW

Great. Good afternoon gentlemen. You mentioned you had two portfolio companies in restructuring, I am going to guess that's Dial Global and Bankruptcy Management Solutions based on the mark this quarter. First off, is that reasonable to look at the -- coming up of those two based on the marks, and second, those marks are at December 31, has the situation deteriorated since then, where you think there could be additional negative marks in the first quarter?

Michael B. Lazar

Hey Greg, it's Mike again. Those are not unreasonable guesses, we will start with that.

Greg Mason - KBW

All right.

Michael B. Lazar

And, with respect to each of those situations, they are both at different stages of a negotiated restructuring of our investment. Each of which will take its own series of turns along the way, and again, it's a good time to think about the same example I just used with (inaudible) ECI. That's a company that we [got] through restructuring, started out with debt securities, we did some restructuring, we ended up with equity securities, where we, together with somebody else controlled the business and controlled the board. It's quite possible that in at least one of those cases, a similar outcome will happen, where we will trade some equity securities for some debt securities, we may participate in other layers of the capital structure along the way.

We'd become already much more active in guiding at the course of the business operations and the ultimate outcome of the situation. That's our downside control. It can be a bumpy ride along the way from a valuation perspective, but we continue to look at the long term of what we started with, what we are taking the company through, and what we expect to get when all of the dust settles. And again, while neither of those two companies is exactly in the same situation as ECI for another example, that's kind of the framework under which we do these things.

So having said that, you know our valuation process and policy, we don't actually prepare the valuations at our level. We only review the third party work that's done by our valuation providers. So it's really up to them, and they are going to look at all the inputs I am sure, as they always do, and those situations continue to evolve. So at March 31, whatever the inputs are, the inputs will be, and they will take that -- their same exact procedures and move forward.

Greg Mason - KBW

Okay. Great.

James R. Maher

I would say, it would be hard to characterize if either business deteriorated since year-end.

Michael B. Lazar

That's a fair point. The operations underlying the investments are somewhat consistent over the last several months. It's not improving.

Greg Mason - KBW

Okay great. Thanks and then one additional question. You took or you had to for GAAP purposes, account for an increase in the potential realized gain incentive fee, even though that's a hypothetical, but I was kind of confused given, I believe there was a net writedown this quarter in the portfolio, was surprised if there was actually an increase in that cap gain accrual versus what I expect it to be, a reversal, can you talk about that a little bit?

Michael B. Lazar

I would -- it's Mike again, I'd ask Corinne may be just to follow-up on the high level of comments I'm about to make, which is also in the period, we had a realized loss, and the GAAP addresses the amount of the unrealized appreciation, I believe, and those two things don't exactly net for the way the accrual works for the GAAP accounting, but Corinne could probably give more detail on that.

Corinne Pankovcin

That's exactly right, and also for the measurement periods, it's slightly different. So I'd be happy to take you through the details of the nitty-gritty accounting offline, but the way Mike characterized it is right, you have an appreciation that's offsetting on a hypothetical liquidation, and the only thing I could point you to in our case today, it's $20 million of net appreciation that's disclosed, which is part of the driver to that answer.

Greg Mason - KBW

Okay. Thank you guys.

Operator

Your next question is from [Ron Jusica] from Wells Fargo.

Unidentified Analyst

Thank you for taking my question. I just wanted kind of a high level view on new originations? It looks like they focused a little bit more on second lien, the one compared to exits in the quarter, I was wondering if that was a relative value, or just a small sample size?

Michael B. Lazar

I think it's precisely larger, but it's much closer to just a small sample size. We have two investments in new companies that we made, we have balanced those with some add-on investments (inaudible) listing portfolio companies. Obviously that's based on what the opportunity set is over any 90-day period, as opposed to some macro call on capital structure arbitrage or anything else like that.

Unidentified Analyst

Okay. And then if I could just have another quick follow-up on Dial Global. I felt there some talks about a proposed restructuring, and on the second lien would be -- about 60% of your second lien will be restructured into equity, I was wondering if that would be a preferred position or a common position under the current proposal?

Michael B. Lazar

Well again it's unfair to say anything definitive at this point, but the likely outcome in this situation is that, we are going to exchange our current second lien loan position for some new second lien loan and some equity, and yes in fact, the current construct has that equity becoming a preferred equity security, with an accreting dividend.

Unidentified Analyst

All right. Thank you very much and congratulations on the quarter guys.

Operator

Your next question is from Arren Cyganovich from Evercore.

Arren Cyganovich - Evercore Group

Thanks. I just wanted to ask about the potential for a slowdown in repayment activity? I know you said earlier that this quarter is exceeding your investments by a small amount, but looking at your portfolio, I think just now only 17% over the portfolio is kind of pre-2010 vintage. Just your thoughts about either I guess maybe what is expected to pay down normally, and then may be on the prepayment front out of the portfolio?

Michael B. Lazar

Sure. Obviously our vision on prepayments is now 2020 over the long term. But we do have some sense of what's coming in the near term on either announced transactions, or transactions where we are in discussions with somebody. With respect to that latter category, I go back to what I said in the prepared remarks, which is that so far, quarter-to-date, we have had some repayments and prepayments of some existing loans, and as we stand today in the quarter, we are slightly net negative and we expect to be slightly net negative on a net new investment basis. So that would mean we have been repaid or prepaid on some additional assets this quarter.

It goes with the territory, as you have seen over time and as we have seen over time, some of our most carefully underwritten transactions, where we are able to earn excess returns, are some of the first deals to get refinanced in a bullish credit market, because now that the company has performed well, and the rates are so high relative to where we sit in the capital structure, we can only enjoy that advantage for so long, before somebody comes along and offers the company a refinancing. Sometimes that's a transaction with which we can be involved, and sometimes, it's just not that attractive for us to reduce our rate or extend our risk and stay in the deal. So a longer winded answer perhaps, most of the prepayments we would think would be behind us after this quarter settles out.

James R. Maher

That being said, it is very hard to predict, and if you just look back over the last couple of years, sort of order of magnitude off of the $1 billion, $1.1 billion portfolio. Repayments have run in about, call it $300 million, $300 million plus, two years ago (inaudible). I think if you use that as a proxy, it's not -- I am not predicting that by any stretch of imagination, I am just telling you what the history has been.

Arren Cyganovich - Evercore Group

Okay. That's helpful. Then, maybe on the liability side, you recently did the convert, maybe just your thoughts about doing it now, I would, that's the way that I would think about doing that and taking advantage of that, is when you have more portfolio of growth, I know it helps from the liability duration side, etcetera and it better matches your assets. But just trying to think of, if you have a shrinking portfolio, why deal with some more intensive financing right now?

Michael B. Lazar

Well, it's a good question and it's something that we consider when we think about doing the convertible offering, or any other debt transaction, liability transaction. I think the overwriting, most important, as you rank them, the thing for us to focus on, is making sure we have adequate duration liabilities. And we really did two transactions in conjunction with each other. The convertible note offering you saw, we executed just last month, and as I mentioned earlier on the call, we can have commitments for an amendment of an extension, and an amendment of our revolver, and we think of those things in concert. So we lay out when we have different lines of credit expiring.

We always like to have sufficient visibility, longer term, longer duration liabilities, and earlier in the prepared remarks, I mentioned that we reduced the pricing on our revolver pretty significantly, 75 basis point reduction in price there, as well as an increase in the availability under the revolver. So when you look at the two transactions put together, we are very-very pleased with what we accomplished, which was to extend the maturities, increase availability, and it doesn't, other than some transaction fees, it's only a slight increase on our overall cost of capital.

James R. Maher

I guess, what I would say is also, as I mentioned before, we have a net increase in portfolio of about $2 million this year, and we are optimistic about 2013, and we would hope to grow that portfolio. So with that in mind, we think that that the capital raise is paid with a lot of sense.

Arren Cyganovich - Evercore Group

Okay. So I guess, that's fair enough, I appreciate the thought process there and then with the backdrop of the environment that we are in right now and the near term expectation it is going to hold, it strikes me to be a little bit optimistic to expect portfolio growth, crossing the equal in this environment?

Michael B. Lazar

Well, it will take the environment in 2013, (inaudible) environment in 2012, and this has been going on for some period of time now, and as we are -- very close to this, couple of transactions we could have been up [in the $100 million] so it's -- and we could also have missed a couple more, and down by 50. But I think it is realistic to think that we will be able to get some growth into the portfolio of 2013.

Arren Cyganovich - Evercore Group

Okay. Thank you very much.

Operator

[Operator Instructions]. Your next question is from Douglas Harter from Credit Suisse.

Douglas Harter - Credit Suisse

Thanks. My question was asked and answered. Thank you.

Operator

No further questions at this time.

James R. Maher

Well thank you very much for joining us today, as I would like to invite you all. If you have further questions to get in touch with us. Thank you.

Operator

Ladies and gentlemen, this does conclude today's conference call, thank you for participating. At this time, you may now disconnect.

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