OFS Capital's CEO Discusses Q1 2013 Results - Earnings Call Transcript

|
 |  About: OFS Capital (OFS)
by: SA Transcripts

OFS Capital Corporation. (NASDAQ:OFS)

Q1 2013 Earnings Call

May 8, 2013, 11:00 a.m. ET

Executives

Mary Jensen – VP, IR

Glenn Pittson – Chairman and CEO

Bob Palmer – CFO

Analysts

Chris Kotowski – Oppenheimer

J.T. Rogers – Janney Capital Markets

Matthew Howlett – UBS

Operator

Good morning and welcome to OFS Capital Corporation’s Earnings Call for the quarter ended March 31st, 2013. All participants will be in listen-only mode. (OPERATOR INSTRUCTOINS) After today’s presentation there will be an opportunity to ask questions. (OPERATOR INSTRUCTIONS) Please note that this event is being recorded. It is now my pleasure to turn the call over to Ms. Mary Jensen, Vice President of Investor Relations of OFS Capital. Ms. Jensen, you may begin.

Mary Jensen

Thank you, operator. Good morning everyone and thank you for joining us. With me today is Glenn Pittson, our Chief Executive Officer and Bob Palmer, our Chief Financial Officer. Before we begin please note that statements made on this call may constitute forward-looking statements within the meanings of the Securities Act of 1933 as amended.

Such statements reflect various assumptions by OFS Capital concerning anticipated results are not guarantees the future performance and are subject to known and unknown uncertainties. Uncertainties in factors that could cause actual results to differ materially from such statements. The uncertainties and other factors are in some ways beyond managements control including the risk factors described from time-to-time in our filings with the Securities and Exchange Commission.

Although we believe that assumptions on which any forward-looking statements are based are reasonable, any of those assumptions could prove to be inaccurate and as a result, the forward-looking statements based on those assumptions also could be incorrect. You should not place undue reliance on these 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 to-date of this call. A replay of the call will be available until May 22nd, 2013 starting approximately two hours after we conclude this morning.

To access the replay please visit our website at ofscapital.com. Our earnings announcements was released this morning and also can be accessed via the Investor Relations section of the website. We plan on filing our 10-Q this evening, with that I’ll now turn the call over to Glenn.

Glenn Pittson

Thanks Mary. Good morning and thank you for joining us. Before we begin, I would like to introduce Mary Jenson, our new Vice President of Investor Relations. Mary has over 15 years of Investor Relations experience within the financial services industry. We’re pleased to have her join our team and I hope you’ll take the opportunity to introduce yourself to her. Now I would like to turn to our earnings results for the first fiscal quarter ended March 31st, 2013.

This is our first full quarter, since our IPO in November of 2012. In connection with our initial public offering on November 7th, 2012. The company converted from a Limited Liability Company to a Corporation. Please note that the operating results for the quarter ended March 31st, 2012 contained in the press release issued this morning reflected the performance of our predecessor OFS Capital LLC prior to our IPO.

This morning, we will provide an overview of OFS Capital’s investment activities and the associated highlights for the first quarter of 2013. Additionally, we will offer our views on the current investment environment as well as provide an update on our progress in converting our Anchor Investment and Tamarix Capital Partners, a small business investment company into a drop-down SBIC fund within OFS Capital.

It was only six weeks ago that we had our last call. During that call, I took the time to describe our strategy and our targeted asset classes. Which we detailed during our IPO road show in late October and early November 2012. The two distinct complementary of our strategy consist of first; the senior loan fund, which consists of club loans and is effectively fully invested. This pool of assets is match funded with floating rate assets financed through a floating rate credit facility with Wells Fargo.

And second; to the SBIC fund. Which is focused on directly originating assets? Generally, these assets have a low teens fixed rate of interest complimented in certain instances by equity investments. This pool of fixed rate assets is funded through a long-term, fixed rate SBA debenture program. The SBIC fund is less than 15% invested relative to its $225 million target investment size.

In terms of operating priorities, we are presently focused on the following three matters. First; keeping the senior loan fund fully invested. Second; obtaining the necessary approvals to convert the SBIC fund into a wholly owned drop-down fund, this is our number one priority today and third; increasing the pace of SBIC fund investments. In this regard, the SBIC fund is expanded staffing related to transaction sourcing and execution to deal with a growing backlog.

At the time of our IPO, we understood that for attractive SBIC conversion process would weigh on our operations during our first year as public company, with that in mind. Our investment advisor agreed to reduce its base management fee by 50%, from 1.75% to 0.875% through October 31st of this year. As we mentioned to the course of the road show, this material discount to the base management fee was fairly straightforward decision. As the management team of our investment advisor is committed to our long-term success and owns in aggregate over 30% of our common stock.

I would now like to review our March 31st, financial results. We completed the quarter with diversified investments in 58 portfolio companies. Fair valued at approximately $228.8 million comprised of $221.2 million in 57 portfolio companies in the senior loan fund and a $7.5 million limited partner investment in the SBIC fund.

Our net assets as of March 31st, 2013 were $141.9 million or $14.76 per share compared with $14.80 per share at December 31st, 2012 and our IPO price at $15 per share. We’ve paid two quarterly dividends since the IPO last November. On January 31st, 2013 we paid a dividend of $0.17 per share, which equated to $0.34 per share pro-rated for the 54 days remaining in 2012 following our IPO.

And on April 30th, we paid a first quarter 2013 dividend up $0.34 per share. Turning to the asset base, we believe that the credit quality of our investment portfolio was sound and its diversification provides meaningful protection to our balance sheet and the company’s ability to produce consistent earnings. As of March 31st, we had only one investment on non-accrual that investment had a fair value of $3.4 million at March 31st, for 1.5% of the $228.8 million total fair value of our investment portfolio.

The aggregate fair value to cost ratio on our debt investments was 98.6% at March 31st. independent third-party evaluation firms provided positive assurance on our fair values for 16 of our 58 portfolio companies as of March 31st, 2013. And 21 of our 50 non-portfolio companies as of December 31st, 2012. With that, I’ll turn the call over to Bob to talk about financial performance.

Bob Palmer

Thanks Glenn. As Glenn noted, our investment portfolio was valued at $228.8 million on a fair value basis as of March 31st, 2013. It consisted of 58 portfolio companies and it was comprised of first-lien senior secured debt investments and 57 borrowers with an aggregate fair value of $221.2 million and our limited partnership investment in the SBIC, which had a fair value of $7.5 million.

The weighted average yield to fair value on our debt investments was 7.43% as of March 31st, 2013. The average portfolio company loan size was approximately $4 million. All of those loans in the senior loan funds are at floating rates. All contain LIBOR floors [ph] and as Glenn noted, we are just one not [ph] accrual at March 31st. A debt investment with a fair value of $3.4 million.

Some of our portfolio, we derived approximately $4.4 million in investment income in the first quarter of this year. All of the investment income came from interest income on our debt investments. During the first quarter of 2013, we incurred $2.9 million of expenses including $847,000 in interest expense on the senior loan fund credit facility. $800,000 in general and administrative expenses and professional fees.

$807,000 in management fees including $512,000 in base management fees and $295,000 to MCF Capital Management LLC for its duties with respect to the senior loan fund credit facility and $469,000 in amortization of deferred financing closing cost, on senior loan fund credit facility. The $469,000 in amortization of deferred financing closing cost included $299,000 of amortization that we accelerated as a result of the January 2013 termination of the Class B tranche of the credit facility.

Net investment income for the quarter was $1.4 million or $0.15 per share. Net realized and unrealized gain on investments total $1.4 million for the quarter ended March 31st, 2013 comprised of $1.2 million in net change in unrealized depreciation on non-affiliate investments that is, investment assets held in the senior loan fund and $0.2 million in net change in unrealized depreciation on affiliate investments that is, our limited partnership investment in the SBIC fund.

We had net increase in net assets of $2.9 million or $0.30 per share for the three months ended March 31, 2013. With a increase split evenly between net investment income and net change in unrealized depreciation. As Glenn noted, we paid a dividend of $0.34 per share on April 30th. With respect to our liquidity, we had $12.2 million of cash and $36.9 million of borrowing availability on the senior loan funds credit facility at March 31st, 2013. With that, I’ll turn the call back over to Glenn.

Glenn Pittson

Thanks Bob. At this point of call, I want to update everyone on our progress and converting the SBIC fund into a drop-down subsidiary. I personally had conversations with a large number of third-party investors in the fund. Based on these discussions, we will soon be sending out a proposal to acquire all their commitments on which $4.5 million is currently funded.

We are also finalizing a drop-down documentation, which will be submitted to the SBA for their approval. While we are generally pleased with our progress, there are number of variables that could impact consummation of the drop-down and we cannot provide guidance as to the timing or ultimate outcome. The company [ph] required unanimous consent, there are by my count about 20 potential stakeholders including SBA, who’s non-approval could materially alter the drop-down process or derail the process in its entirety.

Finally, I would like to share a few observations on a leverage loan market. Over the last several months, we have observed growing competition leading to significant pricing compression in this asset class. For example, Standard & Poor’s recently reported that the average yield on broadly syndicated loans rated single B was 5.39% as of March 31st. While the average yield on similar loans close so far in May was 4.7%.

Despite this downward trend, we believe the credit spreads continue to remain above historical norm. I’ve notified Bob earlier in the call; the yield on our proprietary senior loan portfolio is currently 7.43%. General market overview usually included the impact of what is sometime referred to as drive by reprising which have become prevalent over the last six months in the broadly syndicated market.

In terms of our senior loan funds, hence the IPO there have been eight of what we refer to as defensive re-pricings. In other words, on eight deals that we considered to be solid investments the senior secured lenders including OFS agreed to reduce the pricing in order to stall the sponsors on those transactions for repaying the loans and taking their business elsewhere.

These pricing concessions generally range from 50 to 100 basis point reduction in credit spread. The eighth re-pricing represent a little less than 15% of the portfolio, in terms of number of (inaudible) over roughly a six month period. In closing, I should reiterate that our short-term focus is to complete the SBIC drop-down process and pick up the pace of investing in the SBIC fund.

Our management team will continue to be selective in its investment process, to ensure that the risk rewarded quite and is appropriately balanced with the goal of ensuring that our shareholders will enjoy stable, uninterrupted dividends over a long period of time. We will be patient in growing our investment portfolio and we will remain focused on preservation of the capital entrusted to us by our shareholders. Okay with that, now let’s just open the telephone lines to take some questions.

Question-and-Answer Session

Operator

(OPERATOR INSTRUCTIONS). Our first question comes from Chris Kotowski at Oppenheimer.

Chris Kotowski – Oppenheimer

Good morning. I was wondering – can you – that we were relative to our model; we missed on the fees, the management fees. Can you describe the $295,000 fee to MCF and is that a recurring thing?

Bob Palmer

Yes Chris, this is Bob Palmer good question. MCF Capital Management LLC is an affiliate of Madison Capital which is subsidiary of New York Life and Madison is styled as the loan manager on the senior loan credit facility and they source deals and provide administrative duties with respect to that portfolio and for that, they earn a 50 basis point per annum fee on investment assets held in that vehicle.

Chris Kotowski – Oppenheimer

So that’s an ongoing thing.

Glenn Pittson

Right and this is Glenn and generally, we consider that part of the financing cost for the overall senior loan fund.

Chris Kotowski – Oppenheimer

Okay and then the $469 million of amortized deferred financing closing cost. How much of that is ongoing?

Bob Palmer

Well that’s thousand by the way, Chris.

Chris Kotowski – Oppenheimer

Sorry, thousand. Yes.

Bob Palmer

We pay fees, but not quite that much. It’d be roughly $170,000 a quarter. We accelerated amortization in the amount of $299,000 in the first quarter because of the termination of the Class B facility in January.

Chris Kotowski – Oppenheimer

Okay and then you referenced a new non-accrual, can you tell us about that, what happened with the company, what kind of did you take a mark on the loan and what’s the outlook for recovery?

Bob Palmer

I can give you a little bit of color, Chris. We have a policy of not commenting in details on specific names, especially where negotiations are ongoing, which is the case, but the name is Strata Pathology Services Inc and it is a pathology laboratory company. We had it fair valued at about 86% at par at December 31st and it’s fair valued at 69.5% of par as of 331 and we hope to be in position to provide you color and the next time, we are on the call with respect to outcomes on this, but I really can’t get into discussions now.

Chris Kotowski – Oppenheimer

Okay and then the 1.429 net realized and unrealized gains on investments. I didn’t quite get the breakdown of that, what can you go through that again?

Bob Palmer

Sure, it was it was 1. Bear me with, just a second, if you will. It’s about $251,000 of gain on our investment in the SBIC fund and $1.2 million of gain on investments in the senior loan fund and that the total of that was $1.4 million.

Chris Kotowski – Oppenheimer

Okay and is the slow pace of deployments in the SBIC fund, is relative to what and I’d have expected six or eight months ago, is that due to the fact that, you haven’t been able to get the drop-down yet and would that accelerate once you get the drop-down or is it, should the pace of deployments theoretically, not be that perfected by getting or not getting the drop-down?

Glenn Pittson

There is definitely, its Glenn here. There is definitely some impact on the drop-down process distracting management and the management team is just focused on the generation of transactions also, so there is little downside in that regard, but I wouldn’t hang my hat on that. I think we’ve been dealing highly competitive environment.

Backlog looks pretty good, as far as transactions bidding in general is kind of part of the reasons, as we talked about some pricing compressions in the market overall and we are dealing with that as far as pricing and our transactions, but now we are definitely disappointed in the pace of growth there. I believe more toward competition right now and but we are dealing with that, but we are also dealing with volume issue and as far as expanding our team devoted to the origination of new transactions.

So but I definitely wouldn’t hang my head on just the drop-down process. I want thinking of doing that, but no that’s not exact, so.

Chris Kotowski – Oppenheimer

Okay, all right. That’s it for me for now. Thanks.

Operator

Our next question comes from J.T. Rogers with Janney Capital Markets.

J.T. Rogers – Janney Capital Markets

Hi, good morning. So looking at the professional administrative and G&A fees. It looks to be about, if I aggregate those about $800,000 flat from 4Q, which was a stub [ph] quarter, is that $800,000 a good run rate or is there any one-time items either to the benefit or with negative in that number?

Bob Palmer

It’s tough to help you with your model in J.T., what I will tell you is that, we are very focused on the admin and overhead expense items. There’s a certain fixed cost element to running up BDC and we need to grow the top line to reduce the percentage there, what I will tell you is that. We are focused on the professional fees and we have begun to increase internal steps, so that we can rely less on outside professionals and consultants. So I do expect to see the professional fees reduce over time.

J.T. Rogers – Janney Capital Markets

Okay, but offsetting that I guess I would assume there’d be increased administrative and other G&A, as you increase staff or is that part of the management fee?

Bob Palmer

Some of that is management fee, but we think that the internal hiring of personnel, will more than the costings will more than offset or be more than offset against the outside professional fee, so we think there will be a net pickup or a net reduction in overhead costs.

J.T. Rogers – Janney Capital Markets

Okay and then looking, touching here a little bit the SBIC until you drop that down, how is that said through or how you’re recognizing income from that, will it be on them making a distribution to shareholders or is that or real (inaudible) because it looks to me like the increase in fair value of that SBIC subsidiary was about what I’d would assume income would be, your pro-rata share of income would be coming off that portfolio.

Bob Palmer

Yes, I mean until and unless we consolidate the SBIC fund. You’re going to continue to see it in the same place on the P&L and the increase was essentially increased in fair value of the underlying investments of the SBIC fund at our percentage ownership.

J.T. Rogers – Janney Capital Markets

Okay and that makes sense, as they based on what the agreement is right now, do they have a distribution schedule for income that they accrue in that fund, so as they bring in interest income, do they pay it out to existing investors?

Bob Palmer

There’s not a schedule for distribution, J.T. the management of the SBIC fund will determine the best use of net cash flow.

J.T. Rogers – Janney Capital Markets

Okay and then, what is your policy in terms of increasing in your investment in the subsidiary and then also your dividend policy, if the drop-down is not successful?

Glenn Pittson

We currently have a firm commitment to invest. I think we’re roughly at $19 million to $20 million in commitment for the fund, but there is overarching commitment depending on the diversification of investors in the fund, that commitment can move up to $25 million, if we don’t become a drop-down. In case of becoming a drop-down, our plan is to and our discussions with the SBA involves committing $75 million in capital to that to maximize the benefits and roll the fund to $225 million.

J.T. Rogers – Janney Capital Markets

Okay and then just on the dividend, I mean without that SBIC consolidated it seems, it’s a $0.34 per share run rate, it will pretty hard to achieve. What are your thoughts on that? In terms of NII coverage ratio.

Glenn Pittson

Definitely agree with you, this is very important. Strategically for us to grow that investment. Absent a drop-down, we would have to reorient our origination activities, which we can do, I mean but that’s a fallback position, I really don’t want to get into right now, but yes it definitely is an issue, if we don’t complete the drop-down, it definitely just cuts the legs out, from underneath the strategy. We do tell in the road show.

J.T. Rogers – Janney Capital Markets

Okay that’s all for me.

Operator

Our next question comes from Matthew Howlett at UBS.

Matthew Howlett – UBS

Hi guys, thanks for taking my question. Is (inaudible) or range of what the excess capital position of the company is today and what’s your philosophy in terms of issuing shares below book, whether to be rights offering or is it something that is a just a general philosophy around that?

Glenn Pittson

As far as a philosophy on issuing it below net asset value we are talking about, are you even talking about that? No there’s no intention of doing anything like that within the firm right now. As I mentioned, the core strategy is to get this SBIC fund done. I think the benefit post to receiving exemptive relief on the SBA debentures were more than help to drive, assuming we could invest wisely, which I’m very confident, the SBIC team can do, that we think that should drive the price up and we won’t have to be worrying about issuing stock below an AV [ph].

Yes, I don’t know if that’s a policy, but it’s definitely the premise we are working under right now.

Matthew Howlett – UBS

No, it’s good that steep that and that’s something that I think the market needs to know. I’m sorry go ahead.

Bob Palmer

I just wanted to add; at this point we’ve got about $37 million of foreign capacity under the senior loan credit facility.

Matthew Howlett – UBS

Okay, so that can fund your commitments to the SBA fully fund.

Glenn Pittson

Yes.

Matthew Howlett – UBS

Okay great and then just moving to the SBIC and currently that’s what market is waiting for, is there a sort of like an ROE sort of range or target that could be achieved, a loss [ph] suggested ROE target, that you think that you achieved with the SBIC’s fully funded. Presumably would be higher than what you can do in the senior secure loan fund. It is assuming that that you could give us in terms of color on that, on what you could achieve in that in subsidiary?

Glenn Pittson

My recollection is on the road show, I was thinking about the slides that we were presenting. We were looking at the SBIC fund generating a rate of return fully utilizing the leverage and looking at today’s interest rates where they’re above 20% rate of return on that investment and the senior loan fund itself, is kind of below teens maybe 12% depending on how much leverage, we can put into that.

The strategy works, concert with one another getting that exemptive relief essentially creates the ability to create a little more leverage in the BDC with very low cost long-term capital. So really does drive our profitability. I think when we are on the road show and I think the number is, our interest rates haven’t moved much, maybe there’s been a little competition and compression in maybe risk, premium side. I’d still hold to mid teens kind of rate of return off of this business model, net of management, based management fees.

Matthew Howlett – UBS

To me that sounds, I mean those were astounding returns of a based on what’s – a pretty risk that you’re taking, is that a law [ph] suggested. Do you feel that’s would incorporate normalized sort of default type environment?

Glenn Pittson

Well the thing we would like to point out is that, the senior loan funds, real bulk of our assets right now are all basically, first-lien loan. First-lien leverage loans, we try to keep them pretty diversified and so even when we are, even we had a non-accrual and the situation we have there, we are not it doesn’t upset the apple cart too much, so to speak as far as our asset base.

As far as the SBIC fund, once we get on the road show. We spoke a bit about the fact, in that case it’s really not a mezzanine focused fund. It’s more of a unitranche type investment strategy. So I’ve heard other people, actually Aeries [ph] earnings call yesterday. I heard it mentioning about the fact that you need to focus on where you not necessarily where you’re at the bottom of the capital structure, but how far up in it, you would go.

And we did make the point along the way, that we do let senior stuff [ph] instead of our unitranche loan, senior borrowings, but usually maybe one turn of leverage. We’re always trying to keep those recoveries. We’re focused on the risk, we’re focused on the risk, we’re focused on returns, but the other thing, kind of unique about our platform is the fact that, the management company owns over 30% of the public outstanding stock.

So risk is really important to us, so we have a bit more. I would say, our strategy is definitely more a senior oriented strategy versus being a mez, so I don’t think it’s necessary to apply, traditional mezzanine recovery rates to our asset pool, just probably we’ve configured it.

Matthew Howlett – UBS

Right. It’s a fair point and the management, they know what the significant ownership which is, and that they get relative to peers in the BDC space. I mean, it is no plan to sell the lock ups expiry and there is nothing, (inaudible) we should be.

Glenn Pittson

We signed a two-year lock up, as I mentioned to many people. It was probably the easiest thing we ever had to sign because we are in this for the long run. This is very important strategic move, our management company is been in the business for over 15 years. This is been our focus as far as how we want to approach providing capital to the middle-market. So this is one of the most important elements of the overall management company at this point and definitely the primary methodology delivering capital to middle-market.

Matthew Howlett – UBS

Great and then just the last question, will you update the market via an 8-K with any progress on the SBIC drop-down?

Glenn Pittson

The day we get the drop-down, I think as soon as this drop-down occur, we will be very excited about it and make sure everyone’s very much aware of it.

Matthew Howlett – UBS

Great. Great, thanks guys.

Glenn Pittson

Welcome.

Operator

This concludes our question-and-answer session. I would like to turn the conference back over to Glenn Pittson for any closing remarks.

Glenn Pittson

Okay well, I would just like to thank everyone for your time today and we look forward to speaking with you next quarter, have a good morning.

Operator

The conference is now concluded. Thank you for attending today’s presentation. You may now disconnect.

Copyright policy: All transcripts on this site are the copyright of Seeking Alpha. However, we view them as an important resource for bloggers and journalists, and are excited to contribute to the democratization of financial information on the Internet. (Until now investors have had to pay thousands of dollars in subscription fees for transcripts.) So our reproduction policy is as follows: You may quote up to 400 words of any transcript on the condition that you attribute the transcript to Seeking Alpha and either link to the original transcript or to www.SeekingAlpha.com. All other use is prohibited.

THE INFORMATION CONTAINED HERE IS A TEXTUAL REPRESENTATION OF THE APPLICABLE COMPANY'S CONFERENCE CALL, CONFERENCE PRESENTATION OR OTHER AUDIO PRESENTATION, AND WHILE EFFORTS ARE MADE TO PROVIDE AN ACCURATE TRANSCRIPTION, THERE MAY BE MATERIAL ERRORS, OMISSIONS, OR INACCURACIES IN THE REPORTING OF THE SUBSTANCE OF THE AUDIO PRESENTATIONS. IN NO WAY DOES SEEKING ALPHA ASSUME ANY RESPONSIBILITY FOR ANY INVESTMENT OR OTHER DECISIONS MADE BASED UPON THE INFORMATION PROVIDED ON THIS WEB SITE OR IN ANY TRANSCRIPT. USERS ARE ADVISED TO REVIEW THE APPLICABLE COMPANY'S AUDIO PRESENTATION ITSELF AND THE APPLICABLE COMPANY'S SEC FILINGS BEFORE MAKING ANY INVESTMENT OR OTHER DECISIONS.

If you have any additional questions about our online transcripts, please contact us at: transcripts@seekingalpha.com. Thank you!