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KCAP Financial (NASDAQ:KCAP)

Q1 2013 Earnings Call

May 07, 2013 9:00 am ET

Executives

Dayl W. Pearson - Chief Executive Officer, President and Non-Independent Director

Edward U. Gilpin - Chief Financial Officer, Principal Accounting Officer, Treasurer and Secretary

Analysts

Greg M. Mason - Keefe, Bruyette, & Woods, Inc., Research Division

John T. G. Rogers - Janney Montgomery Scott LLC, Research Division

Christopher York - JMP Securities LLC, Research Division

Operator

Good morning, ladies and gentlemen, and welcome to the KCAP Financial First Quarter 2013 Earnings Conference Call. An earnings press release was issued yesterday, Monday, May 6, 2013. If you did not receive a copy, the release is available on the company's website at www.kcapfinancial.com in the Investor Relations section. [Operator Instructions]

As a reminder, this conference is being recorded today, Monday, May 6, 2013. This call is also being hosted on a live webcast, which can be accessed at our company's website, www.kcapfinancial.com in the Investor Relations section under Events. In addition, if you'd like to be added to the company's distribution list for news events, including earnings releases, press -- please contact Denise Rodriguez at (212) 455-8300.

Today's conference call includes forward-looking statements and projections, and we ask that you refer to KCAP Financial's most recent filings with the SEC for important factors that could cause actual results to differ materially from those projections. KCAP Financial does not undertake to update its forward-looking statements unless required by law.

I would now like to introduce your host for today's conference, Mr. Dayl Pearson, President and Chief Executive Officer of KCAP Financial. Mr. Pearson, you may begin.

Dayl W. Pearson

Thank you, all, for joining KCAP Financial for a review of the first quarter of 2013. I will open the call with some broad commentary about important highlights and activities during the quarter and subsequent events, including the performance of our asset manager affiliates and our principal investment portfolio. I will then turn the call over to our Chief Financial Officer, Ted Gilpin, for him to provide a recap of our first quarter operating results and our financial condition at the end of the quarter. We will then open the line up for your questions at the end of the call.

First, let me provide a brief recap of some important highlights. In the first quarter of 2013, our NII decreased from $0.28 in the fourth quarter to $0.24. Our dividend remained at $0.28. This decrease was partially due to about $600,000 in audit expense that we had in the first quarter plus the significant increase in shares outstanding due to an equity offering in February, the proceeds of which were not immediately invested.

Subsequent to the end of the quarter, we priced an on-balance-sheet debt securitization of approximately $105 million to provide additional leverage for our core middle market lending business. A significant portion of the proceeds from this facility will be invested in first-lien middle market loans. Due to the pricing of this facility, the overall returns on this leverage will be equivalent to our mezzanine loans but will reduce the overall risk profile of our balance sheet. The transaction is expected to close in the middle of June.

Our asset manager affiliates continue to warehouse assets for their next CLO, which we expect to price before the end of the quarter.

I will now review our principal investments and new origination activity. Deal flow in the middle market lending business year-to-date has been about $800 million in new potential opportunities. We have reviewed 101 new deals. We committed to 12 new deals, 8 of those closed in the first quarter. Many of these were middle-market first-lien loans for our balance sheet securitization.

The first -- in the first quarter, we closed 8 new investments totaling approximately $43.75 million, including loans to our AMAs to provide capital for the new CLO warehouse. Much -- many of those loans closed late in the quarter, and if you look at our net -- investment -- or the interest income from debt securities, about 42% of that occurred in the month of March.

To-date in the second quarter, we have closed approximately 8.5 million of new loans in 3 transactions. We also had one loan payoff in the first quarter of 4.5 million and an additional loan payoff in the second quarter of about 5 million. We expect 3 other loans to fund this month and have a robust pipeline of new deals.

Given the uncertain economic environment and an aggressive credit market, we have remained very cautious in terms of deploying capital despite having substantial liquidity. The combined yield on our debt portfolio of loans, bonds and CLOs securities was 18% on par and 20% on fair value at the end of the quarter. As of March 31, our weighted average mark-to-market value to par on our debt securities portfolio was 87 compared to 81 for yearend 2011 -- 2012, sorry. As for our CLO portfolio, our weighted average mark-to-market value to par was 74, a decrease in the weighted average mark-to-market to par of 78 at yearend 2012.

Our 100% ownership of our asset manager affiliates were valued at approximately $80 million based on their assets under management and perspective cash flows. Our investment portfolio at the quarter end 2013 totaled approximately $357 million.

Looking at the composition of our portfolio. Portfolio quality continues to hold up well. At the end of the first quarter of 2013, our debt securities totaled approximately $152 million and represented 42% of the investment portfolio. First-lien loans represents 51% of the debt securities, and second-lien loans, 26%. Approximately 11% of our debt investments are fixed-rate investments, with a weighted average rate of 11%. At March 31, 2013, we had 5 issuers on nonaccrual status, representing less than 1% of total assets at fair value. This is unchanged from the end of 2012.

All CLOs managed by KDA and Trimaran continued to be current on equity distributions and management fees. The stable income stream for our asset manager affiliates allows them to make periodic distributions to us in the form of dividend. In the first quarter, there was a distribution of $3 million. Additionally, as of March 31, 2013, our asset manager affiliates had approximately $3.5 billion of par value assets under management. This does not include assets in the warehouse for new transaction. We also continued to evaluate debt and equity financing options, which will allow us to focus on continued balance sheet growth, increasing net investment income and dividend distributions.

And now I'll ask Ted Gilpin to walk you through the details of our financial performance. Ted?

Edward U. Gilpin

Thank you, Dayl, and good morning, everyone. First, let me cover some of the higher-level financial information, then I'll go into a little more detail on specific metrics.

So as of March 31, 2013, as Dayl mentioned, our NAV stood at $8.33 per share. This compares to $7.85 at the end of December of 2012. The increase can be attributed to issuing shares above NAV in the first quarter and to a dividend payable at yearend of approximately 7.4 million, which had an effect of an equivalent of about $0.23 per share based on common shares outstanding in March of 2013.

The company declared a dividend of $0.28 for the first quarter of 2013, the same as the prior quarter end, and that compares to $0.18 for the first quarter of last year.

The component pieces of the dividend can be found in our operating results for 2013 first quarter. First, interest income for the 3 months ended March 31, 2013, was $2.5 million or $0.08 per share, again relatively flat to $2.5 million and $0.10 per share for the same period of 2012. Second, dividends from invested CLO securities were $5.9 million or $0.20 per share in the first quarter of 2013 compared with $4 million and $0.17 per share in the same period of 2012. The majority of the increase can be attributed to the acquisition of the equity in the 4 Trimaran CLOs and to the addition of the Catamaran 2012 CLO.

Finally, the third revenue component of the dividend from our asset manager affiliates was $3 million or $0.10 per share in the first quarter of 2013 as compared to $825,000 in the first quarter of 2012 or $0.03 per share. The increase is resulting from our acquisition of Trimaran Advisors earlier in 2012 and the respective net asset management fees available to be distributed up to us. Something to note, we had a onetime expense of approximately $950,000 in the first quarter related to the severance of the asset manager affiliates, so the run rate for the near term is approximately $3.3 million per quarter without the charge.

These 3 revenue components resulted in total investment revenue of $11.4 million for the quarter ended March 31, 2013, as compared to $7.4 million for the same period of 2012. This coupled with the fact that total expenses year-over-year increased to about -- increased 4.4 million. We recorded net investment income or NII of $6.9 million or approximately $0.24 per share.

Another note. We issued 5,432,500 new shares in the quarter, proceeds of which we are in the process of fully investing. Without the drag of the new shares, NII per average share would have been $0.26 a share.

Of the 4.4 million of expenses, the 2.3 million related to debt expense increased approximately 818,000 over the same quarter in the prior year. In addition, approximately $350,000 or $0.01 per share were related to traditionally higher first quarter expenses.

Now I'll cover a few aspects in more detail. As I mentioned earlier, first quarter year-over-year investment income from debt securities remained flat at approximately $2.5 million. First quarter year-over-year investment income from CLO fund securities increased 47.5% or $1.9 million to approximately $5.9 million from approximately $4 million in 2012. This increase is due to the aforementioned addition of subordinated tranches of CLO fund securities acquired in connection with Trimaran.

The company recorded net realized and unrealized appreciation of approximately $267,000 or $0.01 per share during the quarter ended March 31, 2013 as compared to net realized and unrealized depreciation of approximately $3.1 million or $0.13 per share for the same period of 2012.

On the liability side of our balance sheet. As of March 31, 2013, our debt outstanding consists of $60 million of convertible notes with a 5-year term and fixed rate of 8.75% and $41.4 million of senior notes with a 7-year term and a fixed rate of 7.375%. Subsequent to the quarter end, approximately $9 million of the convertible notes converted into 1,102,093 shares of common stock.

At quarter end, we had sufficient liquidity in cash and higher-liquid investments to meet our credit and underwriting projections. Our asset coverage ratio at quarter end was 362%, well above the minimum required of 200% for BDCs.

And for -- so for additional information regarding the above metrics and for full first quarter 2013 results, please refer to our recently filed first quarter 10-Q. It's available online at www.sec.gov or on our website, www.kcapfinancial.com.

And with that, I'd like to thank you for your time. And we'll now turn the call back over to the operator to start the Q&A session. Operator?

Question-and-Answer Session

Operator

[Operator Instructions] We have a question from Greg Mason of KBW.

Greg M. Mason - Keefe, Bruyette, & Woods, Inc., Research Division

Gentlemen, first off, Dayl, can you talk a little bit more about the securitization in terms of, I think you said you officially priced it. So can you talk about what debt you'd hold on your balance sheet and what the cost of that debt might be?

Dayl W. Pearson

Yes. The debt on the balance sheet is about -- is approximately $105 million. And if you sort of fully load all the costs, including discounts and everything else, it's a little bit -- it's right around 3%. And we expect to be at that -- sort of at -- in sort of 80% of that is first lien. 20% of that, we can invest in a combination of second lien and unsecured.

Greg M. Mason - Keefe, Bruyette, & Woods, Inc., Research Division

So is that -- you say 3%. Is that L plus 3%? Or would that be more like L plus 2 70 [ph], 2 75 [ph], all-in cost of 3%?

Dayl W. Pearson

Yes, well, it's really sort of L plus 2 85[ph], so it's right around 3%.

Greg M. Mason - Keefe, Bruyette, & Woods, Inc., Research Division

Okay, great. And then...

Dayl W. Pearson

And [indiscernible] I think the term adjusts to, say -- it's -- now unlike our previous credit facilities that we had that had a 3-year or 4-year revolving credit component and that was it, this has a 4-year reinvestment period and then a -- and, after that, a 6-year term out. So it's really a 10-year money, assuming we need it to run out at 10 years.

Greg M. Mason - Keefe, Bruyette, & Woods, Inc., Research Division

Great. And then can you talk about -- because of that securitization, you mentioned you're going to have to focus on first-lien middle-market loans. Can you talk about what you're seeing today in yields on the first lien middle market and kind of what your pipeline is for that area?

Dayl W. Pearson

Pipeline is pretty good, although a lot of our pipeline right now is more second lien and mezzanine. But we're also using this as a marketing tool in that we can commit to a club deal, to a piece of first lien to get second lien and mezzanine opportunities. In terms of pricing, it's sort of all over the place but it's sort of traditional small -- smaller and middle-market stuff. It's between 6% and 7%, all in. There will be the sprinkling over time. Initially, there'll be some broadly syndicated. Over time, that will -- we'll essentially trade out of what broadly syndicated we have and we'll be mostly first lien, mostly in middle market.

Greg M. Mason - Keefe, Bruyette, & Woods, Inc., Research Division

Great. And then one more, and I'll hop back in the queue. You had some write-downs this quarter in your CLO equity investments. Can you talk about what the reason for that write-down was? And is this going to impact our earnings and cash flow generation going forward from those CLO equity tranches?

Edward U. Gilpin

Yes, this is Ted. Well, these CLO equities is coming -- some of these are in past their reinvestment periods. So every time we receive a payment in the quarter, they would -- they tend to go. They delevering so they -- their value is trending in. We're obviously -- that kicks in, on the other side, incentive fees so that we've -- the manager will receive incentive fees, which offsets some of that. And also, we are obviously adding new CLOs that we'll hope to fill that bucket and then some. So...

Dayl W. Pearson

Yes. One other point on that, Greg, is, you may or may not remember, back in 2007 and early 2008, with your new CLOs, when you book a new CLO, the equity tranche, you're really not recognizing much income on that for the first 2 quarters because it's sort of the cash is being used to pay the fees of the transactions. So for example, the Catamaran deal that we closed in December, you're not going to really see a healthy distribution until the third quarter of this year. So it's a little bit a drag there, but once those kick in, obviously they'll be pretty healthy.

Operator

[Operator Instructions] I have a question from J.T. Rogers of Janney Capital Markets.

John T. G. Rogers - Janney Montgomery Scott LLC, Research Division

You saw operating expenses increase in the quarter. I'm just wondering how much of that is seasonal versus you guys maybe adding headcount or costs generally going up?

Edward U. Gilpin

Yes, let me begin. As I said, about -- the first quarter is traditionally a little bit higher. And what we're looking at is it's about $0.01 a share higher than its -- than a normal run rate, about 350,000. Part of that relates to some of the -- and that's KCAP. Part of that relates to what Dayl mentioned, was audit fees coming in a lot and would pay from the first quarter. Some of that is now at the asset manager level, which also impacts their ability to dividend. But for the most part, it was about 350,000.

Dayl W. Pearson

At KCAP.

Edward U. Gilpin

At KCAP.

Dayl W. Pearson

And then some additional parts. Again, we can't spread the audit fees over the year. We have to take them all in the quarter. So if you go back and look at our first quarter numbers historically, the expenses have always been a little bit on the high side. And given our size, our audit expenses are relatively high. As we grow, obviously, that will become less important.

John T. G. Rogers - Janney Montgomery Scott LLC, Research Division

Okay, great. And then I wonder if you guys could talk about any trends you're seeing in the CLO market for the -- what you're expecting the price in -- by June. Would there be any reason why this would be any different than the Catamaran transaction in the prior quarter?

Dayl W. Pearson

Are you talking about our on-balance-sheet securitization?

John T. G. Rogers - Janney Montgomery Scott LLC, Research Division

No. This is through the -- yes.

Dayl W. Pearson

[indiscernible] no, I think that deal -- as I said, we're warehousing those assets now. And the broadly syndicated market has tightened quite a bit in terms of pricing in the last 6 months. And the domain -- the supply of paper is tight, but we're finding good value right now. And we're sort of taking it a little bit slower in terms of the warehousing in getting this done, because we wanted to make sure we added as much new issue as possible. But we're very close to having sort of the other pieces of the equity put in place, and we hope to be in launching into the debt side of it in the next week or 2. So a lot of guys up there, a lot of deals getting done.

John T. G. Rogers - Janney Montgomery Scott LLC, Research Division

All right. And so other than, I guess, just the assets going in the CLO note, no changes in the structure, leverage, pricing on the debt side.

Dayl W. Pearson

Well, the liabilities have definitely come in quite a bit, probably 25 to 30 basis points from where they were in December.

John T. G. Rogers - Janney Montgomery Scott LLC, Research Division

Okay. And then just this last thing, on your -- we've seen quite a bit of refinancing on your CLOs that are past their reinvestment period. Any change in sort of your expectation as to the rate at which they wind down?

Dayl W. Pearson

Well, it's lumpy. The whole refinancing is lumpy. I mean, luckily, a lot of the new deals have been the so-called cashless rolls, which allows sort of CLOs that are in past their reinvestment period to not commit to a new deal even though it's somewhat of a new deal, so that helps a bit. But there is a fair amount of refinancing activity. And we have seen -- we were at probably $100 million of de-leveraging in the quarter over the entire -- it was $3.6 million, it's now $3.5 million, so...

John T. G. Rogers - Janney Montgomery Scott LLC, Research Division

All right. Just wondering where that sort of compares to what your expectations were, maybe, 6 months ago?

Dayl W. Pearson

Pretty much in-line. Maybe not quite as aggressive initially as we thought a little more aggressive more recently.

Operator

The next question is from Chris York of JMP Securities.

Christopher York - JMP Securities LLC, Research Division

Gentlemen, you've made some strong investments in your asset management business over the last couple of quarters and realizing nice growth as well. Could you give me an idea for headcount at the manager and the potential need for future hires?

Dayl W. Pearson

Yes, I think we added a couple of analysts over the course of the last 6 months in anticipation of this growth. And we don't really see -- it's a very leverageable structure because whether you're managing 5 funds or 10 funds or 15 funds, you're essentially investing in the same number of loans. And so really, you need about the same number of analysts because you're spreading those loans instead of pivoting $10 million to loan x and putting $2 million each in 5 funds or you're doing $20 million to loan x and you're putting $2 million each in 10 funds. So we constantly look at the needs. And if we need to, we will add additional staff. But I think we sort of conservatively think we're in pretty good shape right now in terms of number of loans cattle-d [ph] per analysts.

Christopher York - JMP Securities LLC, Research Division

Okay. And then what did you close the quarter at for headcount?

Dayl W. Pearson

At the asset manager?

Christopher York - JMP Securities LLC, Research Division

Yes.

Dayl W. Pearson

Well, it's a little bit of -- look, for an 8-credit staff, I think, compared probably to 6 at the end of the third quarter.

Christopher York - JMP Securities LLC, Research Division

Great, okay. And then are you still focusing on originating first-lien middle-market loans in order to pledge the assets to that new debt instrument?

Dayl W. Pearson

Yes.

Christopher York - JMP Securities LLC, Research Division

Okay. And then, forgive me if I missed this, but what's the weighted average yield on the investment portfolio? And does that include your money market?

Dayl W. Pearson

Weighted average yield on investment portfolio -- hold on a second. Weighted average yield of our total investment portfolio was 18% on par, 20% on fair value. And that does not -- that's what it says here.

Edward U. Gilpin

And then [indiscernible] loan portfolio?

Dayl W. Pearson

Talking -- are you talking about the total debt portfolio? Bottom debt [ph] number and loan CLOs?

Christopher York - JMP Securities LLC, Research Division

Yes, correct.

Dayl W. Pearson

Yes. On loans and CLOs combined -- but the total debt portfolio, it's 18% on par, 20% on fair value. On loans alone, it's about 8%.

Operator

We have a follow-up question from Greg Mason, KBW.

Greg M. Mason - Keefe, Bruyette, & Woods, Inc., Research Division

Can you talk about the new credit facility that was issued Trimaran Advisors? And just I assume that's for the warehousing facility, but just talk about that new facility.

Edward U. Gilpin

Yes, sure. It's -- yes, KCAP lent money to Trimaran essentially to their -- to ramp up their warehouse lines. We did that in the fourth quarter of last year. Again, we did -- we're doing the same thing for this warehouse line, so...

Dayl W. Pearson

You didn't see it last year because it got funded and paid off in the quarter, but it's actually going over to quarter at this point. But...

Greg M. Mason - Keefe, Bruyette, & Woods, Inc., Research Division

That's what I was going to ask, how long do you expect to be in outstanding with that loan?

Dayl W. Pearson

Well, that will get paid off when we closed in the CLO, which we expect to close before the end of the quarter.

Greg M. Mason - Keefe, Bruyette, & Woods, Inc., Research Division

Okay, great. And can you give us -- I assume that facility is in the $45 million of originations this quarter?

Dayl W. Pearson

Yes. And again, when they get through trade, Greg, they'll -- a big piece of that will then be invested in the equity and potentially a single B tranche in the new CLOs. So we're not getting all of that back.

Edward U. Gilpin

Shifts in the loan...

Dayl W. Pearson

Shifts in that loan to the KCAP's investment in the equity.

Greg M. Mason - Keefe, Bruyette, & Woods, Inc., Research Division

The incentive fees and the legacy Trimaran CLOs, can you talk about how many of those have turned on today and expectations for timing and potential of any additional incentive fees?

Dayl W. Pearson

In the first quarter, 2 -- there were 2 paying incentive fees. We expect 2 more to pay probably starting the third and fourth quarter.

Greg M. Mason - Keefe, Bruyette, & Woods, Inc., Research Division

Great. And so that gets to my last question, just on your dividend philosophy. I know, in the past, you've talked about you want the dividend to be covered from an operating income perspective. Obviously that was low this quarter, $0.24 versus a $0.28 dividend. Can you give us an update on your dividend thought process and on -- going forward?

Dayl W. Pearson

Yes. And I think the board continues to evaluate that quarterly. And again, as we've talked about, they look forward over the next 4 quarters, so we're not constantly adjusting our dividend but to try to sort of anticipate what we're going to be able to earn over the next 4 quarters. And that philosophy has not changed. And we'll evaluate -- the board evaluates it every quarter when we make our dividend decision.

Greg M. Mason - Keefe, Bruyette, & Woods, Inc., Research Division

Great. So it was reasonable to assume when you announced the $0.28 dividend that you knew this weaker first quarter was coming?

Dayl W. Pearson

It was in our year-end budget. It was a little bit -- it ended up being a little bit weaker just because our -- to be honest with you, in our budget, we didn't anticipate issuing as many shares as we did. But it really was nothing bad. That was a marginal impact. It was pretty much in line with our full year budget.

Operator

Thank you. There are no further questions at this time. I'd like to turn the call over to management for any closing remarks.

Dayl W. Pearson

Thank you for your time and your questions. And we hope to talk to you again in August. Thank you very much.

Edward U. Gilpin

Thank you again.

Operator

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

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