THL Credit Incorporated (NASDAQ:TCRD)
Q2 2016 Earnings Conference Call
August 05, 2016 10:30 AM ET
Sabrina Rusnak-Carlson - General Counsel
Sam Tillinghast - Co-CEO
Chris Flynn - Co-CEO
Terry Olson - COO & CFO
Jonathan Bock - Wells Fargo Securities
Kyle Joseph - Jefferies
Good morning and welcome to the THL Credit's Earnings Conference Call for its Second Fiscal Quarter 2016 Results. It is my pleasure to turn the call over to Ms. Sabrina Rusnak-Carlson, General Counsel of THL Credit. Ms. Rusnak-Carlson, you may begin.
Thank you, Operator. Good morning and thank you for joining us. With me today are Sam Tillinghast and Chris Flynn, our co-Chief Executive Officers, and Terry Olson, our Chief Operating Officer and Chief Financial Officer. Before we begin, please note that statements made on this call may constitute forward-looking statements within the meaning of the Securities Act of 1933 as amended. Such statements reflect various assumptions by THL Credit concerning anticipated results that are not guarantees of future performance and are subject to known and unknown 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 factors described from time to time in our filings with the Securities and Exchange Commission. Although we believe the assumptions on which any forward-looking statements are based are reasonable, any of these 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. THL Credit 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 earnings announcements and 10-Q were released yesterday afternoon, copies of which can be found on our website, along with our Q2 investor presentation that we may refer to during this call. The webcast replay of this call will be available until August 12, 2016, starting approximately two hours after we conclude this morning. To access the replay please visit our website at www.THLCreditBDC.com.
With that, I'll turn the call over to Sam.
Thank you, Sabrina. Good morning, everyone. To set the stage for the call, I'll provide financial highlights on our results and ongoing portfolio repositioning. First we'll talk in more detail on the portfolio and certain credits and Terry will provide additional details around the financial results. Our net investment income per share for the quarter was $0.35, relative to our dividend paid of $0.34 per share. We are pleased to announce that on August 2, our Board of Directors approved a quarterly dividend of $0.34 per share for the third fiscal quarter of 2016, payable on September 30.
Similar to last quarter, net investment income exceeded our dividend primarily due to a reduction in our incentive fee as a result of unrealized losses in the portfolio. As a reminder, payment of the quarterly incentive fee is directly tied to our asset performance in such a way to protect the shareholders in the event of both realized and unrealized losses. Chris will talk more on the portfolio shortly.
During the second quarter we continued to execute on our strategy of transitioning our portfolio to more secured loans and proactively restructuring certain unsponsored legacy investments as we continue to work toward building what we believe will be a more resilient portfolio. These unsponsored investments are the result of a legacy investment strategy that began in 2010 after our IPO and lasted until the first quarter of 2014.
The legacy unsponsored portfolio only has 7 credits still currently on the books. Four of these unsponsored companies are rated 1 or 2 meaning they are performing at or above our expectations. Of the three other legacy unsponsored transactions, two have already been restructured, OEM and Tri Starr, and the last one, Copperweld, is in the process of being restructured.
Our NAV per share at quarter end was $11.88. The 2.9% decrease in NAV from March 31 is primarily due to a combination of market and credit specific factors. The largest contributor this quarter was a markdown of our investment in Tri Starr reflecting the restructuring in July of our subordinated debt into a controlling equity position. As of June 30, we had 49 portfolio investments valued at $692 million, down from $731 million at March 31. The weighted average yield on new investments was 10.8% and the weighted average yield for the portfolio was 10.9% including the Logan JV. This excludes loans that were recently restructured.
We invested $17.5 million in six existing portfolio companies in the second quarter to support growth for our positions. Over 80% of our fundings in Q2 were invested directly in first lien securities or the Logan JV. Our deal volume in the lower middle market was muted for much of the first half of 2016 due to both lower new issuance and a slower refinancing and recapitalization market. We are now beginning to see an increased level of activity as we enter the back half of the year.
We continue to see a flight to quality by most lenders. As a result, we believe competition has increased for the largest and most stable businesses and pricing has come under pressure, especially in the first lien market. We believe there is a clear bifurcation on those higher quality assets and those assets that are risky. Our business model is simple in this environment. We are seeking higher quality assets and we will pay out substantially all of what we earn from these assets. We will not stretch for yield.
During the quarter we experienced portfolio contraction of around $40 million due to repayments in excess of investments and certain changes in fair value. We realized proceeds of $22 million from our second lien loan in Connecture which included a prepayment premium and other fees of $0.4 million. We also received proceeds of $9.6 million in connection with the repayment of our second lien loan in Vision.
We continue to be proud of the performance of our fully realized investments which as of June 30 have generated gross IRR of 15.4% since our IPO. As our legal folks will want me to say, gross IRR reflects historical results relating to our past performance. It's not necessarily indicative of our future results. And in addition, gross IRR obviously doesn't reflect the effect of fees, expenses and taxes.
We continue to seek opportunities to monetize our larger equity investments and we're hopeful that improving equity markets will allow us to do so. We fully realized our equity investment in Surgery Center Holdings which was sold in Q2 for a $3.7 million gain. Proceeds from repayments in Q2 were used to deleverage our balance sheet, invest in Logan, continue to support our existing portfolio companies, and to buy back stock under our share repurchase program.
During the first half of 2016, we repurchased 1.6 million of our stock. Since we began repurchasing under the program in May, 2015, we have bought back a total of approximately 735,000 or $8.8 million reflecting an 8.2% discount to NAV. For the remainder of 2016, we will evaluate repurchasing more stock as market conditions and other factors such as our leverage and liquidity levels warrant.
Now I'll turn the call over to Chris to talk more on our portfolio.
Thanks, Sam, and good morning, everyone. I'll start off with some portfolio highlights and then dive into some more specifics on select credits. As of June 30, our portfolio of $692 million was composed predominantly of secured loans, with 70% of the portfolio invested in first and second lien loans. The remainder of the portfolio invested 7% in subordinated debt, 8% in the Logan JV, and 4% in income producing securities which include CLO Equity, all based on fair value. The remaining 11% was in equity or other investments.
Additionally at quarter end, 84% of the debt portfolio was invested in floating rate loans with LIBOR floors, which we believe leaves our portfolio well positioned to adjust to a rising interest rate environment.
Our portfolio continues to be diversified by industry and by investment size. Shortly after quarter end, we completed the restructuring of an unsponsored subordinated debt investment in Tri Starr, a supply chain logistics provider. Our debt security was converted into a majority equity stake and we also purchased part of the first lien loan for approximately $3 million as part of a substantial discount to par.
We believe the restructured balance sheet should position the company with the necessary liquidity to drive earnings growth going forward. As shareholders, we are working with financial advisory firms to drive change into the cost structure of the business including deemphasizing certain service offerings and other initiatives to minimize our recovery to our original sub debt investment. While we are pleased with the early progress, our investment continues to be scored a 5, meaning we do not expect to fully to recover our original investment.
We also restructured our first lien investment in Loadmaster, a manufacturer of derricks and oilfield equipment in July. In connection with this, we did not accrue income in Q2 and reversed approximately $415,000 of interest receivables from March 31 during that quarter. Loadmaster is one of our three first lien investments in the energy space and only represents 1% of our portfolio as of June 30 on a fair market, fair value basis. We converted a portion of our first lien investment into a preferred income producing equity in connection with the restructuring in July. We also made a small follow on investment in a secured blast out term loan alongside an additional investment from the sponsor who continues to be supportive of the company.
The restructuring will better position the Company from a liquidity standpoint during this trough in the energy cycle. We and the company and the sponsor are all actively evaluating a number of accretive add-on acquisitions to diversify its revenue channel toward a more downstream segment of the industry. We believe these restructurings will allow us to improve operations at these companies and work more closely with management to weather any operational industry sector issues. We believe this will help us preserve enterprise value in the long term and improve recovery value of these assets.
I want to comment briefly on Copperweld, another one of our unsponsored investments in the industrial space. As a reminder, the company is a producer of copper based wire products and has faced commodity price headwinds that have hindered volume and resulted in underperformance. We are currently working with all the constituents of the capital structure including its largest customer to reposition the balance sheet and potentially return a portion of our investment to accrual status. With the addition of Loadmaster and Copperweld to nonaccrual status at the end of the quarter, together with Tri Starr, they represent 4.4% of our portfolio based on fair value.
As of June 30, 70% of the companies in our portfolio on a fair value basis are rated 1 or 2 which means they are meeting or exceeding our underwriting expectations. 26% was rated 3 which means they are operating slightly below our expectations, but principal and interest are not overdue. Loadmaster and Copperweld were moved to a 4 rating which represents 4% of our portfolio. That means the company is performing materially below our underwriting expectations and returns are likely to be impaired. However, we do expect to recover our investment principal and some return over time.
Tri Starr is the only 5 rated credit representing less than 1% of the portfolio. 5 rated credits, as a reminder, are in payment default and principal and/or interest are not expected to be paid in full. Finally I want to give a brief update on the Logan joint venture. As of June 30 the portfolio consisted of 94 companies totaling $198 million at par. 82% was comprised of broadly syndicated or club transactions and 18% thereafter was the more directly originated investments.
Our equity contribution in the Logan joint venture was $59 million. From our perspective, spreads on the broadly syndicated markets stabilized in Q2, resulted in unrealized depreciation for this quarter. We believe the portfolio credit remains strong with no payment default. We recognized $1.8 million in dividend income for the second quarter representing a 12.8% dividend yield based on average invested equity over the period of time.
With that, I'll turn the call over to Terry to talk more about quarterly performance.
Thanks, Chris, and good morning, everyone. I'll provide a little more color on our investment activity and financial performance during the quarter. Of the $17.5 million new dollars put to work in Q2, we contributed $5.6 million to the Logan JV. The remaining $11.9 million was invested in debt and equity follow-on investments in several portfolio companies. The weighted average yield on these investments excluding Logan were 10.8%.
We generated $20.5 million of investment income this quarter, which was comprised of the following. $15 million of interest income on debt securities which included $0.5 million of PIK representing 2% of the investment income, this is the level that's been consistent in recent quarters. But also included prepayment premiums of $300,000, the effect of putting Loadmaster and Copperweld on accrual impacted interest income during the quarter by approximately $0.06 per share.
$2.6 million of dividend income included the $1.1 million from the Logan joint venture Chris mentioned and approximately $800,000 from C&K Markets which has paid a dividend for the last three quarters. We also recognized $1.7 million of interest income on other income producing securities including our interest in the Duff & Phelps accounts receivable agreement generating on a current yield based on costs of 17.6% and our three CLO Equity positions which continue to generate a yield of 14.2% as a result of strong performing portfolios. We also generated $380,000 from fee income related to our managed funds which were down slightly from the prior quarter as a result of these funds winding down. We generated $800,000 of other fee income from several of our portfolio companies.
During the quarter we incurred $8.8 million in expenses which were comprised primarily of $3.9 million in fees and expenses related to our borrowings. We also incurred $2.8 million of base management fees. Our administrative, professional, and G&A expenses totaled $2 million, and as Sam noted earlier, we did not earn an incentive fee this quarter. Absent the total return provision in our investment management agreement, our advisor would have been entitled to receive approximately $2.3 million in fees.
We had net change in unrealized depreciation offset partially by a realized gain in Surgery, mentioned earlier, which negatively impacted book value by $0.37 per share in Q2. As Sam and Chris mentioned, we restructured our investments in Loadmaster and Tri Starr after quarter end, resulting in realized losses of $6.6 million and $17.5 million, respectively. I will point out that these losses were reflected in unrealized losses as of June 30 as part of the NAV.
As of June 30, our leverage level was at 0.78 times equity, which was within our targeted range of 0.6 to 0.8 and down from our 0.83 as of March 31. We were able to deleverage our balance sheet during the quarter with proceeds and repayments. Going forward we expect to continue to utilize proceeds from repayments to fund our new investment opportunities and/or repurchase stock should market conditions and liquidity warrant. And our repayments continue to average about $50 million per quarter.
With that I'll turn the call back to Chris for some concluding remarks.
Thanks, Terry. There are two things we'd like to emphasize. As we move into the second half of 2016, we are continuing our deliberate shift to develop a predominantly secured portfolio, away from subordinated debt, unsponsored investments, as well as cyclical investments in general. This will take time. While doing this, we are taking proactive steps to manage our existing portfolio through the credit specific or cyclical challenges to preserve our shareholders' capital and continue to deliver an attractive risk adjusted return over the long term. While taking these steps can put pressure on our earnings capacity in the short term, we believe that it will benefit our shareholders in the long run. Our goal is to deliver a strong secured portfolio that pays to its shareholders substantially all of what it earns.
Before I turn the call over to the operator to start the Q&A, I'd like to announce that Hunter Stropp, our President, will be leaving the firm at the end of September to pursue other opportunities. Sam and I will be assuming Hunter's responsibilities. Hunter has been with us at THL Credit since it was founded in 2007. We want to publicly thank him for his contributions to our success and wish him the best in future endeavors.
And with that we'd like to open the line for questions. Operator?
Thank you. [Operator Instructions] Our first question today comes from the line of Jonathan Bock with Wells Fargo Securities. Your line is open.
Sam and Chris, as we look at the market today, we clearly agree with your sentiment that first lien yields have come in, it's an all-in more competitive environment. And Sam, I think you put it quite squarely that now is not really a time to reach for yield and you won't do it. So taking a step back then, if we look at the current dividend yield profile that you have in addition to the cost structure that you have, and let's take a moment and assume that NAV doesn't go anywhere to provide an NOI benefit, can you cover your current dividend yield today in the future as you continue to make this shift?
Yes, Jon, this is Terry. Let me kind of take the first half of that and then I'll let Sam and Chris weigh in as well. As you know, we evaluate the dividends with our board on an ongoing basis and make this determination on a quarterly basis. And I'm sure you and others on this call can appreciate there are a number of factors, right? Portfolio mix, leverage, credit performance, one-time items. Quite frankly, even our level of spillover income. We've consistently paid our dividend aligned with earnings dating back to the IPO in 2010. More recently the earnings have consistently exceeded the dividend. To the extent we get some upside, we've done specials along the way as certain gains have allowed us to do. As we shift the portfolio to more senior secured assets and work through some of these restructured unsponsored credits, we'll employ those same types of -- employ the same type of thinking in that discussion. To the extent that those factors change either positively or negatively, it'll influence our decision on whether the board adjusts the dividend in a particular quarter. Sam, Chris, anything to add to that?
Yes, so Jon, in terms of yield, what we're seeing is -- kind of take a step back for a second. We're seeing a lot of money flow into direct lending in the middle market space from private credit funds. The capital is really coming from insurance companies and pension funds and endowments. And we're seeing that ourselves in DirectLending3 which was mentioned on this call before. So that's bringing pressure on yields in recent quarters. We do not want to chase yields. We don't want to focus on stretching for yields in this kind of competitive environment. That leads to more risky transactions. We really need to focus on more junior capital investments, which is something we were transitioning away from. So our focus is to build a resilient senior secured portfolio.
So if you think about what we've done in the portfolio this quarter as we talked about, 80% of Q2 fundings were first lien in Logan. And Logan is now 8% of the portfolio. Sub debt is now down to 7% of the portfolio. We had repayments on Vision and Connecture which were second liens and we chose not to reinvest that in second liens but rather to reduce leverage in the portfolio. We had an equity realization on Surgery and we'll put that into more first lien type assets. So we don't want to target particular yields in order to hit some kind of targeted earnings or dividend. What we want to do is focus on transitioning our portfolio to a stronger primarily first lien portfolio. We want to give investors access to higher quality assets in the lower middle market and we'll pay out whatever that portfolio earns.
I firmly agree with that. I think that's certainly -- management teams that take a proactive view on trying to originate things correctly, even if dividend alignment is in sight or perhaps expected, it's the right decision. And as folks kind of consider that, I'd say it's an important consideration here and elsewhere. And then now maybe moving to a few other individual kind of investments first, so you know we had seen some markdowns in recent quarters. But looking at Copperweld, it came quickly with the position marked at 94% at par last quarter. What changed? And more importantly, the speed of change in terms of kind of what took you by surprise?
So Copperweld, I think we may have touched on this last quarter, Copperweld makes what's called bi-metallic metals. It basically is wrapping copper around aluminum. And that product is usually used in like the cable industry for coaxial cables, it's used in the utility industry for electrical and transmission lines, sort of like grounding wire. It's an oftentimes cheaper substitute for pure copper wires. It's also used in commercial and residential housing. Just a lighter metal, sometimes cheaper. Copper prices over the last few years have dropped and so Copperweld's product as a substitute is not as attractive as pure copper wire is. So we've been in discussions, Jon, with a number of parties involved in this, in the situation, including the largest customer here. And so restructuring conversations are ongoing. There's not a lot I can say about it because we are in the middle of it, but we think that the mark reflects the situation.
And two other portfolio questions if I may. So Washington Inventory Services did get marked down slightly in the quarter. But if we look at a loan bid, and granted bids are a bit directional as opposed to absolute. If you see a loan bid in the 30s with this marked at 80, that doesn't necessarily concern me given the loan that you pull from isn't as correct. But there's another BDC that owns the same exact loan that's holding this at 66. Why would you hold in the 80s on this situation? What do you see that another BDC does not?
Hi, Jon, this is Chris. We obviously know the credit well. That secondary bid ask spread, if you will, shows no real trades at any of those levels. And conversely it shows that there's no real debts or liquidity on some of these investments. If you look at WIS in general, we went through our traditional process internally of determining a value. We used our outside third party as well to determine the value. We did not have a conversation with other participants in said investment to determine where they were going to market. This is where we believe there is fair value based on the information that we have.
If you look at the business itself, this isn't a revenue issue on the company itself. The revenue, it was actually up. And in our words, we think the company took a couple of missteps in managing some of its operational costs and hopefully those are short term in nature and the company will get that turned around and the business will be up and going. There's really only two companies that do this in the sector. WIS is the second largest one. So in our opinion it still checks the box of does this business need to exist, will it continue to exist going forward, and we feel like we're accurately reflecting where we see value in that investment.
Jon, it's Terry. Can I just something to your other point regarding other BDCs, obviously we don't have visibility on what other firms are marking on things within a quarter. But every quarter for any position that we hold in the portfolio, we do look at our prior quarter mark versus how people have carried them. Quite frankly, we're directionally close. Quite frankly I think in aggregate we're probably more conservative than what other marks are in general. But as you can appreciate, with any security that's got a little bit of stress, there's a pretty wide range of values you can come up with that, depending on how you're thinking about it or what information you may or may not have, that for something a little more stressed can put a little wider range around it. So I think there's some variability when you get into particular areas like this.
Yes, and then lastly, just Charming Charlie, we have seen some I guess I'd say reported stress and there's been amendments to covenants, breaches, etc. Just as our last question, can you give us an update on that credit in light of kind of the retail, the retailer segment's potential weakness going forward?
Yes, I think that price in large part reflects the kind of broader markets' view on retail. Charming Charlie went through an amendment recently that was really a deleveraging event. Took the opportunity earlier this year to actually purchase Charming Charlie because we think it's at an attractive price. So they had a -- we've known Charming Charlie, that credit, for a long time. We were in the mezzanine several years ago. We know Charlie well. They deviated somewhat from their strategy late last year. They're seeing the effects of that this year. They've corrected course. May take a while to kind of get the numbers back on track, but it's really what you're seeing in the numbers on Charming Charlie, in the financial results I'm talking about, it's really a reflection of that change and now it's kind of moved back to the way they built the company.
And Jon, this is Chris, the only thing I'd add to that is, as we sit back and really do a ground up analysis on the individual investments that we make, Charming is an investment that we've held on the portfolio under various forms for an extended period of time. I do think there's a lot of industry pressure on this just given its sector. We see that potentially as an opportunity, right, because we can come in, look at the sector that's potentially out of favor as retail is, and come back and still find value. We would categorize Charming in that way.
[Operator Instructions] Our next question comes from the line of Kyle Joseph with Jefferies. Your line is open.
And apologies, I did hop on late, so sorry if you addressed this earlier. But just related to the July restructurings versus 2Q nonaccruals, I'm just wondering, given the investments were on nonaccrual, there's not going to be any impact in the third quarter based on those restructurings is I guess what I'm getting at?
Hi, Kyle, this is Terry. Thanks for the question. I did mention that, that the losses that you see reflected were baked into the June 30 NAV and unrealized.
Okay. And then in terms of their impact on interest income, given they were on nonaccrual in the second quarter, and it looks like you did restructure one into a debt security, would there be potentially a little bit of a positive impact?
Sorry, in Q3?
I think for both restructured investments, Tri Starr and Loadmaster and the new positions, we're obviously mindful of the recent restructuring and we'll evaluate the interest income recognition through Q3 as we close off Q3. But we're optimistic that if we take the steps, the steps taken and the steps we plan to take, with the new balance sheets in place, should position us well.
Kyle, this is Chris. Just to expand on that, not credit specific in particular, but in general. As you think through managing through a portfolio or any specific credit risk that has an issue, when we've done these restructurings, we're trying to right-size that capital structure to give this business an opportunity to pay whatever debt it should, based on the information we have now. But more importantly, we're not so focused on this stage of return on principal, but return of principal. We just want to make sure that we've established it in such a way where we can take a more active role in managing these credits and get our capital back to go redeploy in more senior secured investments that Sam alluded to earlier.
And then just on the income statement, you guys have some other expense items besides interest, base management and incentive fees. Do you have any potential to reduce those expenses at all or any cost saves we could look at going forward?
Big picture, as our direct lending platform scales, we would provide, it would allow us a bigger denominator over which to spread our costs of our infrastructure. So I think it's some benefit down the road. Hard to quantify today, but over time we would expect to see some benefit there to THL Credit shareholder.
[Operator Instructions] And I'm showing no further questions at this time. I'd like to turn the call back over to Sam Tillinghast for any closing remarks.
Thanks, everybody. We appreciate your questions. We look forward to talking to you next quarter.
Ladies and gentlemen, thank you for participating in today's conference. This does conclude today's program. You may all disconnect. Everyone have a great day.
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