OFS Capital. (NASDAQ:OFS)
Q4 2015 Results Earnings Conference Call
March 11, 2016, 11:00 AM ET
Steve Altebrando - Vice President of Investor Relations
Bilal Rashid - Chairman and Chief Executive Officer
Jeff Cerny - Chief Financial Officer and Treasurer.
Mickey Schleien - Ladenburg
Terry Ma - Barclays
Matthew Howlett - UBS
Good morning and welcome to the OFS Capital Corporation Fourth Quarter and Full Year 2015 Earnings Conference Call. All participants will be in a listen-only mode. [Operator Instructions] After today’s presentation, there will be an opportunity to ask questions. [Operator Instructions] Please note this event is being recorded.
I would now like to turn the conference over to Steve Altebrando, Vice President of Investor Relations. Please go ahead.
Good morning, everyone and thank you for joining us. With me today is Bilal Rashid, our Chairman and Chief Executive Officer; and Jeff Cerny, our Chief Financial Officer and Treasurer.
Please note that we issued a press release this morning announcing our fourth quarter and year end 2015 results. This press release was subsequently filed on Form 8-K with the SEC. Both documents can be obtained under the Investor Relations section of our website at ofscapital.com.
Before we begin please note that the 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 are not guarantees of future performance, and are subject to known and unknown risks, uncertainties and other factors that could cause actual results to differ materially from such statements.
The 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 SEC. Although we believe these assumptions are reasonable, any of those assumptions could prove inaccurate and as a result, the forward-looking statements based on those assumptions could also be incorrect.
You should not place undue reliance on those forward-looking statements. OFS Capital undertakes no duty to update any forward-looking statements made herein. All forward-looking statements speak only as of the date of this call. Our comments may reference adjusted net investment income and non-GAAP measure. Please refer to our earnings press release for a reconciliation.
With that, I’ll turn the call over to our Chairman and Chief Executive Officer, Bilal Rashid.
Thank you, Steve. Good morning and welcome. Closing out a successful 2015 we had a particularly strong fourth quarter with adjusted net investment income, a non-GAAP measure of $0.46 per share, which is significantly more than our $0.34 distribution. This increase in net investment income was due to strong interest income, higher prepayment fees and an acceleration of origination fees.
We view income from these types of fees as a recurring part of our business, however this quarter the fee income was higher than normal. Overall for 2015, our adjusted net investment income was $1.47 per share compared to our $1.36 per share distribution.
Our net asset value increased 2% compared to the third quarter and 4% from the prior year. In the fourth quarter we realized a gain of approximately $658,000 or $0.07 per share related to a warrant position. This was well above our previously reported fair value. This was the second quarter in 2015 that we had a significant realization on a warrant.
The net asset value also increased due to our net investment income being well in excess of our distribution.
In an environment of deteriorating asset values among credit portfolios, we believe that an increase in our net asset value is a real testimanent to our underwriting standards. We had just one loan on non-accrual representing less than 1% of the portfolio at fair value. As we have mentioned before, we do not have any investments in the oil and gas sector which has been a major source of deterioration in net asset value of other credit portfolios.
As you are aware, the broader credit and equity markets have been volatile over the last several quarters. So far the lower middle market had been relatively insulated from this volatility. We will continue to focus on the lower middle market especially the non sponsor part of the market, an area we have been focusing on due to its strong risk adjusted returns and relative stability.
In addition, we are carefully observing the broader loan market and are well positioned to take advantage of the dislocation in that market due to our external managers’ broad investment platform.
We believe that we hold a competitive advantage due to the strength of our external manager which has a $1.7 billion credit platform. Our manager has weathered multiple credit cycles since its founding in 1994 and our team has the size and breadth of expertise across all parts of the leverage loan market.
This provides us with considerable economic and capital markets intelligence in addition to expertise across industries. Through the first two months of 2016, the pace of deployment of capital has been relatively slow as we carefully consider new investments leaving us with considerable dry powder. Our significant investment capacity and the strength of our balance sheet puts us in a strong position to take advantage of the growing number of investment opportunities in the market. As always, we will only invest where we see the best risk adjusted returns.
Because of our building cash position, we would expect first quarter net investment income to be lower compared to the fourth quarter. We believe being patient in the short term will create greater value for shareholders in the medium to long term.
Continuing into 2016, we intend to maintain our focus on our core tenants. One, maintaining our strict underwriting standards, this has resulted in low non-accruals and an avoidance of portfolio companies in the highly cyclical oil and gas sector. Two, being responsive to our borrowers needs by providing flexible capital solutions, this had led to repeat business, a reputation has a reliable partner and good quality deal flow.
Three, always focusing on the best risk adjusted returns for the longer term instead of short term gain. Being a long term shareholder with 30% ownership, the external manager’s interest are aligned with those of the other shareholders.
As the last several quarters have shown we have been rewarded for being thoughtful and deliberate in the investments we make. We have also been rewarded for our expertise in the non-sponsored part of the lower middle market. Our seasoned team has long standing sourcing relationships allowing us to see a broad array of potential transactions and to be highly selective in making investments.
Our portfolio benefits from the heavy emphasis our investment team places on companies with strong management team, high barriers to entry and strong free cash flow characteristics.
Looking ahead, our portfolio is positioned to benefit from a meaningful increase in interest rates. A majority of our loan assets, our floating rate, while our debt is 100% fixed rate. We have $150 million in fixed rate SBA debentures, with a weighted average interest rate of 3.18%. We have no maturities until 2022.
At a time when capital maybe constrained for others, we are in the fortunate position of having significant capital resources in an increasingly favourable investment environment. As of yearend, we had several potential sources of available capital. Number one, we had $32.7 million in cash, number two; we had $24.6 million invested in the senior club loan portfolio that can be redeployed in higher yielding investments, number three we have the ability to raise additional capital in the bank loan or the bond market.
As a reminder, SBIC debt does not count towards the BDC leverage test, so we have not tapped any of our available statutory leverage. Lastly, our second SBIC license was submitted last year, if approved we would have access to additional capital in SBA debentures. We do not have an update regarding its timing and status, but we continue to have an ongoing dialogue with the SBA as our portfolio continues to perform.
Going forward, our primary focus remains the same, to generate long term value for our shareholders through strong current cash flow and stability in the long term value of our portfolio.
As we have done so far, we will continue to finance the company in a thoughtful manner. We will only raise additional capital, if it is accretive. As a 30% owner of the company, the interests, of our external manager, are aligned with those of our shareholders.
At this point, I’ll turn the call over to Chief Financial Officer, Jeff Cerny who will provide more details on the financials.
Thank you, Bilal. We are very happy with our fourth quarter results and we continue to focus on enhancing our yield and net investment income. We have 23% of our net asset value in cash, giving us flexibility in a tough capital raising environment.
As Bilal mentioned, we continued to focus on optimizing our capital base with higher yielding, lower middle market loans as we believe the relative value opportunity remains strong in this market. This strategy helped to maintain our net investment income above our distribution for the quarter.
Due to macro issues and widening spreads over the past several months, we believe other areas of the loan market are beginning to offer attractive relative value opportunities and we continue to look at those opportunities.
This quarter we had 39 companies in our investment portfolio totaling $257.2 million on our fair value basis equating to 102% of cost. The debt portfolio is at 98.9% and the equity portfolio is at 130% of cost.
Our fair value marks this quarter declined overall for the loan portfolio largely due to widening credit spreads while the equity portfolio increased in fair value. As a percentage of fair value our investments were approximately 62% senior secured loans, 25% subordinated debt and 13% equity. As a percentage of cost, our equity investments are just under 10%.
Our average investment in each portfolio company was $6.6 million at fair value or 2.6% of the total portfolio. The overall weighted average yield to fair value on our debt investments continues to move in a positive direction. It increased 19 basis points since the last quarter to 12%.
At the end of the quarter, 59% of our loan portfolio consisted of floating rate coupons. All of our floating rate loans have LIBOR floors. Non-accruals consist of a single loan, Phoenix Brands, with a fair value of only $798,000. This loan won a non-accrual during the third quarter of 2015.
As far as deal activity during the fourth quarter, we closed five transactions in new portfolio companies with an aggregate invested amount of $42.8 million. These investments included senior secured loans and equity investments.
We derived approximately $8.9 million in total investment income in the fourth quarter, compared to $7.7 million last quarter. This quarter-over-quarter increase was largely due to the 19 basis point increase in the weighted average yield to fair value which I previously mentioned and increased acceleration of original issue discount and prepayment fees due to several investments paying off.
Expenses totaled $4.6 million for the quarter compared with $4.1 million for the prior quarter. The $500,000 decrease in expenses was largely driven by an increase in incentive fee expense due to higher net investment income and increase in administrative fees and an increase in interest expense due to $22.6 million in outstanding SBA debentures that were pooled in late September.
Net investment income for the fourth quarter was approximately $4.3 million or $0.44 per share, which exceeds our prior quarter net investment income of $0.38 per share. On an adjusted basis which is a non-GAAP measure, fourth quarter net investment income was $0.46 per share. As Bilal previously mentioned, we more than fully covered our distribution this quarter with net investment income.
We still have the capacity to invest with approximately $33 million of cash, as well as $22 million remaining in the lower yielding assets. We have made good progress in deploying capital and optimizing our portfolio and we will continue to prudently deploy capital and generate liquidity on a timeline that allows us to maximize our interest income.
We intend to sell lower yielding assets or otherwise raise capital when we believe it is accretive and can be deployed in a timely manner.
With that I will turn the call back over to Bilal.
Thank you, Jeff. To summarize, our strong 2015 results demonstrate the strength of our investment platform and our increased brand awareness among borrowers. The recent stress in the credit markets and the deterioration of fundamentals in certain sectors of the economy have brought to core the strength of our underwriting capabilities and the long term alignment of interest between the BDC and our external manager.
Our external manager has extensive experience working through multiple credit cycles, and in all parts of the leverage loan market. We have strong value added origination capabilities. Our focus and our strength has been the lower middle market especially the loan sponsor transactions where we continue to find attractive risk adjusted returns compared to other parts of the middle market. Our teams underwriting expertise and sourcing relationships has allowed us to successfully participate in that part of the middle market.
We have attractive long-term fixed rate financing through the SBIC program that positions us well for an expected increase in interest rates.
Finally, in a sector that has seen other participants struggling to raise capital, we have sufficient capital available to take advantage of growing opportunities in the market. Despite the recent challenges in the credit markets, our net asset value has increased 4% from the prior year. We think that this is a credit to our methodical and time tested underwriting process, patience and long term thinking.
OFS Capital remains committed to providing long term value to all its stakeholders, including both shareholders and borrowers. As a lender, we remain focussed on being responsive to the needs of our borrowers and providing them flexible capital solutions.
With that operator please open the call for questions.
Thank you. We will now begin the question-and-answer sessions. [Operator Instructions] Our first question is from Mickey Schleien, of Ladenburg. Please go ahead.
Good morning, Bilal and congratulations on an excellent quarter. Bilal, could you perhaps remind us how the BDC works with the rest of the OFS platform, not just the credit business but the overall platform in terms of originating deals and how that differentiates you from other BDCs?
Sure, that’s a good question Mickey, thanks for your compliment earlier. So you know as we mentioned OFS itself has 107 million of assets under management and where the external managers focused on corporate credit specifically leverage loans. So, the size and scale of OFS itself is much large than BDC itself. The BDC has about 300 million of assets and benefits from that broader platform. In addition to that, OFS is actually -- the manager itself is part of a much larger group of affiliated managers that include managers that focus on real estate private equity, infrastructure private equity, the corporate private equity platform.
And so, OFS really benefits from being part of a much larger group of affiliated managers, we benefit from the legal compliance HR, IR technology infrastructure, certainly capital market activity, so we get the attention from outside parties like banks and other capital providers which is much greater than the size of OFS by itself.
So, from that standpoint I think OFS capital, when you look at it as a $300 million BDC, you had benefit greatly from OFS capital management, the external manager that manages credit assets of $1.7 billion which is the way we benefit there is that we have – we invest in other parts of the loan market, syndicated part of the loan market, separately we have strong industry expertise there especially in this environment where we’ve seen some turmoil in that sector. We get a lot of intelligence as to what’s happening the broader credit markets and as I mentioned we have strong industry knowledge there and expertise.
So that’s one thing there and just reiterating the fact that we are part of a much broader affiliated – part of a much broader group of affiliated managers that benefit from each other in terms of just shared infrastructure but also shared knowledge and expertise, and intelligence that we get from the market.
Thank you for that, Bilal. That’s really helpful. I wanted to ask just couple of more questions. Your base management fee is 1.75, we’ve seen some other BDCs lower their fees to 1.5 and look back seem to be coming common place and sort of best-in-class, is management discussing with the board revision of the external management agreement to bring in more line with some other of the newer structures?
You know I think some of the guys out there who are reducing their management fees and certainly maybe doing earlier, I’m not an expert in what on that side, but because they’re having some pressure in terms of earnings, their dividends because of some pressure on their spread income and there maybe some non-accrual loans rising there and assets that generate income maybe going down.
In our case as you’ve seen, we’ve been earning dividend now for the last several quarters, this quarter certainly recovered the dividend by a huge margin. And so, what I would say, changes to the investment management fee is not front in center because we haven’t felt that pressure but certainly we always evaluate what’s going on in the market and we’ll continue to do, discuss that internally here among ourselves but also with the board.
All right, my last question is just housekeeping, when can we expect you to file the 10-K?
Yes. We would expect to file early next week.
Okay. Thanks for your time this morning. I appreciate it.
Our next question is from Terry Ma of Barclays. Please go ahead.
Hey, guys. I think you guys mentioned that the first two months of 2016 you guys slow originations, you maybe just contextualize that a little bit whether or not its from lower deal flow or you guys being over the more selective because you’re seeing risk in the structures and whatnot?
Yes. I mean, I would say that, Q1 generally is a slower quarter, suddenly when we started quarter, January was a slow month and things started – we started seeing some good deep flow coming to us towards the middle to end of February, and as you know this deals sometime to actually close, so some of that deals flow will go into the second quarter. So I think the deal flow was slow and I think its general, I think its seem that right up to the New Years you have people coming back and getting back into the groove of things so you -- its sometimes related to that the slowness of the inflow.
And we are – you know, we’re always cautious in terms of underwriting and I think that’s as we look at our NAV, look at the performance, look at the fact that our non-accruals are so low and we don’t have any investments in oil and gas sectors. I think that’s a testament to that. I would say we are being little more cautions than usual, so certainly we’re keeping everything in mind here, as we move through these current markets
Hi, got it. And I just think about NAV work quarter to quarter, you guys have the $0.07 benefit from a one position, now earns your dividend about $0.10, its probably not the like $0.06 or $0.07 or what’s accounting for that different?
Well, we did have a slight declines in the loan portfolio as I mentioned that our equity portfolio performed quite well, we’re had a unrealized gain on assets called HealthFusion and as well as another realized gain and then earnings from the quarter.
Okay. What’s actually driving the mark-ups on the equity position? You maybe just give more color on that?
What you’re going to see is about realized and unrealized equity increase of almost $3 million and the majority of that is on public now and that has been simply realized. So we had an offer on more one company’s that has since closed. It’s purchased by a public company.
Got it. And can you just quantify how much of the loan book was marked down?
You know on an apples-to-apples it’s always tough that to come up with this number, but the assets are existed at 9.30 versus the assets that still exist at 12.31, it was about 0.5%
Okay. Got it. And then on the 1.3 million of fee income was that all from prepayments and accelerations of OID, and how should we think about that going forward?
You said the1.3, say it again.
Fee income, is that 1.3 million of fee income.
Fee income, yes, so that as Bilal mentioned, that was a little higher than normal this quarter, but it is a recurring part of our business. If deals revalue, most of deals have prepayment fees, we recognize closing fees. We have OID acceleration when something pays off, so it’s a little bit higher this quarter than normal, but it is a recurring portion of our ongoing business.
Okay. Got it. And was there anything one-time in the interest income line of $7.6 million?
No. I don’t think so.
Okay. Got it. That’s it from me. Thanks.
Our next question is from Matthew Howlett of UBS. Please go ahead.
Hi, guys. Congrats and thanks for taking my question. Bilal when you look at optimizing the balance sheet I know you have cash and you have the floating rate liquid portfolio, but I mean, so you have a lot of options, you go tap the bank lending side, in case, you can tap the baby bond market or another form of fund I think, maybe could you just kind of walk us through what you’re thinking about permanent financing in place and what do you think its open or will be open to you in the next six to 12 months?
Yes. I think that’s a good question, Matt. So I mean we’re certainly as we said we have decent amount of capital and dry powder available here, so we first we’ll obviously rely on that. As it relates to permanent financing you certainly as we mentioned we have the bank loan market available to us and so that’s one option. We have very good relationships with all the major banks that provide that kind of financing. And as I mentioned we’re part of much larger affiliated platform here, so that gives us access to some good bank financing. So we’re definitely evaluating that. The second piece is a bank is a baby bond market and that is certainly available as well to us.
I mean, the way I compared these two is that the bank loan market is a market which is a way you’re getting sort of shorter term financing, you’re talking about four, five years financing, its secure, it had covenants and it has – it has some criteria or investment criteria that you have to follow, so there’s some operating inflexibility there, but it’s cheaper. You are talking more about sort of LIBOR plus 350 types of range maybe 375 and that or 325 ranges. So it’s cheaper but had net flexibility, its shorter term compared to the baby bond market and has covenants.
So, then you compare that to the bond market which is longer term, its unsecured, they really know sort of major covenants there and it gives you sort of ultimate flexibility in terms of what types of assets you can put in there. But it is expensive, you’re talking about sort of high 600 to or high 6% to sort of low 7% range and that depends on if you’re doing a five-year bond, seven-year bond, ten-year bond et cetera. So it is more expensive but you’re able to put assets in there with a lot more flexibility. So perhaps you can make up for the increased cost by putting assets that are high yielding there. So that’s something that we are evaluating and constantly evaluate and again on that side we have very strong relationships with investment banks and banks like yourselves as well where we can certainly use one of those to cap that market if we decide to do that.
And then really the third option obviously is the SBIC license, we’ve applied that. As you know we applied for it about a year ago, that process is still ongoing. As we said, we don’t have an update on timing of that if we are able to receive that, but that’s a third option that could be available to us if we are approved by the SPA. So, I think right now I feel really good about the amount of capital we have and I feel really good about the opportunities we have in the market. And beyond that when we need to raise capital we have several options that we can avail ourselves off. As you mentioned earlier on and you know that the SBIC leverage that we currently have does not count toward the leverage debt, so for us to raise additional capital if we have to we can tap to debt market as to close to doing any kind of dilutive equity offering.
Yes, exactly. And that was my next question, just on the flexibility you have. You can fully fund the existing SBIC which sort of cash and somewhat liquid securities loans you have and then perhaps you’re going fund the second line and I wanted to ask you on what’s going to Congress right now, I guess you know approved to go to 350 in debt, potentially I mean, lot of this we would again, lot of the stuff can be done without tapping the equity markets, some of you wouldn’t have an interest in doing that below NAV at this point?
Yes. Though I think that’s correct, I mean, we don’t have any interest in doing dilutive equity offering. As you know that we really – the external manager owns more than 30% of the outstanding shares, so there is clear alignment of interest there between the manager and the shareholder. So I think we are – as I was saying I think we are in a lucky position of one having quite a decent amount of capital already, but then when we have to go and raise capital we can do it in a debt market as oppose to doing equity offerings. So I feel very good about that.
Great. I guess just the follow-up on the dividend policy and now the board meets and clearly you have a lot of room, potential loan to increase that. I mean, how – with a trading this much below on NAV how important is it to increase to past, seems like you’re not getting credit for certainly for your balance, your diversification, your performance relative to the group, what you’re sort trading below and what’s the thinking around increasing the dividend at this point?
Yes. We certainly have an ongoing dialogue with the board about that. But we haven’t really made any definitive decisions on that front, but certainly think about it and consider it on an ongoing basis.
Great. Thanks, Bilal. Really appreciate it.
[Operator Instructions] Showing no additional questions, this concludes our question-and-answer session. I’d like to turn the conference back over to Bilal Rashid for any closing remarks.
Thank you all for joining the call today, and for your questions. We look forward to speaking with everyone again on our next call. Operator, you may end the call. Thank you.
Thank you. The conference is now concluded. Thank you for attending today’s presentation. You may now disconnect.
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