Gladstone Investment Corporation\De Q2 FY2023 Earnings Call

Greetings and welcome to the Gladstone Investment Second Quarter Earnings Call. As a reminder, this conference is being recorded. It is now my pleasure to introduce your host, David Gladstone, Chief Executive Officer. Thank you, sir. You may begin.

Thank you, Latonia. That was a very nice introduction and good morning to all of you that are listening in. This is David Gladstone, Chairman, Gladstone Investment. This is the second quarter ending as for the fiscal year that ends March 31, 2023. We are ending the quarter on September 30, 2022, to talk to you about. All the shareholders and analysts that are on, hopefully you are all ready to ask us lots of good questions when we get to that part of that and we are talking about the symbol GAIN as well as two others, GAIN as the common stock and GAINN and GAINZ is for the registered notes and things that we have listed as well. So, thank you all for calling in. We are always happy to provide updates to shareholders and analysts who are on the phone call. There are two goals here: to help you understand what happened in the last quarter and also to give you a current view of the future. Now we will start out with our General Counsel, as we always do, Michael LiCalsi. Michael?

Thanks, David. Good morning, everybody. Today’s call may include forward-looking statements under the Securities Act of 1933 and the Securities Exchange Act of 1934, including those regarding our future performance. These forward-looking statements involve certain risks and uncertainties and other factors even though they are based on our current plans, which we believe to be reasonable. Many factors may cause our actual results to be materially different from any future results expressed or implied by these forward-looking statements, including all risk factors listed on our Forms 10-Q, 10-K and other documents we filed with the SEC. We find them on the Investors page of our website that is gladstoneinvestment.com or the SEC’s website which is www.sec.gov. We undertake no obligation to publicly update or revise any forward-looking statements whether as a result of new information, future events or otherwise, except as required by law. Please also note that any past performance or market information is not a guarantee of any future results. We ask that you take the opportunity to visit our website again, gladstoneinvestment.com, sign up for our email notification service. You can also find us on Twitter @GladstoneComps and on Facebook, keyword, The Gladstone Companies. Today’s call is simply an overview of our results through September 30, 2022. We ask that you review our press release and 10-Q both issued yesterday for more detailed information. With that, I will turn it over to Gladstone Investment’s President, Dave Dullum.

Hey, Mike, thank you very much and good morning, everyone. Welcome. Again, we are pleased to report that GAIN had another good quarter for fiscal year 2023. This follows on the previous solid first quarter of the fiscal year. We clearly are in a challenging period with rising interest rates and inflationary costs. However, our portfolio companies are, happily, meeting these challenges. As a result, we ended the second quarter of fiscal year 2023, which was on September 30, 2022, with adjusted net investment income (NII) of $0.29 per share and total investments at fair value of $738 million, which is up from $690 million at June 30, 2022. Our deal activity this quarter was fairly good as we made one new acquisition and invested $39 million. We also invested $30 million and recapitalized one of our existing portfolio companies. In connection with this investment, we received a return of our preferred equity investment of $10 million. We received dividend and success fee income of $4.8 million and recognized a realized gain of $2.2 million, thereby increasing our debt investment in that company when the dust settled to $57.7 million. Again, we were able to generate capital gains, fee income and increase our actual investment in this portfolio company. I should note that we will have opportunities for recapitalizations from time to time. These are positive events as they generally allow us to generate capital gains and other income while increasing our investment in a company, where clearly we know the management team and the business. It’s a good opportunity. With the buyout market still competitive, this is a good way for us to create value within the portfolio and therefore reward shareholders. Subsequent to the quarter end, we invested an additional $8.4 million to fund an add-on acquisition to one of our portfolio companies. Also subsequent to the quarter end, we announced a 6.7% increase in our monthly dividend to $0.08 per share, up from $0.075 per share for a new annual run-rate of $0.96 per share. Additionally, we declared a supplemental distribution of $0.12 per share, which will be paid in December of 2022. We anticipate being able to fund future supplemental distributions as we recognize realized capital gains on the equity portion of future exits and potentially from other recapitalizations that we might do. Our bio-focused strategy continues to successfully generate both income from monthly distributions to shareholders and capital gains for supplemental distributions. We did experience a small decline in valuations in the aggregate across our portfolio, primarily due to declining valuation multiples, even though we had increases in EBITDA at many of our portfolio companies. Our balance sheet continues to be strong with loan leverage and a very positive liquidity position with significant availability on our credit facility. You will hear a lot more about this from Rachael Easton, our CFO. This allows us to continue providing support to our portfolio companies for add-on acquisitions and interim financing if the need arises, while actively seeking new buyout opportunities and growing our assets. Looking forward, even though there seems to be some moderation in the multiples being used to determine the values of buyouts, the market is still very competitive with strong deal flow and significant liquidity in buyout funds, which is our competition. We will remain patient and selective in our due diligence and review process while aggressively seeking new acquisitions and implementing recapitalizations with existing portfolio companies as appropriate. The new acquisition effort is very important and is a high priority for us. In summing up the quarter and looking forward, we believe the state of our portfolio is very good. We have a strong liquid balance sheet and an active level of buyout activity and continued prospect of good earnings and distributions over the next year. Rachael, would you tell us a little bit more detail about all of that?

Absolutely. Thanks, David. Good morning. I will start with a summary of the fund’s operating performance for the quarter ended September 30, 2022. In the second quarter of fiscal year 2023, we generated adjusted net investment income of $9.7 million or $0.29 per share. This was up from $8.3 million or $0.25 per share in the prior quarter. We continue to believe that adjusted net investment income, which is net investment income exclusive of any capital gains-based incentive fees, is a useful and representative indicator of ongoing operations. The increase in adjusted NII was driven by an increase in total investment income to $20.8 million compared to $19.3 million in the prior quarter as well as a decrease in net expenses to $9.4 million from $11.9 million in the prior quarter. The $1.5 million increase in total investment income was primarily due to an increase in debt investments in the current quarter, as well as an increase in LIBOR impacting our interest rates. Additionally, driving the increase in interest income, one portfolio company that was previously on non-accrual returned to accrual status this quarter. Going forward, there are two portfolio companies that remain on non-accrual status. We will continue working with those companies to get back on accrual status if possible. The $2.5 million decrease in net expenses was primarily driven by a decrease in accrued capital gains-based incentive fees due to the net impact of realized and unrealized gains and losses as required under U.S. GAAP. We believe that maintaining liquidity and flexibility to support and grow our portfolio are key elements of our success. We have long-term capital in place and at September 30, 2022 had $163.4 million available on our $180 million credit facility. Additionally, we raised approximately $0.5 million in net proceeds under our new common stock ATM program, all sales of which were above NAV. Overall, our leverage is low, with an asset coverage ratio at September 30, 2022, of 254.1%. Our NAV per share declined during the quarter to $13.31 per share at September 30, compared to $13.44 per share in the prior quarter. The decrease was primarily driven by $10.6 million of net unrealized appreciation and $7.5 million of distributions paid to common shareholders. These amounts were partially offset by $11.4 million of net investment income and $2.3 million of realized gains on investments. Consistent with prior quarters, our distributable book earnings to shareholders remain strong. With that in mind, and as previously announced in October 2022, our Board of Directors increased our monthly distribution run-rate to $0.96 per share per year and declared a $0.12 per share supplemental distribution to be paid in December of this year. Using the new monthly distribution run-rate of $0.96 per share per year and the $0.24 per share in supplemental distributions paid and declared so far for the year, noting that this may not ultimately reflect what will be declared for the year. Our fiscal year distributions would total $1.20 per common share or a yield of about 9.2% using yesterday’s closing price of $12.99. This covers my part of today’s call. Back to you, David.

Thank you. Very nice, Rachael. It was very nice for Dave and Michael as well for providing good information to our shareholders. This call and the 10-Q filed with the SEC yesterday should bring everyone up to date in the company. The team has reported solid results for the quarter, and we believe the team is in a great position to continue these successes through the remainder of our fiscal year ending March 31, 2023. I’m telling you, getting over a 9% yield on the price of the stock these days is a very strong return. I hope all of you call your broker and get some shares. We believe that Gladstone Investment is an attractive investment and we are seeking continuous monthly distributions and supplemental distributions from potential capital gains and other income. The team hopes to continue to show you strong returns for your investment and we will take good care of your money, as you know most of us, here at the company have a lot of shares in this company as well as the other funds. So, now I am going to stop, and we will ask our analyst friends and maybe some shareholders to ask us some questions, and we will do our best to give you a good answer.

Thank you. Our first question comes from Mickey Schleien with Ladenburg Thalmann. Please proceed.

Good morning, everyone. Dave, I wanted to ask you about how business owners are behaving in terms of their willingness to perhaps sell their businesses when we think about the headwind of rising interest rates for them and the headwinds also from a potential recession? In other words, is that driving them to have more interest in selling and providing you perhaps a bigger pipeline than you have in the past?

Hey, Mickey. Good morning. Thanks for that question. I can’t honestly tell you that we are seeing that. I would say there has been a bit of a slowdown in the pure family-owned or controlled business somewhat to that degree. There are other variables, such as what sort of succession there is. We’ve had a few situations where you start getting into due diligence and the values come down when you really get into it. As a result, that actually to sellers and we back off and do not move forward. So, to your point, there is a bit of that where they would love to sell it, but if it’s not at a value they would rather stick with it. So, I wouldn’t say that is helping to improve the deal flow in that regard. The other seller group would be other private equity firms, and they are more looking to exit regardless. Having said all of that, as I mentioned, there is still enough demand and capital that is keeping some of those valuations at higher values than frankly we think we can support. So, net-net, it’s a struggle.

Okay, I appreciate that. Dave, your portfolio sort of includes many companies that are fundamental businesses focused on the U.S. economy. It would be really interesting to understand if you could give some sense of how their revenues are developing and their margins as well given all this tightening that the Fed is doing.

So, I would say we are starting to just feel a little bit of a slowdown. We have three categories I think of, manufacturing, business services, and especially consumer. We are starting to see a little bit of a slowdown on the demand side, on the consumer side, manufacturing is slowing a little bit also. The business services side, that’s actually pretty robust right now. The bigger challenge continues to be in certain categories, finding labor. Even though we know there are folks that are not looking for jobs, which I think impacts the way we think of unemployment. But the bigger challenge is really around good quality labor, price and labor prices seem to be moderating a bit, and obviously supply chain struggles are improving. We have seen clearly the cost for importing from, say, China or the Far East, where you were dealing with container costs that were $15,000 to $20,000 back about six months ago, now those are more normal, around $5,000 to $7,000 per container. That impacts those companies that we have that are importing. So, across the board, I would say it’s starting to slow a bit, but nothing dramatic in that regard.

And Dave, when you think about all those comments, and look at the forward interest rate curves, what level of concern do you have regarding your company’s ability to fund their debt service in terms of cash and interest coverage ratios and their ability to absorb what looks like going to be meaningfully higher interest rates over the next couple of quarters?

Right. Currently, as you know, the way our deals are structured with LIBOR plus and floors. We have been mostly in the category where we are above the floors, or we are at our floors. With LIBOR increasing, we are starting to see a bit of an increase over and above what they have been paying. However, because our floors have been relatively high. I would say our yield on our total portfolio is 11.9% to 12%. We are not seeing as big an impact right now. The other thing, as you all know, because of the way we own these companies and capitalize them, we have a little bit of flexibility if we need to give our company some help, so to speak, in a deferral or slight reduction if things become tight, which we have had to do in the past. But right now, we are not seeing that to be a big problem with any of our portfolio companies. We obviously have two that have been on non-accrual for a while, while one came off of non-accrual, which is a very good thing. The two that are currently on non-accrual, we are working hard with those companies. I think one has a very good chance of coming off non-accrual sometime in the next six to nine months; the other one not so sure. But that’s not a huge driver affecting our results going forward.

I appreciate that, Dave. A couple of last questions, more housekeeping sort of questions. The portfolio’s weighted average yield climbed only 20 basis points, but during that period LIBOR increased 150 basis points. You just talked about LIBOR floors, were your LIBOR floors so high that that accounts for that change, or is there something else that I should understand?

You are right there. Our floors are generally around 2% to 3% across the portfolio. Now as LIBOR continues to increase this quarter, we should see that yield lift as well.

Okay. You see that if floors are higher than what’s typical in the middle market. My last question is just your view on balance sheet leverage, or what sort of level of debt-to-equity are you comfortable with in the current market environment?

Right now we are at about 250%, and I think that’s a level that we are comfortable with. We are currently about $20 million out on our line of credit. I think we have a lot of room there. But we look at it holistically in our business and capital structure. We were conservative in our leverage metrics, and I don’t think we are looking to change that.

Yes. As we look forward and hopefully make some new acquisitions this year, we have the capacity. That's the good news. As Rachael mentioned, if we start to get in the kind of 180% leverage ratio, that’s where we begin to look at it. We introduced an ATM program earlier this year in common stock, and we were raising not aggressively. We started to raise when prices began to decline. We are currently a little below that now, so we will not raise any common stock at this level going forward. As prices hopefully will start moving back up, we will gradually add some equity to the balance sheet as we look forward and sort of match it with new acquisitions we are making. Right now, as Rachael said, we are in really good shape and as we look forward, even with some good new acquisitions, we will be in decent shape from both a leverage and capital perspective likely through the halfway point of next year.

Okay. That’s it for me this morning. I appreciate your time, as always. Thank you.

Thanks, Mickey.

Thank you.

So, our next question.

Our next question comes from Kyle Joseph with Jefferies. Please proceed.

Hey, good morning, guys, and thanks for taking my questions. Just curious on your commentary regarding things remaining competitive in the middle market in terms of buyouts, what would be the outlook for you if rates continue to rise? Do you see some competitive disruptions there? In terms of capital allocation priorities, are add-on acquisitions kind of the near-term focus for you guys?

Yes. Hey, Kyle, good to talk to you. We have been aggressively making some add-ons. As mentioned this past quarter, we added on to one of our portfolio companies, and we are continuing to grow that business. We are actively looking for add-ons. That’s a good way for us to execute recapitalizations with companies that make sense. In terms of competitiveness, as rates rise, the impact is on traditional private equity funds, meaning our competition. The leverage that they are being provided is declining. This should mean that we become more competitive. However, private equity firms are being more aggressive on equity, putting in more equity into deals, assuming that they would offload that later. The short answer is, it’s still a struggle; it’s still competitive. We will not pay the multiples we are seeing because it doesn’t work for our model. We will continue to be patient and I believe we will do well this year, but it will take a while to make the types of acquisitions we want to achieve.

Got it. Very helpful. Thanks for answering my question.

Next question, please.

There are no further questions in the queue at this time. Mr. Gladstone, if you have any closing comments for the group?

Well, that said, we like good questions, so we are missing out on this one. We will have to wait until next quarter to hear some really strong questions, hopefully next time. That’s the end of this. Thank you all for tuning in.

Thank you. This does conclude today’s teleconference webcast. You may disconnect your lines at this time and have a great day.