OFS Capital's CEO Discusses Q3 2013 Results - Earnings Call Transcript

Nov. 8.13 | About: OFS Capital (OFS)

OFS Capital Corporation (NASDAQ:OFS)

Q3 2013 Earnings Call

November 8, 2013 10:00 AM ET

Executives

Mary Jensen – VP, IR

Glenn Pittson – Chairman and CEO

Robert Palmer – CFO

Analysts

Mickey Schleien – Ladenburg

J.T. Rogers – Janney Capital

Operator

Good morning and welcome to OFS Capital Corporation’s Earnings Call for the Quarter Ended September 30, 2013. It is my pleasure to turn the call over to Ms. Mary Jensen, Vice President of Investor Relations. Ms. Jensen, you may begin.

Mary Jensen

Thank you. 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. Please note our earnings announcement was released this morning and can be accessed via the Investor Relations section of our website at ofscapital.com. We plan on filing our 10-Q later this evening. Before we begin, please note that statements made on this call and webcast may constitute forward-looking statements, within the meaning of the Securities Act of 1933 as amended. Such statements reflect various assumptions by OFS Capital concerning anticipated results and are not guarantees of future performance and are subject to known and unknown uncertainties, uncertainties and other factors that could cause actual results to differ materially from such statements. Uncertainties and other factors are in some ways beyond management’s control including the risk factors described from time-to-time in our filings with the Securities and Exchange Commission.

Although we believe these assumptions 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 of the date and time of this call. A replay of the call will be available until November 18, 2013, beginning approximately two hours after we conclude this morning. Alternatively, the webcast will be available for the next 90 days. To access either replay, please visit our website at ofscapital.com.

With that, I’ll turn the call over to Glenn.

Glenn Pittson

Thanks, Mary. Good morning and thank you for joining us, as we discuss our results for the fiscal quarter ended September 30, 2013. I hope you had an opportunity to review our third quarter earnings announcement, which as Mary mentioned, was distributed a few hours ago and is available in the Investor Relations website. One year ago today, we made our public debut and rang the opening bell on the NASDAQ. It was a culmination of a busy month that included receiving permission from the SEC, to launch our IPO and traveling around U.S. to meet any of you during our roadshow. At that time, we discussed both the macroeconomic environment and the growing demand for middle market credit, as well as the specific opportunities that OFS Capital offered shareholders. A year is passed and we have faced some challenges in realizing these goals, both in terms of our results and finalizing all the steps in the process of implementing our business plan. However, we feel good about where we are in the process and believe we are at the threshold of fully implementing our strategy, which will position us for meaningful growth.

We have diligently pursued the two investment objectives outlined during our IPO process. First, to make prudent investments in both the senior loan fund as well as the SBIC Fund and second the most important goal, was to convert our investment in the SBIC Fund into a wholly owned drop-down subsidiary. As you may recall, during this summer, we concluded negotiations with the other limited partners of the SBIC Fund, enabling us to submit applications with both the SBA and the SEC. As we indicated before, this was done with the intention to materially expand our financing sources.

During the negotiations with the other limited partners, we obtained the purchase options set to expire December 6th, which provided us, ample time to complete the transaction. Despite the burden of the federal government 16 day shutdown in October, a time when our application was in for review with the SBA, we remained confident that we will be able to complete the SBA drop-down on time and before the purchase option expires. In addition, the SEC has been highly response [ph] exempt to release applications and accordingly, we are optimistic that the SEC will, in the near term, grants us exempted relief similar to that obtained with other SBIC applicants.

As we sit here one year later, we appreciate that our investors that remain supportive, given the hurdles involved in completing this process. We recognized this challenge and we’re determined that the right thing to do for all shareholders was for the external manager to assume that significant cost of the IPO, as well as cut the base management fee in half for the first year. The manager assumed those costs in order to develop a long-term source of equity capital to invest in middle market companies. As you know, management continues to have a significant stake in OFS Capital, which ensures our alignment with all shareholders. Turning to our third quarter results, frankly they were not what we would like them to be. However, they were some positive takeaways. The senior loan fund continues to perform and is substantially invested. And despite the delays in the drop-down process, the SBIC Fund continues to make new investments.

Now we will turn the call over to Bob to discuss our third quarter financial performance.

Robert Palmer

Thanks, Glenn. Our investment portfolio totaled $219.3 million on a fair value basis as of September 30th. It consisted of 56 portfolio companies and was comprised of senior secured debt investments of 55 borrowers with an aggregate fair value of $208 million, as well as our limited partnership investment in the SBIC Fund, which had a fair value of 11.3 million. The weighted average yield to fair value on our secured debt investments was 7.21% as of September 30th and the average portfolio company and loan size was approximately $3.9 million. All of the loans in the senior loan fund are at floating rates. All contained LIBOR floors and we had just one non-accrual at September 30th, a debt investment with a fair value of $2.1 million.

During the third quarter of 2013, we closed two senior secured debt investments totaling $7.5 million, comprised of $3 million investment in a new portfolio company and $4.5 million company investment in the refinance of an existing portfolio company’s credit facility. We were fully repaid on senior debt investments totaling $9.3 million in two companies our portfolio at June 30th. In addition, we had repricing amendments during the quarter on five portfolio companies within a senior loan fund to $18.4 million in aggregate principal balances outstanding at September 30th, including the aforementioned $4.5 million refinance transaction.

The SBIC Fund ended the quarter with debt investments in five portfolio companies with $25.9 million in aggregate principal balance outstanding and equity investments of $4.9 million at fair value in the same five portfolio companies. Thus far in the fourth quarter, the SBIC Fund has made senior secured debt investments totaling $10.8 million in two new portfolio companies and obtained equity stakes in each new portfolio company at an aggregate cost of $500,000. From a senior loan fund portfolio, we derived approximately $4 million in investment income in the third quarter of this year. Almost all of the investment income came from interest income on our debt investments.

During the third quarter of this year, we incurred approximately $2.6 million of expenses, compared with $2.8 million in the second quarter and $2.9 million in the first quarter of this year. Included in the third quarter expenses were; $821,000 in interest expense on the senior loan fund credit facility, $856,000 in general and administrative expenses, professional fees and administrative fee, $744,000 in management fees which included $497,000 in base management fees and $247,000 to MCF Capital Management for its duties with respect to senior loan fund credit facility and $168,000 in amortization and deferred finance and closing costs on the senior loan fund credit facility. Included in the $856,000 in the third quarter 2013 general and administrative expenses, professional fees and administrative fee, were approximately $50,000 in legal fees relating to our efforts to obtain drop-down approval from the SBA and exempted relief from the SEC. That figure compared to approximately $250,000 in the second quarter. Although we will incur additional legal expenses until conclusion of the drop-down and exempted relief processes, such expenses which have totaled in excess of $300,000 so far this year, are non-recurring in nature.

Net investment income for the quarter was approximately $1.4 million or $0.15 per share, consistent with the $0.15 per share in net investment income, we earned in each of the first two quarters of this year. Net unrealized loss on investments totaled $1.1 million for the quarter ended September 30th, comprised of $1.5 million in net change and unrealized appreciation of non-affiliated expenses, that is, investment assets held in the senior loan fund and $400,000 in net changing, unrealized appreciation unaffiliated investments, that is, our limited partnership investment in the SBIC Fund. Approximately 60% or $900,000 of the $1.5 million in unrealized appreciation in the senior loan fund, related to a decrease in the fair value of our debt investment in Strata Pathology, which remains our only non-accrual credit.

We had net increase in – net assets of $400,000 or $0.04 per share for the three months ended September 30th, and we made a $0.34 per share distribution on October 31st. We estimate the tax characteristics of our distributions to shareholders on Form 1099 after the end of each fiscal year. However, if the tax characteristics of that distribution were determined for the quarter ended September 30th, we estimate that $0.19 per share would have been characterized as a return of capital to shareholders. As for our liquidity, we had $6.8 million in cash and cash equivalents, as well as $49.9 million of foreign availability on the senior loan funds credit facility at September 30th. As of November 04, we had approximately $51.2 million of foreign capacity. We’re currently in negotiations with our lender to extend the reinvestment on our credit facility, which is set to expire on December 31st.

With that, I’ll turn the call back over to, Glenn.

Glenn Pittson

Thanks, Bob. With respect to the middle market, we continue to see strong demand by company’s seeking capital and we have been successful in keeping the senior loan fund invested. In reference to the smaller end of the middle market, in other words, the current and perspective of the SBIC Fund, demand is particularly vibrant after taking into account the continued but slow expansion of the economy. Further, the SBIC team has been increasing the pace of business development through direct calling efforts, as well as expanding its network of likeminded SBIC Funds and other BDCs. And we are pleased with the quality and quantity of deal flow within the SBIC Fund. Since our IPO, our senior loan fund has remained substantially invested and we continue to see attractive new opportunities in this asset class.

In summary, our short-term focus is to complete the SBIC drop-down process and accelerate the pace of SBIC Fund investing. Our long-term focus is to create shareholder value through quality earnings growth, as well as stable, uninterrupted dividends. We look to achieve this through prudent investments that ensure a balance risk reward equation. And we will continue to be patient in growing our investment portfolio, while remaining focused on preserving capital.

With that, we will be happy to take your questions.

Question-and-Answer Session

Operator

We will now begin the question-and-answer session. [Operator Instructions]. We have a question from Mickey Schleien from Ladenburg. Please go ahead.

Mickey Schleien – Ladenburg

Good morning. My question relates to the SBIC. I was hoping you could perhaps describe their origination team and process and also the size of their backlog and pipeline?

Glenn Pittson

Right now we have a team of about we’ve been hiring a bit lately. So we have four – about 11 people devoted completely to the SBIC Fund right now, including people coming on board as we speak. As far as the pipeline goes, our meetings we have on a weekly basis have been expanding – running quite long. I’m sitting with a nice little stack of proposals and term fees that we’ve been offering out into the market as far as new transactions.

So we’ve been slowly taking our foot off the brake here as we get closer to the date of the possible approval drop-down, because as you’re aware Mickey we will end up doubling the size, over-doubling the size of the fund and that would put us in a position to make a little larger commitments to these transactions and put us little better shape as far as doing a little larger transaction size with that. But we feel pretty good about the flow of business. I think a lot of that has to do with the fact that we’re pressing harder into the market right now, now that we’re developed a certain amount of confidence related to getting this drop-down buttoned up.

Mickey Schleien – Ladenburg

What sort of channels does that team count on to originate business? Is it meeting with business brokers and conferences like that or something else?

Glenn Pittson

Well it’s definitely business brokers and conferences try to work our way through most of the major conferences out there. Deal directly with the CPA firms, hired someone specifically on the West Coast who had a small business investment background, a lot of his work with mezzanine transactions associated with supporting bank funding activities. So we’ve gone directly to banks, we’ve worked with CPA firms, accounting firms, legal firms as far as the state planning goes. Also, we’ve been also just actually reaching more heavily into rolodexes now that we have a much clearer story as to what we can present to people. Up to today it’s been – till now it’s been somewhat unusual to be trying to describe exactly the affiliation between Tamaracks and OFS. So we’ve actually been able to start speaking with a little more clarity to these people.

So it’s been a lot of the intermediaries, been a lot of the guys who have M&A shops with one or two people in it in different cities throughout the country, some of the smaller towns. It’s been more of a direct calling effort. We’ve also been trying to work directly with companies that we might know – it’s a little closer to may be a private equity business development effort that it would just be in terms of calling just a sponsored group or whatever. But actually we do work with a lot of people now call I guess what do they call them? What do they call sponsors with no money?

Robert Palmer

Homeless sponsors.

Glenn Pittson

Homeless sponsors that sounds crazy. We feel a lot of guys who don’t have the dedicated funds but are out there to trying to put together transactions.

Mickey Schleien – Ladenburg

Would you be in a position to give us some sense of the trajectory of the SBIC once this is all concluded in terms of the size of the portfolio?

Glenn Pittson

I think when I was down on the roadshow we were talking in terms of trying to run the SBIC Fund at roughly $8 million to $9 million a month in originations giving you $20 million to $30 million a quarter. We’re still working towards that number. We’re still trying to build the platform in order to deliver that type of business origination activity. So I think that’s the run rate we’re working toward as of now with the backlog we have. We’re hopefully – we’ll be able to start speaking in the future earnings call specifically to those types of numbers.

Mickey Schleien – Ladenburg

Very good. Thanks for your time this morning.

Glenn Pittson

Thanks.

Robert Palmer

Thanks for the question.

Operator

Our next question is J.T. Rogers from Janney Capital. Please go ahead.

J.T. Rogers – Janney Capital

Good morning. Thanks for taking my question. I guess firstly, just on the on balance sheet stuff, was there any fee income on the top-line interest income?

Robert Palmer

No, I mean it’s interest income and there is no dividends coming through on that because all of that is in the SBIC Fund, J.T.

J.T. Rogers – Janney Capital

Well I guess my question was is the top-line run rate just for your William Fund is that a good run rate, in terms of going forward, is that something to expect on the interest income line?

Robert Palmer

Yeah it’s pretty consistent J.T. over the last three quarters $4 million to $4.2 million a quarter on the top-line.

J.T. Rogers – Janney Capital

Okay. Thanks for the detail on the 300,000 associated – legal fees associated with the SBIC drop-down. Question, are there any start up related SG&A costs that are may be one-time, that might disappear in coming quarters? And then I was just wondering if you roughly had an idea what kind of – what percentage of SG&A is fixed potentially be leveraged as you go to portfolio?

Robert Palmer

There is a certain amount of stocks compliance expenses J.T. that should recur in much smaller numbers after we get through the first years since we will be stocks compliant in the close of this year. For the first half of this year well for the last few quarters that’s totaled about $80,000 and you’ll see that running through professional fees. The SBIC exempt really been drop-down we’ve already talked about. The fixed fees I think you’ve seen administrative expenses over the last three quarters in the $180,000 to $200,000 range for the last two quarters, which is down meaningfully from the first quarter rose about $280,000. So we feel like we’re getting pretty good controls over our SG&A, but we’ll give you more clarity over time J.T. Is that helpful?

J.T. Rogers – Janney Capital

Yeah, yeah that’s helpful. And obviously I mean the big item here I think is Tamaracks it sounds like you’re getting close to the finish line there. Would it drop-down – what is the whole size [indiscernible]?

Glenn Pittson

Right now we’ve been working along the lines of I think in average kind of thinking hard about going about $5 million. I think once we get the drop-down done, you have tenant, tenant is definitely not that concerning to us taking into account our capital base and whatnot. So that’s kind of range we’re working in although, we’re debating $15 million investment whether or not that fits properly in there. The other judgment we’ll be making as we look at the size of whole just whether or not what is it? Is it a preferred stock investment? Is it a mezz B or is it a further up in the capital structure, senior debt fees where in the cold situations your capital’s pretty well protected.

So all those would enter into a decision as far as size, but on a larger size credit, more senior type credit activities are getting close to 10% of equity may be but not much, not more than that. And – but I would say our average would stay a little bit below $10 million and most certainly deals we’re working with. And there is a lot of demand right now out there for transactions unitranche type transactions, as we said we’ve been trying to work a bit with the other likeminded SBIC Funds and BDCs and we’d like to share business with them in order to build the diversified book here. But the good thing about that is, we get – they always send transactions back here way to take a look at, so it kind of helps keep the flow alive and build a little more diversification into our portfolio, which we think serves us well.

J.T. Rogers – Janney Capital

Okay, great. Thanks. And then just in terms of new deals, it sounds like you’re looking at a number of different options, but I was wondering you said sort of a typical deal that you all look at the lower middle market. So what kind of yields are you getting and then what kind of leverage are we seeing? This could be for the unitranche or for junior debt capital.

Glenn Pittson

Well there are senior loan is very much different than what the activities we engage in the SBIC Fund. The senior loan funds, I think we’ve talked about this in the past, your average size of operating profit EBITDA whatever metric you’d like to use is $10 million to $20 million range of type of borrowers little larger size there. I would think that most of those transactions don’t really get much past three times leverage against that number little bit above it, depending on the rate of return we get on that. And that’s all usually always floating rate coupon with usually floor.

So that’s the senior loan fund. So on the SBIC Fund, I don’t think we go much beyond 3.5 times in leverage, even when we permit a may be a small revolver or a small bank oriented term loan in front of us, we try to stay above that 3.5 times leverage point against cash flow. And if we do end up going beyond that, you probably will see it like we in the form of may be a prep stock or whatever to may be believe the rates to return, just high enough where warrants putting a little bit of paper in there like that. But our goal is to always build a portfolio of current income producing assets. It’s the first question we have and every time I look at the portfolio making sure that all of our assets are producing current income in order to show since we’re dividend paying vehicle, we need to stay focused on that and not too far from that goal. That makes sense or?

J.T. Rogers – Janney Capital

Yeah, yeah absolutely. I guess the question was more on the income producing side, what are the typical yields of loans you’re seeing in the market right now, 13% to 15%; 15% to 16% 10%?

Glenn Pittson

On this senior loan funds side what we’re seeing is the same kind of yield we’ve been getting which is in the seven-ish range kind of look over it other sources broadly syndicated sides of the middle markets. That yield seems to be coming out and the assets that we think about that are called middle market and kind of single B rated. The yields on those seem to be 3% 3.5% with 1% floor. So you’re talking 4% or 4.5%. So we don’t find those very attractive we would look in there every once in a while but we never seem to have find anything that’s interesting. On the SBIC Fund side, we’re continuing in the range of 11% to 12% in the current cash coupons, may be 1% 2% in picked type instruments and then either a direct investment in the equity depending on our receivable about the play there or some type of warrant component to that.

I think as we mentioned on multiple occasions, we try to work around structuring the unitranche type deals to obtaining yield in the range of 20% IRR for the fund, but that’s kind of the single data point. We’ll take less risk and let that IRR shrink and/or we may even take a little more risk and let they go higher. But the single data we start structuring something is usually around – why is it not a 20% IRR and why is it that number or why is it more or why is it less? And that’s kind of an essential discussion point when we sit down and think about committing capital to these smaller companies. And these smaller companies will be in the $3 million to $15 million EBITDA range, so much smaller entities dealing with much different situations at hand. Generally there is no sponsor involved or as what you’re saying earlier if would sponsor also trying to put together a deal. So that can – is that more on point what you’re asking?

J.T. Rogers – Janney Capital

Absolutely. And then just for clarification, how do you get from the 12% 14% current coupons to the 20% IRR what’s the warrant coverage if you would get in a typical deal like this?

Glenn Pittson

It really depends on we’ll get – we think our ownership stakes range from 5% up to we’re in the 40s one of them Bob?

Robert Palmer

No in the 20s in the SBIC.

Glenn Pittson

We’ll be moving into equity along that whole spectrum, depending on what we can negotiate? How much value we’re bringing to the situation at hand the financing opportunity at hand?

J.T. Rogers – Janney Capital

Great. And there is one last question if I could, do you have the weighted average yield of the Tamaracks portfolio right now and may be average leverage?

Robert Palmer

Not in hand but the yields are typically between 12% and 16% including pick I think we’ve got 12 cash with four picks so they are in that range. And leverage is as Glenn said, are typically below 3% through that portfolio. Since it’s a private fund we’ve still been somewhat sensitive to the other investors as far as disclosure we want to make related to that pool. But hopefully during the next period, we’ll be in a position to give you a lot more information, as hopefully as the assets are consolidated on the balance sheet as we drop-down.

J.T. Rogers – Janney Capital

Okay. Thanks for taking my questions.

Operator

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

Glenn Pittson

Thanks, everyone for your time. Thanks for all the questions. And we look forward to speaking to you hopefully with a lot of with a much different story on our next call. Thanks everybody.

Operator

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

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