Earnings Call Transcript - OFS Q1 2022

Operator, Operator

Good morning, and welcome to the OFS Capital Corporation First Quarter 2022 Earnings Call. All participants will be in listen-only mode. After today’s presentation, there will be an opportunity to ask questions. Please note this event is being recorded. I would now like to turn the conference over to Steve Altebrando, Vice President of Capital Markets. Please go ahead.

Steve Altebrando, Vice President of Capital Markets

Good morning, everyone, and thank you for joining us. Also on the call today is Bilal Rashid, Chairman and Chief Executive Officer of OFS Capital; and Jeff Cerny, the Company’s Chief Financial Officer and Treasurer. Please note that we issued a press release this morning announcing our first quarter results and filed our Form 10-Q. Each of the documents can be obtained under the Investor Relations section of our website at ofscapital.com. Before we begin, please note that statements made on this call and webcast may constitute forward-looking statements as defined under applicable securities laws. Such statements reflect various assumptions, expectations, and opinions by OFS management 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 way 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 also could be incorrect. You should not place undue reliance on these forward-looking statements. OFS Capital undertakes no duty to update any forward-looking statements made herein, and all forward-looking statements speak only as of the date of this call. During this call, we will be referring to non-GAAP financial measures. These non-GAAP measures are not prepared in accordance with Generally Accepted Accounting Principles. A reconciliation of the non-GAAP financial measures to the most directly comparable GAAP measures is available in the Investor Relations section of our website under the heading Tax and Non-GAAP Information. With that, I’ll turn the call over to Chairman and Chief Executive Officer, Bilal Rashid.

Bilal Rashid, Chairman and CEO

Thank you, Steve. Good morning. We are pleased to report another strong quarter. Some key takeaways: Our net asset value per share increased to $15.52, another historical high for the company. We have increased our quarterly distribution to $0.39 per share for the second quarter, up from the $0.28 per share we paid for the first quarter, marking the seventh consecutive increase in our quarterly distribution. Net investment income was $0.22 per share. Adjusted net investment income was $0.30 per share, which excludes the accrual for the capital gains incentive fee. We had no new loans or non-accrual in the quarter. In fact, we have not placed any loans or non-accrual for the seventh consecutive quarter. We deployed $55 million in new investments and made $15.1 million in add-on investments with existing portfolio companies. OFS Capital is approaching its 10th anniversary as a public company. Since our IPO, OFS has paid out $11.77 per share in distributions and our net asset value per share exceeds our IPO price of $15 per share. We believe this performance puts us in select company among peers. We believe that we are well-positioned to benefit from higher interest rates, as our loans are largely floating rate, and our financing is primarily fixed rate. Our financing continues to provide us operational flexibility. As of the quarter's end, more than 67% of our debt matures in 2025 or later, and more than half of our debt is unsecured. In addition, our senior loan facility matures in 2024 and is non-recourse to the BDC. Our corporate line of credit is flexible, with no mark-to-market provisions. In terms of our investment activity, we are cognizant of macroeconomic and geopolitical uncertainties and continue to remain cautious. We believe that our disciplined approach, along with the strength of our balance sheet, has enabled us to deliver solid performance. We have relied on our longstanding investment process and the dedicated and experienced team of our advisors. Even with several unprecedented events impacting the economy, we continue to believe that we will benefit from this experience, which spans multiple asset classes and industries. Today, our advisor manages $3.1 billion across the loan and structured credit markets, and has worked through multiple credit cycles and global economic disruptions over the past 25 plus years. In this uncertain economic environment, which has been significantly impacted by inflation, rising interest rates, and geopolitical conflict, we believe we continue to be well-positioned both in terms of our portfolio as well as our liabilities. We believe that our portfolio remains defensively positioned, both in terms of seniority in the capital structure and industry selection. As a percentage of fair value, approximately 97% of our loan portfolio was senior secured at the end of the first quarter and is well-diversified across multiple industries. Our largest exposures are in healthcare, technology, business services, and manufacturing, and we continue to avoid highly cyclical industries such as oil and gas, metals, and mining. At this point, I'll turn the call over to Jeff Cerny, our Chief Financial Officer, to give you more details and color for the quarter.

Jeff Cerny, CFO

Thanks, Bilal. Good morning, everyone. We continue to be encouraged by our overall performance. Last quarter, we generated an increase of more than 2% in our net asset value from the prior quarter to $15.52, which is once again at a historical high. It is also 24% above our pre-pandemic level at the end of the fiscal year 2019. As Bilal said, our net asset value per share at this quarter exceeds our IPO price of $15 per share. And since our IPO, we've made cumulative distributions of $11.77 per share. This quarter, we increased our distribution to $0.29 per share, a seventh consecutive quarterly increase. We posted net investment income of $0.22 per share, and excluding the accrual of the capital gains incentive fee, our adjusted net investment income of $0.30 per share was strong and $0.02 above last quarter's distribution. To get into more specifics, the increase in our net asset value is primarily driven by higher fair value marks on select equity investments, as was the case with our equity investment in Pfanstiehl, as well as our equity investment in Vectren. Higher valuation marks on the equity portfolio were partially offset by lower margin and structured finance notes and more liquid senior debt investments due to spreadwise in liquid protocols. Since our IPO, we had invested $45 million in the equity or receive warrants in more than 40 portfolio companies. To date, we have net realized gains of approximately $23 million, which equates to a 1.8 times multiple on invested capital. As of March 31, our net unrealized gain is just over $70 million on the remaining invested capital of $17.7 million, which equates to approximately five times. We believe that these metrics demonstrate the strength of our investment process and are one of the reasons for a record net asset value. Once again, we had no new non-accruals this quarter. We have not had new non-accruals since the second quarter of 2020. At fair value, we have 2.1% of the loan portfolio on non-accrual. Turning to the income statement, total investment income was $10.9 million for the quarter, down from $15.3 million in the prior quarter. This was primarily due to a decrease in dividend and fee income, including syndication fees, which were at very high levels in the prior quarter and can fluctuate from quarter to quarter, depending on portfolio investment activity. Also contributing to the decline in investment income was portfolio rotation out of certain higher yielding assets and lower amortization of deferred origination fees due to a lower portfolio turnout. Total expenses of $7.9 million were down $2.9 million from the prior quarter, primarily due to lower income and capital gains incentive fees. We also benefited from lower interest expense due to the full quarterly benefit of lower weighted average pricing on unsecured notes resulting from the November issuances and related free cash flow. As I just mentioned, net investment income was $0.22 per share for the first quarter. And on an adjusted basis, it was $0.30 per share after adding back our capital gains accrual. As Bilal discussed earlier this morning, we announced a distribution of $0.29 per share, a 3.6% increase in the quarterly rate and the seventh consecutive increase. We believe the strength of our platform and investment portfolio will continue to help drive healthy earnings. Our bond offerings last year helped to improve our capital structure and we remain focused on our liquidity and maintaining a healthy balance sheet. In the first quarter, we realized the full benefit of our new lower priced $55 million of unsecured debt issued in the fourth quarter. It is worth noting that 67% of our debt matures in 2025 or later, and 52% of our outstanding debt at quarter end is unsecured. Excluding the SBIC debt, our debt-to-equity ratio was stable quarter-over-quarter at approximately 1.4 times. Turning to our investments, we are pleased by the continued strong performance of our portfolio companies, with the majority of them posting positive revenue and EBITDA growth. We continue to have confidence in our underwriting selectivity, which increases the likelihood that the portfolio performs positively in the future. Several of our portfolio companies continue to identify opportunities for growth for which we are evaluating incremental funding. These opportunities give us relationship and informational advantages in making investment decisions. In terms of originations, we've deployed $15.1 million on add-on investments to existing portfolio companies, and $55 million in new investments in the first quarter while remaining cautious given the macroeconomic and geopolitical environment. The majority of our investments are in loans, and as of March 31, 97% of the loan portfolio was senior secured. In addition, over 90% of the loan portfolio consists of floating rates with variable rates that are subject to a LIBOR floor. As of March 31, the weighted average LIBOR floor was 85 basis points. With three-month LIBOR now well above 1% and statements by the Fed and other central banks that rates will continue to rise, we anticipate a positive impact on our net investment income over the coming quarters, as we have over 90% of our loan portfolio in floating rate loans, while the majority of our debt is fixed rate. As a percentage of cost, our overall investment portfolio includes approximately 74% senior secured loans, 8% subordinated debt, 19% structured finance notes, and 4% equity securities. Our portfolio remains diversified. At the end of the quarter, we had 95 portfolio investments, totaling approximately $557 million on a fair value basis, with an average investment size of $5.9 million or approximately 1% of the portfolio's total fair value. For the quarter ended March 31, the income yield on the investment portfolio, which includes all interest and amortization, deferred loan fees was 9%. With that, I'll turn the call back over to Bilal.

Bilal Rashid, Chairman and CEO

Thank you, Jeff. In closing, we are pleased with our first quarter performance. Our net asset value has continued to grow, driven by the performance of both our debt and equity investments. We increased our distribution for the seventh straight quarter, reflecting our view of our improved performance, and our expected outlook for the quarters ahead, even in light of this uncertain economic environment. Since the beginning of 2011, OFS has invested more than $1.7 billion with a cumulative net realized loss of just 2% over the last 11 years, while generating attractive yields on our portfolio. Our loan portfolio is almost completely comprised of senior secured loans, standing at 97%. And our financing is primarily long term, with 67% of our debt maturing in 2025 and beyond. In addition, more than half of our outstanding debt is unsecured. We believe that this gives us operational flexibility to execute on our business plan. Lastly, we believe the size, experience, and reputation of our advisors continue to benefit our business. With a $3.1 billion corporate credit platform within a more than $30 billion Asset Management Group, our advisor has broad resources, including longstanding banking and capital markets relationships. It has gone through multiple credit cycles over the past 25 years and has a strong alignment of interest with a 22% ownership of the BDC. With that operator, please open up the call for questions.

Operator, Operator

We will now begin the question and answer session. The first question comes from Mickey Schleien with Ladenburg. Please go ahead.

Mickey Schleien, Analyst

Yes. Good morning, everyone. Hope you're all well. Bilal, with all this volatility in the private markets for much of this year. Are you seeing more deal flow migrating to direct lenders like OFS? And what kind of quality are you seeing in the pipeline?

Bilal Rashid, Chairman and CEO

Yes. So, Mickey, I think that we're not seeing yet because of the volatility in the public markets. I mean, we're not seeing a lot of deal flow coming in from that market to the private markets, certainly in the lower middle market where we play. But I think that it's still early as it relates to the volatility in the public markets. So, that may happen over time. And with respect to the quality of the deal flow, I think the quality still remains fairly good. We're not seeing any major changes in the quality of the deal flow compared to before this whole volatility began. So, again, I think it's still early in this high volatility environment. But so far we are seeing relative stability in the private lending market.

Mickey Schleien, Analyst

Bilal, that volatility in the public markets is obviously reflecting all these headwinds, whether it's inflation or the political unrest in Europe, or Fed tightening. You and the rest of your team have a lot of experience in the credit markets. So, we have defaults at record lows and all this volatility. What's your view on the trajectory for defaults over the next couple of years?

Bilal Rashid, Chairman and CEO

Yes, that's a great question. We consider this frequently. As you mentioned, there are two main risks: inflation and the possibility of a recession. Both occurring simultaneously clearly presents challenges for the economy. Our approach has been consistent with how we have addressed these issues before. We prioritize staying senior secured in our capital structure, and the majority of our loan portfolio reflects that senior secured position, which helps to lessen some of the risk. Given an environment with inflation and a potential recession in the next few years, it's likely that we will see an increase in default rates across the industry. However, I believe that our capital structure will help mitigate that risk. Additionally, our team's extensive underwriting experience through multiple credit cycles will certainly aid us in navigating this uncertain environment.

Mickey Schleien, Analyst

Thanks for that explanation, Bilal. That's helpful. But if I can ask, in terms of the senior secured portion of the portfolio. How does that break down between first-lien unitranche and second-lien?

Jeff Cerny, CFO

Yes. Mickey, thanks for the question. This is Jeff. So, about 15% to 16% in second-lien, and the remainder is first-lien. I don't have a split out at my fingertips as I would consider unitranche, but I would say that most of our unitranche loans are still at relatively low leverage points. And I would say that our second-lien book tends to be a little larger, a little more liquid type names, and it's a pretty granular portfolio. So most of the names there tend to be smaller than the average size. So, we feel really good about the quality of our book. And quarter-over-quarter, we've continued to see revenue and EBITDA growth with the vast majority of the businesses. So we have very limited companies on the watch list. So we feel very, very good about the portfolio.

Mickey Schleien, Analyst

Thanks, Jeff. That's helpful. My last question, obviously, the forward LIBOR and SOFR curves are steep, and nominal rates on your debt investments could go up fairly sharply over the near term, and I think you talked about that in your prepared remarks. But that's going to make debt a lot more expensive for borrowers over time. How much of that increase in nominal rates do you think private lenders like OFS will retain versus maybe seeing some spread compression due to competition or just to help support your portfolio companies?

Jeff Cerny, CFO

Given that LIBOR and SOFR represent a relatively minor part of our overall coupon, we've seen similar situations in the past, like in 2019 when LIBOR spiked significantly. Despite three-month LIBOR rising from 30 basis points to over 2%, the portfolio remained resilient. As we anticipate further increases in floating rates, we do expect some pressure on companies. However, we’ve incorporated that risk into our downside models for these investments. We consistently include interest rate sensitivity to maintain a sufficient cushion, and we do not foresee this being a major concern for our portfolio.

Mickey Schleien, Analyst

That's interesting and helpful. Thanks, Jeff. Those are all my questions this morning.

Jeff Cerny, CFO

Thanks, Mick.

Operator, Operator

This concludes our question and answer session and today's OFS Capital Corporation first quarter 2022 earnings call. Thank you for attending today's presentation. You may now disconnect.