BlackRock Kelso Capital (NASDAQ:BKCC)
Q3 2013 Earnings Call
November 7, 2013, 4:30 PM ET
James Maher - Chairman and Chief Executive Officer
Michael Lazar - Chief Operating Officer
Corinne Pankovcin - Chief Financial Officer
Laurence Paredes - Secretary and General Counsel, Advisor
Rich Shane - JPMorgan
John Bock - Wells Fargo Securities
Troy Ward - KBW
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. (Operator Instructions) Thank you. Mr. Maher, you may begin your conference.
Welcome to our third quarter conference call. Before we begin, Larry will review some general conference call information.
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 word 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 list 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've posted to our website an investor presentation that compliments 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 November 2013 Investor Presentation link in the Presentation section of the Investor Relations page.
With that, I would now like to turn the call back over to Jim.
Thanks, Larry. Good afternoon and thank you for joining our call today. We had a solid third quarter for new investments, putting $133 million to work, while sales, repayments and other exists totaled only $16 million. $117 million net growth represents the largest quarterly net increase in our overall portfolio in more than two years.
We are hopeful that positive net growth will continue, as we believe the majority of prepayment activity driven by refinancing transactions is behind us at this point. We continue to expect that the Dial Global transaction will close in the fourth quarter. This quarter brings our originations to $365 million, including PIK income for the last nine months, exceeding total originations for all of 2012.
For the third quarter our adjusted net investment income was $0.22 per share. Our pre-incentive fee, net investment income was $0.25 per share. Capital deployment during the quarter was focused on investments in new portfolio companies comprising more than $100 million of our originations for the quarter. Nearly all of which were made secured floating rate debt investments. During the quarter, our weighted average yields fell slightly to 11.7% for income producing securities.
More generally, market conditions remain difficult, particularly on the upper-end of the middle market for investments and sponsor-backed M&A transactions. So far 2013 is characterized by continued record inflows of capital to debt funds. Deal flow seems to be somewhat better, albeit at lower rates, higher leveraged levels and in more issuer friendly structures. In short, it's a great time to be an investor in the equity of private middle market companies.
Current economic conditions and the performance of our portfolio companies continues to improve. As we look at new investment opportunities, we try to balance these strong economic fundamentals against the week credit market technical factors. Generally these conditions have led us the focus on higher quality senior loans, often with some significant credit support from asset coverage.
We are very focused on the high risk adjusted returns of our current equity investments. Many of these investments were acquired through active, distressed investing and restructuring. As a result, these equity investments often have attachment points that are far more attractive than current debt offerings.
We expect to harvest these equity investments over time and anticipate that those proceeds when combined with our net investment income will allow us to continue to support our dividends without reductions in anyway. Although one of our most significant equity investments is being marketed for sale, we expect to continue holding the bulk of our equity investments, as the rate of return on these investments is currently significantly higher, and we can earn by reinvesting the proceeds.
Finally, we continue to increase our borrowings. We move close to our goal of approximately 0.75x leverage. Even after $117 million of net portfolio investments, we continue to have sufficient debt capacity with which to grow our portfolio and don't expect to raise additional equity capital in the near-term.
Michael will now discuss our results and portfolio activity in more detail.
Thank you, Jim. In advance of the conference call, we posted our quarterly investor presentation on our website. An overview of our third quarter results starts on Page 2.
We're pleased that excluding cash, our investment portfolio grew to $1,139 million at the end of the third quarter. Net asset stood at $696 million and net asset value per share increased by a $0.01 to $9.38.
With respect to earnings, our portfolio generated investment income of $31.4 million for the third quarter, which was down from $36.1 in the prior quarter. The $4.8 million reduction in investment income in the third quarter resulted from lower average yields during the period combined with $2.7 million less fee income earned during the third quarter.
In addition, much of the repayment activity that we experienced during the second quarter did not have a full effect on the second quarter's interest income as repayments were somewhat back-end weighted. As a reminder, fee income tends to be relatively consistent for our business over the long run, although at times it maybe somewhat lumpy from quarter-to-quarter.
Total expenses for the three months ended September 30 were $22.5 million compared to $14.9 million in the second quarter. The principal difference between the two periods relates to hypothetical incentive fees on unrealized gains. Incentive fees accrued based on a hypothetical capital gains calculation for the three months ended September were $9.4 million compared with $1.7 million in the second quarter.
To derive this expense, which is required by GAAP, a hypothetical liquidation of the portfolio is performed each quarter, which if positive, results in an incentive management fee accrual. It should be noted, however, that a fee so calculated and accrued is not due in payable, if at all until the end of each measurement period and only to the extent any gains are actually realized.
As of the June 30, 2013, measurement period, no gains based on incentive management fee was due and payable. The total accrual at the end of the current quarter is the result of the $97.5 million of net unrealized appreciation on the balance sheet as of quarter-end. We believe that our adjusted net investment income, which removes hypothetical fees and as an adjustment to accrue for fees payable on the income is the better indication of our quarterly performance.
A reconciliation of these GAAP and non-GAAP measures appears on Page 11 of our Investor Presentation. Adjusted net investment income of $16.1 million in the quarter compares with $19.1 million in the second quarter and equated to $0.22 per share. The large portion of our new investment for the third quarter related to investments in new portfolio companies and a substantial portion of our dollars invested during the quarter were in senior secured first and second lien loans.
Two of the more significant transactions involved sponsor-backed companies and two others involved asset-rich energy producing businesses. Some of the more significant investments we made during the quarter were as follows. During July, we invested $22.5 million in the second lien term loan of Water Pik, a former portfolio company that is a manufacturer of oral hygiene products and replacement shower heads. We previously provided financing for the company from 2007 to 2011.
We invested $20 million in a club transaction in the first lien debt of K2 Pure Solutions, the Centre Partners portfolio company. We also funded $27.9 million of a senior secured second lien loan to Citrus Energy Appalachia. Citrus is an E&P operator in the Marcellus shale. At closing the loan represented the only net debt in the company's capital structure and is secured behind only a bank revolving credit facility.
During September we invested $30 million in the Shoreline Energy second lien term loan. Shoreline is an E&P operator with acreage along the Gulf Coast operating more than 200 active and 400 total wells. We also added to our investments in Progress Financial and Bankruptcy Management Solutions during the third quarter.
During the quarter we also finalized the restructuring of the The Bargain! Shop, which we have been actively engaged in since yearend of 2012. We completed the purchase of substantially all of The Bargain! Shop assets through a newly formed entity called Red Apple Stores. The majority of our existing term loan was converted into a new 16% senior secured term loan of $20 million with the remaining $1.5 million converted to common equity. Additionally, we invested $12 million in junior debt and equity and now control the company.
We're glad to have the transaction behind us and we look forward to capturing more of the improving performance going forward. In conjunction with portfolio company investments, we recorded fees of $2.4 million during the quarter, and during Q3, we did not realize any fees for prepayments or early exits.
As you can tell from our activity during the quarter, we have generally been focused on the secured debt investments in the current environment. We are looking to make commitments in the capital structures of businesses in which our investments are supported not only by future free cash flow generation and current enterprise value, but where identifiable assets are present that lend the support to our loans.
We view this as a defensive posture and we expect to continue seeking these more conservative investment structures. Often these investments provide slightly lower current yields as was the case for our investments made in new portfolio companies this quarter.
In general, our portfolio companies are performing quite well and many of our former problem children have seen improvements in operations or their capital structures or both. We had no investments on our non-accrual at quarter-end. And the weighted average rating of our portfolio companies at the end of the third quarter was 1.11 compared with 1.16 on June 30.
With that, I'd now like to turn the call over to Corinne to review some additional financial information for the quarter.
Thanks, Mike, and hello everyone. I will now take a few moments to review some of the details of our 2013 third quarter financial information. At September 30, 2013, our portfolio consisted of 47 portfolio companies and was invested 48% in senior secured loans, 21% in equity investments, 19% in senior secured notes, 11% in unsecured or subordinated debt securities and 1% in cash and cash equivalent.
As compared to the prior quarter, the composition of our portfolio invested in senior secured loans increased 5%. Our average portfolio company investments and amortized cost excluding investments below $5 million was approximately $21.6 million, down from $22.6 million at the prior quarter-end.
On a trailing four quarters basis, our net investment income as adjusted is $0.96 per share as compared to $1.04 per share one quarter earlier. The decrease is due to exits of some of our higher yielding assets in recent quarters as well as the timing of fees earned in conjunction with early repayments of certain portfolio companies over the last 12 month period.
The weighted average yield of the debt and income producing equity securities in our portfolio at its current cost basis was 11.7% at September 30. The weighted average yields on our senior secured loans and our other debt securities at their current costs basis were 10.9% and 13.2%, respectively at September 30. Yields excluding equity investments with no stated dividend rate, short-term investments and cash and cash equivalents.
Relative to our $1.2 billion dollar portfolio at fair value, we continue to have sufficient debt capacity to deploy in attractive investment opportunities. At September 30, we were in compliance with regulatory coverage requirements with an asset coverage ratio of 267% and were in compliance with all financial covenants under our debt agreements.
At September 30, 2013, we had approximately $13.7 million in cash and cash equivalents; $30.7 million in payables for investments purchased; $412.9 million in debt outstanding; and subject to leverage and borrowing base restrictions $236 million available for use under our amended, restated senior secured revolving credit facility, which matures in March of 2017.
With that I will like to turn the call back to Jim.
Thanks, Corrine. After some $133 million of new investments in the third quarter, equity is comprised 21% of the portfolio. As I mentioned, we remain very pleased with the performance on the underlying companies in which we hold equity investments and believe that many of these investments will continue to compound at a rate that exceeds the rate generally available in the marketplace today. That being said, we are always focused on potential exits, as these investments mature.
We remain patient in the current environment and we remain focused on growing our portfolio, and increasing utilization under our debt facilities. Dividend coverage from net investment income and equity appreciation remains a priority for us and we remain comfortable about the level of the dividend.
We would like to take this opportunity to once again thank our investment team for all of their efforts and to thank you for your time and attention to today.
Operator, would you now please open the call for questions.
(Operator Instructions) You do have a question from Rich Shane from JPMorgan.
Rich Shane - JPMorgan
Just one thing related to the incentive fee. I'm just trying to figure out, given the size of the unrealized gain during the quarter. And again I understand its been accounting new ones here. Incentive management fee that you accrued, is this essentially a 100% of the unrealized gains, because you're in that funny spot where it's the catch up on the incentive fee until a 100% is accruing to the manager or is there something else here? Because we've never really seen a quarter where the relationship was basically one-to-one?
I think Corinne should probably, should answer the question, because at a high level records it's much more accounting then anything else. It doesn't have anything specifically to do with the way the catch up provision works of the fee arrangement, it's much more of a sort of a coincident of accounting that happened in this period.
It's purely math. So because of the rolling quarter and the change in P&L from that 12 month ended period, you wind up with a significant accrual adjustment in this quarter, but the simple way to look at it I think is if you look at the balance sheet, and please, this isn't a perfect calculation, because there are some other accounting nuances. But if you look at the $97.5 million of net unrealized depreciation and think of it in terms of about 20%, you get about $20 million.
And so this quarters P&L is just an accrual that brings the balance sheet accrual up to that approximate amount that Corinne just described. It's just so happens that approximates the amount of appreciation that occurred during the quarter, but it really has to do with rolling off a quarter from five quarters ago and having a new four quarters ago starting point for performing the calculation.
Your next question is from John Bock from Wells Fargo Securities.
John Bock - Wells Fargo Securities
Real quick, as it related to some of the new investments. While you mention in you senior secured, we see a significant portion are related to second lien, and we're under the impression that second lien loans have a very different risk profile, as it relates to a first lien senior secured debt. Can you give us a sense of the leverage levels and perhaps some of the view that you're taking that get you more comfortable and maybe what some would consider a slightly higher risk asset class in light all the liquidity that sloshing around there?
I think so of the four that I mentioned Jonathan in the call, the easiest one to start with is K2 Pure Solutions, because that's our first lien loan. So the next one, I would mention is probably Citrus, I guess, because it's larger. So Citrus is a second lien loan in basically in energy company. And what we look to in addition to the cash flows of the business are the underlying values of sort of to put it generically, the stuff that's in the ground, as an additional collateral pool.
So this is a second lien term loan, but the only other debt in this capital structure is the revolver for the business. So even though it's second lien, it's not like you're lending to a retailer or to a company that doesn't have hard assets, where the second lien represents just like an order of preference in bankruptcy.
Of course, it does mean that here as well, but there are assets theoretically that you are secured by in this case. And they're very standards assets. We do this on a PV10 analysis basis. We look at the value of the underlying lease holds. I mean, Citrus for example has almost 4,000 net acres in the Marcellus. It's kind of easy to get comfortable with it on that basis.
So first you have the cash flows and the forecasts. Second you have the value of the enterprise. And in this case, third, you have the value of the assets. And here, it's very simple for our capital structure, which you'll find in a lot of these energy related investment opportunities, where it maybe second lien, but it's really second lien behind only a bank revolver. The reason that at second lien, there isn't like typical inventory and receivables in the business the bank will lend against. So we get second in line, but we're quite comfortable there.
Rich Shane - JPMorgan
Maybe in total, the aggregate leverage, where would you pit leverage in the second lien transactions, overall as a multiple of EBITDA?
So John, I think with something like Citrus or Shoreline, it's really a multiple of PV10. And so what we're looking to do is to be lending well inside of the PV10. If you wanted to use sort of a 2013 EBITDA number for a company like Citrus, for example on a net debt basis we're also under three times on a debt-to-EBITDA basis.
As inception of the transaction.
So it's really PV-10 plus EBITDA. And the secondly lien there is very different than in a typical manufacturing company or a typical service business where you'll see kind of a 4x6 or whatever it might be capital structure.
Rich Shane - JPMorgan
One question, as it relates to K2, I understand that that, obviously, Ares was very heavily involved in that transaction, and if you look on their balance sheet you'll see that on their first lien senior secured piece, they're receiving a 7% rate. And as we look here, we see a 10% rate? Can you tell us what accounts for that differential, if it's essentially the same loan?
So what it is, is this is a club deal, it's kind of a custom made suit for this refinancing transaction. Again, by the way it's a pretty much an asset-related, I won't say asset-backed, but an asset-related transaction. But in addition to that, the reason there are different yields on the securities that we hold and the securities that Ares hold is that although it is one loan and one security, we have an inter-borrower, rather inter-lender agreement amongst us about a first out, second out arrangement on the loan.
That's not in terms of security any different, but it's in terms of order of who has repaid out the cash flow first, is the first out, second out component. And it's a club deal and other companies that you follow, I'm sure you've noticed this security on their balance sheets as well.
Your next question is from Troy Ward from KBW.
Troy Ward - KBW
Jim, can you just reiterate some of your commentary on your thought process on the equity investments in the portfolio and specifically how we should be thinking about that asset mix going forward? And then how that relates to the dividend payment or dividend coverage?
I think as we've moved up in terms of the percentage of a portfolio that is equity, obviously there is no immediate investment income from those equity securities. And I have in the past said that we were going to reduce our exposure there. And we are indeed, because one of our most significant companies is up for sale.
But there are several other, and this is where I think our thought process has changed a little bit, there are several other significant holdings in the equity in our equity holdings that are appreciating in a pretty rapid rate, and in a couple of cases we had the opportunity to sell them this quarter and/or around the net asset value for each of those securities.
We did a lot of work on them and came to the conclusion that they were going to continue at least for the foreseeable future, i.e. let's just call it, the next twelve months, appreciate at a much higher level that we couldn't reinvest that money in debt securities.
So rather we think from a shareholder standpoint holding onto those securities rather than cashing them and to create short-term NII was a bad economic decision. And then so we've made the decision to sort of alter our strategy, in terms of our overall strategy, it's our long-term goal to reduce the equity position down from what is 21%. I suspect that will go up in the next quarter. As a matter of fact, I think it will go up in the next quarter as a percentage of total assets, but overall our long-term objective is to reduce that.
I would add to Jim's comment, the nuance that you may not take away from just looking at the SOI in our financial statements because many of these equities were acquired aggressively by us through distrust investing or restructurings. Many of the equities are at an equivalent, call it, leveraged level or attachment point in the capital structures of these companies, that's lower than were debt would normally attach.
So they're actually pretty safe as far as equities goes because there is really no debt or little debt or very manageable amount of debt in front of them and yet the values of the businesses continue to accrete more rapidly than the returns on currently available debt securities.
Troy Ward - KBW
I fully understand, and of course we would agree that if you have an asset that if you look at all the numbers and you think it's going to go up, then why sell it today for X, that I can sell it maybe six months now, maybe six years from now at X plus something, that's the right decision.
But take that to next step, though how does that equity, and you're holding onto equity, which will have a higher value and unrealized value in the portfolio, how does that helps support the dividend and how does that work into your thought process of the dividend, I think just staying at the current level.
I think it works into our thought process, is that we think those securities will accrete in value substantially on a quarter-to-quarter basis going forward. And we think that if we take that into consideration in terms of where we set our dividend, so it's a combination of NII and the appreciation on what amounts to be a different portfolio, than most of a BDCs with substantial equity exposure. We think that's the right way to look at it.
Troy Ward - KBW
So separately you're going to have a piece of the unrealized depreciation in equity as part of the dividend?
Yes. And at the end of the day, what we're really looking at is NAV and having NAV stay at least as high as it is today and appreciate from where it is today.
There are no further questions at this time. Presenters, do you have any closing remarks?
None other than, thank you all for participating, and as always, if you have any further questions please feel free to give us a call. Thank you.
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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