Garrison Capital's (GARS) CEO Joseph Tansey on Q2 2014 Results - Earnings Call Transcript

Aug.13.14 | About: Garrison Capital (GARS)

Garrison Capital Inc. (NASDAQ:GARS)

Q2 2014 Earnings Conference Call

August 11, 2014 10:30 AM ET

Executives

Joseph Tansey – Chief Executive Officer

Mitchell Drucker - Chief Investment Officer

Brian Chase – Chief Financial Officer

Analysts

Bob Napoli – William Blair

Mickey Schleien - Ladenburg Thalmann & Co

Chris Kotowski - Oppenheimer

Operator

Welcome to today's Garrison Capital Inc. Second Quarter ended June 30, 2014 Earnings Call. For the second quarter ended June 30, 2014 earnings presentation that the we intend to refer to on the earnings call please visit the investor relations link on the homepage of our Web site, www.garrisoncapitalbdc.com and click on the second quarter June 30, 2014 earnings presentation under upcoming events. Questions will be taken via the phone during the Q&A session at the end.

It is now my pleasure to turn the Webcast over to Mr. Joseph Tansey, CEO. Sir, you may now begin.

Joseph Tansey

Good morning everybody, and thank you for joining the call. I’m joined by Brian Chase, our Chief Financial Officer, and Mitch Drucker, our Chief Investment Officer. Last Wednesday, we issued our quarterly earnings report and press release for the quarter ended June 30th. We also posted a supplemental earnings presentation to our website, which we will be referencing throughout today’s call.

Following some of my big picture comments, Mitch will highlight a few specific investments from the quarter and discuss the portfolio in greater detail. Brian will then discuss our financial performance before we open up the line for Q&A.

We are very pleased with our second quarter results and the third quarter is off to a strong start. Activity was diverse, and emblematic of the scale and breadth of our platform. Our core business showed strong originations during the quarter, though many of the actual closings occurred in July. Although spreads in the businesses have generally tightened over the last several quarters, we continue to be selective and on average preserve double digit yields while adhering to our strict credit guidelines.

Our investment in consumer loans originated by Prosper significantly increased during the quarter as we ramped towards critical mass. This culminated with the closing of a static securitization of our Prosper loans in the middle of July. Along with a similar transaction executed by one of our affiliated Funds, the transaction represents the beginning of what should be a robust financing market in the peer-to-peer lending space. The development of a securitization market will further institutionalize platforms like Prosper, which will likely be accretive to its enterprise valuation. In fact, the single largest driver of our earnings during the quarter came from a significant increase in the valuation of our equity in Prosper. At quarter end, the position was worth about 5 times what we paid for it at the end of 2013. This valuation was driven by the latest round of equity that was raised by the company in May, implying an enterprise value of $650 million. In July, we prudently tendered 20% of our equity in Prosper ensuring the recovery of our full cost basis in the investment.

Finally, to round out the quarter, we were able to opportunistically buy several loans from a Fund looking to trim its balance sheet. This is the third such portfolio purchase since the IPO and has been an efficient way to add new core assets to the balance sheet at similar rates of return and risk profiles to our originated loans. It has also provided us an opportunity to develop relationships with some new sponsors, allowing us to see some of their future deal flow.

I will now turn it over to Mitch who will provide some more color on the loan market and more specifics about our investment activity during the quarter.

Mitch Drucker

Thank you Joe. Regulatory pressure and bank consolidation dynamics, discussed in previous quarters, continue to limit liquidity in the lower middle market. Consequently, our market continues to experience less spread compression and leverage expansion than the broadly syndicated segment. We do anticipate slight tightening, however, as banks slowly become more aggressive and private funds enter the lower middle market in search of enhanced yields. As always, we will continue to be selective and pursue only those credits with adequate risk adjusted returns and solid loan-to-value metrics.

In the second quarter, long-standing customer and intermediary relationships, combined with the depth of our platform, yielded robust and differentiated deal flow.

Additions to core assets, which include originations and transactions that roughly generate a yield of 9% or better, totaled $104 million for the second quarter. After eliminating the transfer of 3 credits that were shifted from the transitory asset pool to the core asset pool, adjusted core volume totaled $91 million. Volume remained above our post-IPO average per quarter. Second quarter origination activity was robust with most deals actually closing in the third quarter. I will discuss interim performance shortly.

We have said previously that origination activity will vary on a quarter to quarter basis, but the depth of our platform will create other opportunities that support our core volume. Throughout the second quarter, we closed on a diverse set of transactions. Through our broker relationships, we identified a seller of lower middle market loans and opportunistically purchased 7 credits totaling $46 million of par value. Activity in the consumer loan segment added another $25 million in volume. Also, new origination and club deals closed during the quarter totaled $16.6 million and consisted of an origination loan for a new sponsor and a club deal for a non-sponsored company.

Core additions for the quarter were partially offset by repayments of $62 million, which were the result of refinancings in the portfolio. Consequently, core investments as a percentage of our overall portfolio totaled 84% at the end of the second quarter, an increase over the previous quarter and a material increase over 37% at the time of the IPO. Notably, the weighted average yield of the core investments closed during the quarter was 12.75% and 11.8% when excluding the effects of the transitory accounts shifted to the core pool. This adjusted yield is in line with historical averages. The higher yields of the portfolio acquisition and upsizing of existing investments offset minor spread compression experienced in our sponsor deal.

We continue to employ a rigorous credit process with tight controls and credit structures. Two of the credits purchased had subordinated debt structures with modest leverage of 4.2x and 2.9x, and the weighted average leverage of all second lien and mezz loans is 3.42x as of 6/30. Most importantly, 77% of our total portfolio is comprised of first lien structures. This percentage has decreased slightly over time mainly due to the growth in the consumer loan portfolio to 10.5% of the total portfolio. We feel that the consumer loan and real estate capabilities illustrate the depth of our platform and we believe these investments provide an attractive risk/return profile.

Our borrowers continue to demonstrate modest but positive cash flow in the face of a slowly improving macro environment. Total portfolio weighted average risk remained stable with average leverage remaining constant at 3.5x. This remains materially below average leverage levels in the upper middle market and broadly syndicated market. It is also less than recent levels financed by our direct competitors in the lower middle market. Solid relationships within our core portfolio accounts have resulted in modest repayments, which has been a crucial driver in the growth of core assets. Shrinkage in the transitory portfolio is consistent with our reported strategic goals.

For the interim period for the third quarter to date, volume totaled $51 million. We have been experiencing a strong quarter for originations of both sponsored and non-sponsored deals. While we have seen a higher proportion of investment flow coming from the private equity community in previous quarters, we anticipate more balance with non-sponsored transactions as the economy picks up momentum and private companies deploy capital for expansion purposes. In addition, we capitalized on enhanced deal flow from our long standing relationships in the asset based lending community. Reciprocal deal flow from ABL lenders has increased significantly in the quarter as bifurcated and first out/last out uni-tranche transactions have gained market-wide acceptance. Finally, Garrison’s broad platform, which includes a financial assets focus, enabled us to generate and close a high yielding proprietary equipment financing opportunity. At this point, I’d like to pass it off to Brian.

Brian Chase

Thanks Mitch. For those of you viewing our earnings presentation, please turn to slide 5 which provides some of the financial highlights for the quarter. Our earnings this quarter were $0.54 per share. As discussed by Joe earlier in the call, the most significant driver of earnings for the quarter was from the $3.9 million increase in value of our equity position in Prosper. Additionally, I am happy to report that our adjusted NII for the quarter was 39 cents per share which significantly exceeds our second quarter 35 cent dividend. A portion of the NII can be attributed to prepayments fees related to core loans that paid off during the quarter. We have announced a third quarter dividend of 35 cents, payable to shareholders on September 26, 2014. As of June 30th, we had a spillover taxable income of approximately 16 cents per share.

Through the end of July, we have effectively completed our migration out of transitory assets into core assets which now represent about 90% of the portfolio. The migration since the IPO has pushed the overall portfolio yield from 8.9% to 10.4% while weighted average debt to EBITDA has actually slightly decreased from 3.6x to 3.5x. During that same period of time we also grew the portfolio by $150 million. As a result, we have grown adjusted NII to a level that approximates our quarterly dividend payout while not increasing the underlying credit risk in the portfolio. In fact, we have grown our book value by 4.3% or 64 cents per share since the IPO.

Liquidity as of quarter end stood at about $120 million which still provides us with ample runway to make new investments. As Joe mentioned earlier in the call we closed on a static securitization of our Prosper consumer loans in July which brought our leverage ratio to about 0.94 to 1.00. The financing has allowed us to further expand our balance sheet by another $20 million.

As mentioned on previous calls, we continue to progress through the SBIC process and subsequent to our green light letter issued in May we were recently notified that our license application has been accepted by the SBA which allows us to make investments in the SBIC but does not yet allow us to draw down on the debentures.

At this time we’ll open up the line for questions.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from the line of Bob Napoli with William Blair. Your line is open.

Bob Napoli - William Blair

Thank you, and good morning - on the Prosper investments, the consumer loans. What does the securitization - from a financing prospective, what limit do you have on consumer loans as a percentage of your balance sheet, and does a securitization enhance that?

Brian Chase

The securitization is static. So there are no new loans going into the securitization and I would say we’re more limited, frankly, just by the size of our overall company in terms of how much – in terms of consumer – we’d buy than any of the financing related to them.

Bob Napoli – William Blair

So what is the limitation, Brian?

Brian Chase

The limitation on how much we can buy?

Bob Napoli – William Blair

On consumer loans, yes. As it’s presented on the balance sheet.

Brian Chase

Well it’s in the non-qualifying asset bucket.

Bob Napoli – William Blair

Right.

Brian Chase

So it would be limited to 30 percent, technically. I mean, I think we have internal thresholds that are lower than that and this effectively, sort of rounded out the investment for now.

Bob Napoli – William Blair

Okay. So I mean, you’re comfortable with the 10 percent? It’s about 10 percent today. Do you want it to be 20 or…?

Joseph Tansey

I don’t know if we’d go – this is Joe – I don’t know if we’d go quite that far, but we are currently not adding. We kind of ramped up a little bit into the securitization because we needed a certain scale and then the facility and the loans themselves will kind of self-amortize down a little bit. And probably as that number goes down a little bit we’ll always be weighing up our uses of the balance sheet at that time.

But I think 10 is a fine number for now but if we’re a little higher, or a little lower I would be comfortable, a little higher a little lower but we’re certainly not looking to double it, if that’s what you’re asking.

Bob Napoli – William Blair

Yes, and then what selectivity do you have on the origination of those loans, in getting those loans from Prosper? And then, do you have any monitoring or servicing responsibilities on those loans?

Joseph Tansey

Prosper does the servicing of those loans themselves and we have an ongoing relationship with Prosper, not just for the BDC but also for other funds of ours, that we’re buying loans sort of everyday through the Prosper marketplace. So, at this point again, as I said, we kind of front loaded some activity there to get the critical mass we needed for the securitization, then completed the securitization, then sort of stopped buying for a little while as we’ve just been managing our balance sheet right now.

Bob Napoli – William Blair

And your ability – selection?

Joseph Tansey

The way that we work with Prosper is that we buy a mix of the higher rated loans and the lower rated loans all the way up and down their balance sheet. Different people have different strategies - they might only buy lower risk assets that would reach a higher return. And so we buy sort of a – what I would call a strip of the different credit quality assets up and down. And that’s the strategy that we feel most comfortable with.

And so we might use a little bit more financing than other folks to buy those loans but just buy the lower risk loans with less leverage, obviously. But we prefer the higher quality assets in our mix.

Bob Napoli – William Blair

Great, and this last question then I’ll turn it over. The problem loans in the portfolio and the credit, I mean your weighted average risk, is pretty stable and I’m looking just – looks like, Anchor Holdings and Virtual?

Brian Chase

Radiologic.

Bob Napoli – William Blair

Right, Radiologic. Those two are the two that are marked down, are there others? And maybe some comments just overall on credit?

Brian Chase

Well Virtual – I’ll let Joe chime in, in a second - but Virtual Radiologic actually was marked up during this quarter. It’s been down…

Bob Napoli – William Blair

Right.

Brian Chase

For a while but actually bounced off that price fairly significantly. Everywhere, Anchor was the most significant write down.

Joseph Tansey

I think both of those companies have had additional capital raised subordinate to us at different points in the last few quarters, particularly in Virtual Radiologic. There wasn’t really any trading at that lower marked level. It was little bit – we do mark it, that is a transitory asset. And I think sometimes in these more midmarket companies when the – if there aren’t trades, the brokers try to drum up trades by putting numbers out there and see if they can get something to happen. And there wasn’t a lot of activity that happened there and I think finally some paper did trade at the higher number and so it created a real mark. Where the lower mark might have been, that broker’s trying to get some action.

And then Anchor did raise some money. Might be subsequent to the quarter…

Brian Chase

It was, yes.

Joseph Tansey

It is a public company so you would see it’s filing’s out there, but it agreed to terms with a financial private equity firm to raise some capital and that loan has traded up a little bit since the end of the quarter on that, more than a little bit actually.

Bob Napoli – William Blair

Okay.

Joseph Tansey

That loan – there was a bit of a restructuring, they had some liquidity needs, question of whether lenders were going to provide capital or the equity guys and it was a bit of a tough negotiating tactic that happens to drive the loan price down right into the end of the quarter. And then I think the capital raised two weeks ago or something like that and the loan price kind of came back up a bit since then.

Bob Napoli – William Blair

All right. Thank you.

Joseph Tansey

You’re welcome. Thanks for the good question.

Operator

Your next question comes from the line of Mickey Schleien with Ladenburg. Your line is open.

Mickey Schleien – Ladenburg Thalmann & Co

Yes. Good morning and thanks for taking my call. I just wanted to get your insight on how you see the give and take between sellers of small and medium sized companies which are enjoying very nice multiples versus your interest in buying into deals at these elevated multiples – I’m trying to get a handle on how that’s going to affect the growth, on a go forward basis, of the core portfolio.

Joseph Tansey

Yes, maybe Mitch can jump in on that but I would say quickly, in the lower middle market there hasn’t been the same multiple expansion there has in some of the, certainly in the larger LBOs, and even the upper end of the market. I think our debt-to-EBITDA ratio, on average across our loan book, has actually been stable-to-down over the last few quarters. Mitch, do you want to jump in?

Mitch Drucker

Yes. Sponsors are definitely paying more for businesses and as a result they’re looking for some spread compression. But it’s a little more inefficient in the lower middle market and the good news for us is we’re not really dependent on sponsors for business. We have a pretty broad and diverse set of targets that we go after where we can get premium yields.

Sponsor business has come in so you’re looking at 8 to 10 percent versus maybe 10 to 12 percent over the last two years. But it’s other areas which we’re targeting where we have verticals such as oil and gas, our real estate expertise, leasing and consumer, or cap markets presence where we can find and buy opportunistic portfolios and also work with asset based lenders and target middle market, non-sponsor companies and generate yield through engineering and working with them by bringing them in on a first-out basis.

So there’s definitely spread compression in the sponsor business, they’re paying higher multiples. The good news is we’re not dependent on the sponsors.

Mickey Schleien – Ladenburg Thalmann & Co

Okay, I understand. Just one follow-up on the SBIC license. Can you give us a sense of when you might be able to start to tap into the SBA debentures?

Brian Chase

It’s Brian. You know we’re not entirely sure. It’s obviously up to the SBA as to how quickly they want to move in terms of processing everything. They have accepted our application post green light letter, which is good news. And we’ve been encouraged that it would be months and not a year. Whether that’s the end of the year or shortly thereafter, or even before, we’re not entirely sure. But we seem to be progressing at a fairly decent pace.

Mickey Schleien – Ladenburg Thalmann & Co

But you did say you’re going to start prequalifying some assets and putting them into the SBIC subsidiary?

Brian Chase

We can. Yes, we’re now able to do that.

Mickey Schleien – Ladenburg Thalmann & Co

Okay. Thank you for your time this morning.

Brian Chase

Sure. Thanks.

Operator

Your next question comes from the line of Chris Kotowski with Oppenheimer. Your line is open.

Chris Kotowski – Oppenheimer

Yes. Good morning. I wonder if you can tell us – you mentioned that you had six loans prepay and or repay and that they were prepayment penalties on that. Can you give us an idea of how much of the $12.8 million of interest income that was?

Brian Chase

I think it’s probably about $1 million in terms of prepayment penalties.

Chris Kotowski – Oppenheimer

Okay.

Brian Chase

Now obviously there’s – you have to sort of look at the interest we would have earned had the loans been outstanding for as long too as sort of an offset if you’re trying to back into a run rate.

Chris Kotowski – Oppenheimer

Yes.

Brian Chase

But in terms of the gross numbers, about $1 million and there maybe a few amendment fees in there as well.

Chris Kotowski – Oppenheimer

And then, just more broadly on the SBA / SBIC. Do you look at that as just another funding source or do you look at that as kind of a new line of business that should increase the core underlying rate of earnings and kind of be accretive to the base level distributions overtime?

Brian Chase

We definitely view it as highly accretive. We went as part of the process when we were dealing with the SBA and submitting information to them. We did an analysis of how many of the loans we’ve originated to date would actually fit in the SBIC and it was quite a few, it was around three quarters.

So there’s nothing that we would actually need the change here in terms of what we do for assets to fit in the SBIC. We’re actually perfectly suited, from where we currently sit, to put assets down into the subsidiary. And so, really the way we looked at it is this is just an opportunity to expand our balance sheet beyond where we’re able to, given the one to one statutory limitation, and so we look at it as a highly accretive source of funding for us.

Chris Kotowski – Oppenheimer

Great. Thank you.

Brian Chase

Sure.

Operator

There are no further questions in queue at this time. I turn the conference back over to our presenters.

Brian Chase

I think that wraps it up for the quarter. I appreciate everybody’s time and we’ll talk to you next time.

Joseph Tansey

Thanks everybody.

Operator

This concludes today’s conference call. You may now disconnect.

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