KCAP Financial's (KCAP) CEO Dayl Pearson on Q1 2018 Results - Earnings Call Transcript

KCAP Financial (KCAP) Q1 2018 Earnings Conference Call May 3, 2018 8:00 AM ET

Executives

Dayl Pearson - President and Chief Executive Officer

Ted Gilpin - Chief Financial Officer

Analysts

Christopher Nolan - Ladenburg Thalmann Financial Services

Ryan Lynch - KBW

Operator

Good morning, ladies and gentlemen. And welcome to the KCAP Financial Inc. Conference Call. An earnings press release was distributed yesterday. If you did not receive a copy, the release is available on the company's website, at www.kcapfinancial.com, in the Investor Relations section.

As a reminder, this conference call is being recorded today, Thursday, May 3, 2018. This call is also being hosted on a live webcast, which can be accessed at our company's website, at www.kcapfinancial.com, in the Investor Relations section under Events.

Today's conference call includes forward-looking statements and projections, and we ask that you refer to KCAP Financial's most recent filings with the SEC for important factors that will cause actual results to differ materially from these projections. KCAP Financial does not undertake to update its forward-looking statements unless required by law.

I would now introduce your host for today's conference, Mr. Dayl Pearson, President and Chief Executive Officer of KCAP Financial. Mr. Pearson, you may begin.

Dayl Pearson

Thank you, and good morning – thank all of you for joining KCAP Financial for a review of our first quarter 2018 results. Today, I'll review key highlights and activities from the quarter, as well as provide context for our direct lending business and the performance of our Asset Manager Affiliates. I'll then turn over the call to our Chief Financial Officer, Ted Gilpin, who'll provide a more thorough review of our operating and financial results for the quarter, and then open the line for your questions.

We continued to execute on our strategy to lower our overall borrowing cost, optimize our balance sheet and position ourselves for growth in 2018 and beyond. In the first quarter, we closed on a new $50 million credit facility. Over the course of 2018 we will increasingly turn our focus to prudently investing with this incremental capital.

During the first quarter, we evaluated a number of opportunities to invest in a very competitive marketplace. We invested or reinvested a total of approximately $52 million since the end of 2017, and although most of the activity did not take place until late in the quarter or early in the second quarter, it is not entirely reflected in our reported NII or net operating income. We are confident that these investments will generate good returns over time. Asset quality continues to be strong with our net asset value essentially unchanged from last quarter.

Turning to our joint venture, the $300 million fund owned by the joint venture and managed by KCAP is now fully invested. During the first quarter of 2018, dividend income from the joint venture was $700,000. This is more than double that of the fourth quarter and should increase as we optimize the portfolio.

While we were active in investing our capital in the first quarter, we currently still have significant dry powder on the balance sheet with liquidity of approximately $36 million, compared to $45 million at year-end 2017, as well as some lower yielding loans available for sale to fund new investments.

Now, let me give you a high level summary of our first quarter 2018 financial highlights before handing it over to Ted. For the first quarter ended March 31, 2018, our NII was approximately $2.5 million or $0.07 per share. This was negatively impacted by some one-time professional fees and the costs associated with the windup of Katonah 2012-1.

Turning to performance of our Asset Manager Affiliates, during the first quarter one of the CLOs was called. That is Catamaran 2012-1, and we are using a significant portion of those assets to fund the warehouse for a new CLO, which we expect to begin marketing in the second quarter. The market for a new CLO fund continues to be robust especially with the end of risk retention.

As of March 31, 2018, our weighted average mark-to-market on par for our debt securities was 95 consistent with the market in the fourth quarter. In terms of our CLO portfolio, our weighted average mark-to-market value to par was 66, slightly higher than year-end.

Our 100% ownership of our Asset Manager Affiliates was valued at approximately 38.7 million based upon assets under management and positive perspective cash flows. The AMAs have approximately $2.8 billion of assets under management with all CLO 1.0 redeemed and five 2.0 CLOs outstanding with an additional one currently in our warehouse.

Our CLO portfolio at the end of the first quarter totaled approximately $41 million. At the end of the first quarter debt securities approximated 116 million or represented about 59% of our investment portfolio. Secured loans now represent 78% of the debt securities portfolio.

All CLOS managed by our AMAs continue to be current on equity distributions and management fees. This income stream from our Asset Manager Affiliates allows them to make periodic distributions to us. During the first quarter, there was a distribution totaling $820,000 of which $500,000 was a return of capital. Additionally as of March 31, 2018 our Asset Manager Affiliates had approximately $2.8 billion of par value assets under management.

In the first quarter, our board of directors approved a cash distribution of $0.10 per common share payable on April 27, 2018 to shareholders of record at the close of business on April 6, 2018 and adopted a dividend reinvestment plan, or DRIP. This plan provides reinvestment of our distributions that we have for our stockholders unless the stockholder elects to receive cash. As a result, if we declare a cash distribution our stockholders who have not opted out of our DRIP will have their cash distributions automatically reinvested with additional shares of common stock.

And now I will ask Ted Gilpin to walk through the details of our financials. Ted?

Ted Gilpin

Thank you, Dayl. Good morning everyone. As of March 31, 2018, net asset value stood at $4.85 compared with $4.87 as of December 31, 2017. Net investment income was 2.5 million or $0.07 per basic share for the first quarter of 2018, down from 2.7 million or $0.07 per basic share in the fourth quarter of 2017, and 3.2 million or $0.09 per basic share in the first quarter of [2017].

Interest income on our debt securities for the quarter ended March 31, 2018 was 3.8 million compared with 3.3 million for the fourth quarter of 2017. Interest income on our debt securities was 4.6 million in the first quarter of 2017. Our debt securities portfolio contribution to total investment income for the quarter was 55%, which compares to approximately 50% for the fourth quarter of 2017 and 59% for the first quarter of 2017.

Investment income from CLO fund securities decreased to 1.9 million in the first quarter of 2018, a decrease from the 2.5 million reported in the fourth quarter of 2017, and 3.1 million in the first quarter of 2017. This is primarily due to the call of Catamaran 2012-1 CLO in the first quarter of 2018.

We received distributions from our Asset Manager Affiliates of $820,000 in the first quarter of 2018, 500,000 of such distribution is in excess of the AMAs estimated tax from earnings and profits, and is therefore treated as return of capital. The AMAs distributed 650 in the first quarter of 2017, all of which was return of capital to KCAP.

For the three months ended March 31, 2018, total expenses decreased by approximately 191,000 as compared to the same in 2017, primarily attributable to the decrease in interest expense partially offset by higher professional fees.

The company recorded net realized and unrealized gains on investments of approximately 318,000 for the three months ended March 31, 2018 compared with net realized and unrealized gains of approximately 1.5 million for the three months ended December 31, 2017 and net realized and unrealized losses of approximately 2.8 million in the first quarter of 2017.

On the liability side of our balance sheet, as of March 31, 2018 par value of our debt outstanding was 104 million, including 19.8 million from our new revolving credit facility. Our asset coverage ratio at quarter end was 270%, compliant with the current minimum required 200% for BDCs. BDCs can increase this leverage under a newly passed statue and KCAP’s board has approved the adoption of the new leverage, which will become effective in March of 2019. KCAP would still be restricted in its ability to increase leverage by covenants in our outstanding publicly traded debt.

With that we would now like to turn the call over to you for any questions. Operator?

Question-and-Answer Session

Operator

[Operator Instructions] Our first question comes from the line of Christopher Nolan with Ladenburg Thalmann. Your line is open.

Christopher Nolan

Hi, guys.

Dayl Pearson

Hi, Chris.

Ted Gilpin

Hi, Chris.

Christopher Nolan

For the higher leverage ratio, given that your unsecured debt seems to prevent you from increasing, what are the options – are you inclined to call that debt at some point or not go above the 1:1 debt-to-equity?

Dayl Pearson

Well, there is one other option which is to amend the debt covenant, which we have discussed with the bankers and it is another possibility for us to tap into.

Ted Gilpin

But the 7.375% notes are – there is only 7 million of them left. They are already in their call period. So, we can obviously clean up that piece. The 6.250% notes were issued – 6.125%, excuse me, they will be callable I think in August, September of 2019. So, we are getting pretty close to that. Obviously that will be an option shortly after it becomes available, [indiscernible] we could amend it, or we could just not do anything until we feel it is necessary.

Dayl Pearson

And we are not really running up against our debt to equity ratio at this point. So, we have some time to figure out the right path to go on.

Christopher Nolan

Okay, and Dayl, given that you guys do have time is there an intention to get a shareholder vote on the higher leverage ratios as well?

Ted Gilpin

Well, it is an either or right, either you could do it. I mean, if we were to file a proxy for some other reason, we will probably include that in the proxy, but I think most people have only done one or the other. And I think the whole idea of it – you have to wait a year before you can do it if you do it through a vote in the board. And I think the idea behind that is that give shareholders a chance if they are uncomfortable with the higher leverage, if they want to trade out of the stock they can. So they can vote with their feet.

Christopher Nolan

Yes, we have seen some BDCs are actually doing both…

Ted Gilpin

[indiscernible] Again, it is a longer-term issue, not a short – not an issue that we have to be deal with over the next 3 to 6 months.

Christopher Nolan

Understood. Also, where do you think we are in the credit cycle? I only ask because, I see that you have a fair amount of junior secured debt, and CLO funds. And depending on where you think you are on the credit cycle, those could be more riskier, or problematic in terms of if we have our downturn, I'm just trying to get your perspective as to where things are?

Ted Gilpin

Yes. I mean, I think – we think it is a very aggressive point in the credit cycle. People like to talk about in innings, and I don't know what is behind that. But obviously the credit markets are pretty aggressive right now. That being said we see numerous deals we turned down over time, 85 or so percent of what we see, and that even includes first lien debt. And so we're pretty comfortable with the two new positions we have at this point. Some had gone through some stress and seem to be coming out the other end. But I think we are pretty comfortable with our portfolio today. I mean, we are very cautious about what we are investing in going forward, particularly with the credit facility we have now that is going to sort of we obviously get more bang for our buck if we do more senior [stuff] with the net credit facility.

So we are being very cautious and we put a fair amount of money to work, but most of it has been in very high quality credits. But you are right. I mean you are seeing a lot of looser covenants, covenant-lite although we generally don't see much covenant-lite in sort of our core middle market business of less than 50 million of EBITDA, but I think we are being very, very cautious.

Christopher Nolan

Final question, how low do you think you can take money market balances in the second quarter?

Ted Gilpin

I'm not sure I…

Christopher Nolan

The money market has been roughly $10 million in the first quarter, should we expect the money market account balances to decline further?

Ted Gilpin

Probably. Although that is going to be a subject also of repayments. So I would think assuming we don't have a massive amount of repayments I would expect that to go down a bit, and I would expect the borrowings under the credit facility to go up as well.

Dayl Pearson

We do have some other sources of capital – with risk retention going away there is going to be some capital coming back from the asset managers that we need to deploy too.

Ted Gilpin

Yes. We have about $12.6 million invested in risk retention vehicles at our asset manager. We expect that those are going to get unwound over time. So there is going to be some additional – when I said we have 36 million of liquidity I am not counting that 12.6 million.

Christopher Nolan

Got it. Okay, thank you. I will get back in the queue.

Dayl Pearson

Thanks.

Ted Gilpin

Thanks.

Operator

Our next question comes from Ryan Lynch with KBW. Your line is open.

Ryan Lynch

Hi, good morning guys. First question, CLO income dropped pretty significantly in the first quarter from the fourth quarter, was that solely due to – I believe you said you called one CLO in the first quarter, was that what drove the…?

Dayl Pearson

It is actually two things, Ryan. One, [071], which was one of our largest positions had been called in the fourth quarter of ’17, and it is now completely gone and then we also called Catamaran 2012. So when it unwound it put a little bit of pressure on the CLO.

Ted Gilpin

Yes. There were some costs – a couple of them, $250,000 of cost associated with liquidating that portfolio that hit directly to the revenue line.

Ryan Lynch

Okay, and…

Ted Gilpin

Go ahead.

Ryan Lynch

Do you guys foresee – it doesn't look like you guys had any set maturities in 2018 for any of the CLOs; you guys foresee yourselves calling any additional CLOs over the coming quarters?

Dayl Pearson

Well, again, generally we don't control the call. That being said the only one – I think we reset – the next one would have been 2013-1, which got reset and extended in the fourth quarter of last year. So that is not callable for a while. 2014-1 was reset, increased and extended. So that is not going to be called for a while too. 2014-2, I guess potentially is a candidate either for further resets or calling, but we don’t anticipate that happening, and so that would be the only ones potentially in 2018. And as I said, we have $200 million of assets at our warehouse. Primarily those came out of 2012, and those are at our warehouse for a new CLO, which we are hopefully in the market with very soon.

Ryan Lynch

Okay. That is helpful. Just going back to the 2:1 leverages just to make sure I am clear, I know you said you have some covenants in your [bonds] that prevent you from going about 1:1 today. Does your credit facility have any sort of 1:1 covenants, or are you guys free to move above the 1:1 credit facility?

Dayl Pearson

We do not have any covenants like that in the credit facility.

Ryan Lynch

Okay. And then just one last kind of modeling question, where there any one-time fees associated with your redemption of the 20 million 7.125 notes in the quarter, and if so what was that one-time accelerated fees?

Dayl Pearson

Yes. It has been 170,000 of expenses that we brought forward. It is – exactly. It shows realized loss and the extinguishment of debt at 169,000.

Ryan Lynch

Okay. And then is the plan – it is not a meaningful number but is the plan as you guys continue to deploy capital in short time debt just to clean up the remaining portion of the 6 million or 7 million remaining on the 7.125 notes probably?

Ted Gilpin

Most likely that will happen. We have approvals from the board to redeem those at any time. I think with rates coming up, actually this is not as onerous as it was a year ago, but obviously we want to clean that up well in advance of the 2019 October maturity. We want to certainly have it cleaned up 12 months before that.

Ryan Lynch

All right. Thanks. Those are my questions.

Dayl Pearson

Thank you, Ryan.

Operator

Thank you. I'm not showing any further questions. So I will now turn the call back over to Mr. Pearson for closing remarks.

Dayl Pearson

Thank you all for joining us this morning. I know we are a little bit earlier than usual. So I apologize for that, but we will talk to you again in August on our second quarter results. Thank you very much.

Operator

Ladies and gentlemen, this does conclude the program. You may now disconnect. Everyone have a great day.