Gladstone Investment Corporation\De Q3 FY2024 Earnings Call

Greetings, and welcome to the Gladstone Investment Corporation Third Quarter Earnings Call. As a reminder, this conference is being recorded. It is now my pleasure to introduce your host, David Gladstone. Thank you, Mr. Gladstone, you may begin.

Thank you, Kat. That was a good beginning. This is David Gladstone, Chairman of Gladstone Investment, and we are discussing our third quarter results for the fiscal year ending December 31, 2023. Our fiscal year will conclude in a couple of months, and this earnings conference call is intended for all shareholders and analysts who follow our company. We are listed on NASDAQ under the symbol GAIN, which stands for capital gains, along with GAINN, GAINZ, and GAINL, which are different registered notes available for purchase. We won't focus much on those today. We appreciate your participation and are glad to provide an update to our shareholders and analysts regarding our perspective on the current business environment. Our two main objectives today are to help you understand what has occurred in the past and, while we cannot predict the future with certainty, to share our current outlook. Now we'll hear from our Deputy General Counsel, Erich Hellmold. Erich?

Thank you, and good morning, everyone. 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 in our Forms 10-Q, 10-K and other documents we file with the SEC. These can all be found on the Investors page of our website. 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 past performance or market information is not a guarantee of future results. Please take the opportunity to visit our website and sign up for our e-mail notification service. You can also find us on Twitter and on Facebook. Today's call is simply an overview of our results through December 31, 2023, so we ask that you review our press release and Form 10-Q, both issued yesterday for more detailed information. Now I'll turn it over to Dave Dullum, President of Gladstone Investment.

Thanks, Erich, and good morning, everyone. We are happy to report that GAIN produced very good results for this third quarter of fiscal year '24, which follows on the previous solid first 2 quarters of fiscal year '24, which, of course, ends in March. We ended the third quarter of fiscal year '24 on 12/31/23 with adjusted NII of $0.26 per share and total assets of $918 million. You'll learn more about this from Rachael Easton, our CFO, when she describes the details around that. Again, those are good results. In regards to activity for the quarter, we did invest $65 million, which helped us to fund an add-on acquisition in one of our existing portfolio companies. And again, we are always looking and are doing new deals, making new investments and new acquisitions, and that continues to be our goal and objective. However, doing add-ons to certain of our existing portfolio companies is really an important aspect of our value-building process because it allows us to increase our investment in companies where we know the management team, the business itself and where we have a strong belief in its future, and it continues to allow us to really build very good value in these fundamental businesses. So we'll continue to do that as necessary and in certain specific cases, while pursuing our main business, which is adding new acquisitions as we go along. We also, as we have in our buyout strategy exits, had a very successful exit with one of our portfolio companies where we actually generated pretty meaningful realized capital gain for us of about $43.5 million. We were able to maintain our monthly distribution to shareholders at $0.08 per share or $0.96 per share on an annual basis, and we paid an aggregate supplemental distribution of $1 per share during November and December of 2023. Again, this large supplemental distribution is a result of the buyout strategy and is our ability to continue rewarding our shareholders with these meaningful distributions from realized capital gains, which are generated on the equity portion of our exits, in addition, of course, to the income that we continue to generate for the monthly distributions and which is obviously very important for the basis of distributions to our shareholders on a monthly basis. Our balance sheet continues to be strong, with very low leverage and a very positive liquidity position with additional availability on our credit facility. So we will continue providing support to our portfolio companies, both for add-on acquisitions and interim financing if the need arises, while actively growing our assets through new buyouts. Turning to the outlook, the deal flow, as we call it, appears to be picking up somewhat as the sellers who have been holding back over the past 6 months or so are testing the market. We do hear from the merger and acquisition groups, investment bankers, who are our primary sources for new acquisition opportunities, that the backlog of new opportunities has been building. It seems like the last 6 months or so of last year were fairly slow somewhat and deals were coming to the market and they were being taken back, et cetera. Now it looks like there's been a bit of an increase in this regard, perhaps as a result of interest rates maybe coming down. But in any event, we continue working on a few new possible buyout deals, and we are currently in that early phase of the process. There does continue to be significant liquidity in the market, meaning that our competitive situation is of course being challenged all the time. So we're going to remain value sensitive while we aggressively compete for new acquisitions. In summing up the quarter and looking forward, we believe the state of our portfolio is very good. We have a strong and liquid balance sheet, an active level of buyout activity and continued prospects of very good earnings and distributions over the next year. So I'll turn it over to Rachael Easton, our CFO, and she can give more details on the financials of the quarter.

Thank you, and good morning, everyone. Looking at our operating performance in the third quarter of fiscal year '24, we generated total investment income of $23.1 million. That was up from $20.3 million in the prior quarter. This increase was primarily due to increased interest income, which was driven by new debt investments made in the quarter, as well as higher dividend and success fee income resulting from fees received associated with an exit during the quarter, as compared to not receiving any of these fees in the prior quarter. Net expenses as of December 31, 2023, were $13.3 million. This was down from $22 million in the prior quarter. This decrease is primarily due to a $10.4 million 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. This decrease was partially offset by an increase in borrowing costs. This resulted in net investment income for the quarter of $9.7 million compared to a net investment loss of $1.7 million in the prior quarter. This fluctuation is primarily due to the large accrued capital gains-based incentive fees recognized during the prior quarter. Adjusted net investment income, which is net investment income or loss exclusive of accrued capital gains-based incentive fees for the quarter, was $9.1 million or $0.26 per share, up $0.02 from $8.1 million or $0.24 per share in that prior quarter. We continue to believe that adjusted net investment income is a useful and representative indicator of our ongoing operations. Consistent with the prior quarter, at December 31, 2023, we continue to have 3 portfolio companies that are on non-accrual status, and we will continue working with those companies to get back on accrual status when possible. We believe that maintaining liquidity and flexibility to support and grow our portfolio are key elements of our success. With our 3 public note issuances, we have long-term fixed-rate capital in place, and as announced yesterday, we have amended and expanded our credit facility, increasing the capacity to $200 million. And as of yesterday's release, we had over $120 million available from that capacity. Additionally during the quarter, we were successful with our common stock ATM program, raising approximately $21 million in net proceeds as well as an additional $7.7 million in net proceeds raised in January, with all sales being accretive and above the then-current NAV. We anticipate continuing to be active in the ATM program. Overall, our leverage remains relatively low with an asset coverage ratio at December 31, 2023, of 207%, providing plenty of cushion to the required 150% coverage. Our NAV decreased to $13.01 per share for the quarter compared to $14.03 per share at the end of the prior quarter. The decrease was primarily driven by $1.36 per share in net unrealized depreciation on investments and $1.24 per share of distributions paid to common shareholders during the quarter, of which $1 per share related to supplemental distributions. These decreases were partially offset by $1.27 per share of realized gains on investments and $0.28 per share of net investment income. Consistent with prior quarters, distributable book earnings to shareholders remained strong. We started the fiscal year with $32 million or $0.95 per share in spillover and our monthly distribution remains consistent at $0.08 per share per month for an annual run rate of $0.96 per share. During this past quarter, in November and December 2023, we paid an aggregate $1.00 per share supplemental distribution. We look to continue funding future supplemental distributions as we recognize realized capital gains on the equity portion of our assets. Using the monthly distribution run rate of $0.96 per share per year and $1.24 per share in supplemental distributions paid so far in the fiscal year 2024, our aggregate estimated fiscal year distributions would total at least $2.20 per common share or a yield of about 16% using yesterday's closing price.

Thank you very much. That was a very, very good quarter, Rachael and Dave, you've done a great job, and Erich, good information for our shareholders. This call and the 10-Q filed yesterday with the Securities and Exchange Commission should bring everyone up to date. The team has reported solid results for the quarter ending December 31, including the add-on investments and exit activity associated with net realized gains. We believe the team is in a great position to continue these successes through the remainder of the fiscal year, and that fiscal year ends March 31, 2024. I just think Gladstone Investment is an attractive investment for investors at this point in time. And you have monthly distributions, and then you have supplemental distributions from the potential capital gains and some other income. The team hopes to continue, of course, to show you a strong return and rather than keep talking about it, let's get some questions from the analysts and shareholders that are on the line. So operator, if you'll come on and manage that, that'd be good.

We will now be conducting a question-and-answer session. Our first question comes from Mickey Schleien from Ladenburg Capital.

Dave, I wanted to understand from you how your portfolio companies are progressing in terms of their revenues and margins outside of consumer. We're all aware that the consumer-facing companies have headwinds, but are you seeing any trends in the rest of the portfolio?

Mike, nice to talk to you. Not truly not really. We're seeing, I would say, pretty consistent, not a decline, but a little slower, call it growth, but things are holding up pretty well across the board, costs of materials, in some cases and distribution costs, which impacted some of our industrial companies, et cetera, from the supply chain side. I would say those have eased a bit, so that's obviously held on that end. But frankly, all in all, we are seeing a fairly moderate going slow, but nothing dramatic one way or the other. Interestingly, some of our consumer products companies actually are doing reasonably well even though, as you said, the consumer side tends to be a little bit slower right now. But generally, I would say pretty stable.

It's great to hear that. Dave, regarding deal flow, we are observing that private equity funds are conducting dividend recaps for their stronger performers to achieve some returns for themselves and their shareholders. Is this something you are considering for your better-performing companies in the near future, which could also assist in optimizing their balance sheets?

Right now, we don't have any plans for dividend recaps. We've done a few in the past with one particular company and another last year, and those were based on the factors you mentioned. Currently, we are not actively pursuing this, although it can be beneficial, especially if it involves a strong business we are keen on and allows us to add value for both shareholders and management teams. It's important for us that any such actions are in alignment with the management teams of our portfolio companies. At the moment, I don't anticipate that being a focus. On a broader note, the market experienced some unusual trends in the latter half of last year, with several deals being pulled, but we are starting to see some recovery. There's a bit of an increase in deal flow happening now. For the opportunities we are considering, we are approaching them with values that align with our expectations, which seems to be working out well. However, there are still some unrealistic valuations out there, and we won't compete in that space. Overall, I would say the outlook appears to be reasonably positive.

Okay. That's interesting and helpful. Dave. My last question, the more liquid markets for credit have reopened as we all know. Are you concerned about refinancing risk for some of your better-performing investments? In other words, could some of these investments go to other suppliers of debt capital at cheaper rates than you're offering them and you'd be taken out?

Yes. No, that's a great question, and obviously something we always look at and have looked at over many, many years. And frankly, I can only think of one company where that actually happened was an unusual circumstance. I would say the fact that our capital is really, as you know, is a combination of the debt and the equity, right, in the transaction. So the effective yield, so to speak, is comparison to say what just pure debt might be even with this environment where debt is coming down, I would say we're still very competitive in that regard. The relationship with the portfolio companies is probably as important as anything. And then the other aspect to that is, while, as you point out, the spreads might be getting a bit tighter, meaning interest rates are coming down, the availability still, I think, at least from what we're seeing, is not just all of a sudden the flood gates have opened, so to speak, right, and you can get all the capital you need at low rates. So right now, honestly, I'm not seeing any challenges for our portfolio companies in that regard. Could it happen? Sure. But I'm not seeing anything right now. And so I'm not overly concerned we're going to get taken out in any situations that we may not want to be taken out of.

Our next question comes from Kyle Joseph from Jefferies.

Just want to get your thoughts on leverage. Obviously, you guys have a lot of dry powder right now, and it sounds like you're getting more optimistic about deal flow into '24. But just talk about where you're comfortable taking leverage to if we do get that deal flow? Or is it really just more a function of the market and what deals get done?

Kyle, I think what you said, it's a function of the market and what deals we get done. So as you know, we keep a pretty conservative leverage profile, I think, compared to the greater BDC peer group. And that's something we do believe is really important, but it's also to provide us the flexibility to support that potential new deal flow. So we want to be able to be in a position where, if we need to fund new deals, we have the ability to take on additional borrowings and it doesn't threaten breaking that 150% test.

Yes. I would like to briefly add to that. As Rachael mentioned earlier in the call, we've had a fairly successful ATM program in place, and we are very cautious about maintaining a safe cushion relative to NAV. We plan to stick with this approach and avoid taking unnecessary risks. This strategy allows us to look ahead with the hope of engaging in new deals while ensuring that we provide the necessary support from the equity side, as Rachael pointed out, to maintain a coverage ratio that keeps us secure.

I have one follow-up question regarding the competitive landscape in the lower middle market private equity. While you anticipate an increase in deal flow, how has the competition evolved? Has the market shifted with interest rates rising significantly from near zero, despite some potential cuts this year?

I would say the market is reflecting what we observed towards the end of last year, at least from our perspective. While it may not be the case everywhere, I can only share our view. The rising rates have slowed down not only costs but also the availability of leverage. The deals we are managing to close seem to be overly financed with equity to get them done. We expect some changes in this situation, but I don't believe it will lead to a sudden return to very high leverage multiples of EBITDA. Caution is still warranted. Some deals we are seeing have enterprise values that are 1 or 2 turns higher than our assessment, but there are still buyers willing to proceed. If they are, it appears they are relying more on equity than debt. The debt market hasn’t yet returned to a point of significantly higher leverage per transaction, even with these elevated values.

Our next question comes from Bryce Rowe from B. Riley Securities.

I wanted to ask about the upsized credit facility. You've had, I guess, some changes, I think you took the available amount down last quarter, and obviously it's moved back up. So maybe there was a bit of a process to get to that higher level. Could you just, if you can, kind of talk about that process? And did you add some banks to the facility? Just any kind of detail there would be helpful.

Yes, we are very pleased to announce that we have expanded the credit facility to $200 million. During our regular amendment process, which concluded at the start of the quarter, we had reduced the amount to $135 million due to losing a couple of banks. We were in the process of working on this expansion, but unfortunately, we couldn't finalize both aspects simultaneously. We managed to increase the facility by bringing in Fifth Third Bank and also increasing the commitment from one of the other banks to reach the $200 million figure. We believe this additional capacity is crucial for providing flexibility as we consider future opportunities in our pipeline.

Got it. That's helpful context, Rachael. And maybe one for Dave. You had an add-on opportunity for an existing portfolio company this quarter. Can you talk a little about that? And are there any other opportunities in the pipeline for your existing portfolio companies to pursue add-on acquisitions?

Sure. That particular company has been in our portfolio for a few years and is somewhat industrial-based. We have been improving it significantly at all levels, including management. We had the opportunity to acquire a substantial business that integrated well with our product. This not only added manufacturing capacity but also enhanced our distribution and access in Europe and other regions. We increased the company’s revenue from roughly $40 million to over $100 million, along with a significant boost in EBITDA. The integration has progressed very well, clearly enhancing overall value. I feel optimistic about that transaction and, importantly, we managed to do this without putting the company into a highly leveraged position. We see similar opportunities among some of our existing portfolio companies. Some of them are smaller and do not need additional financing from GAIN because their balance sheets are strong enough to handle smaller acquisitions that make sense, like product line expansions. We are committed to adding value to our existing companies whenever possible. One of our other portfolio companies recently made a sizable acquisition, and we were able to support that investment as well. In short, we will continue to pursue these opportunities.

This concludes our question-and-answer session. I would like to turn the floor back over to David Gladstone for closing comments.

Thank you. It was a strong quarter, and I believe when we compile the numbers for the year ending March 31, it will be one of our best years ever. We expect to surpass $1 billion in assets by that time, although I can't predict the future. We anticipate that things are recovering and growing, and many in the investment community see business development companies like ours as a good investment opportunity. Thank you all, and that concludes this presentation.

This concludes today's teleconference. You may disconnect your lines at this time. Thank you for your participation.