Rand Capital Corp Q2 FY2021 Earnings Call

Greetings. Welcome to the Rand Capital Corporation Second Quarter 2021 Financial Results Conference Call. At this time, all participants are in a listen-only mode. A question-and-answer session will follow the formal presentation. Please note, this conference is being recorded. I'll now turn the conference over to your host, Deborah Pawlowski, Investor Relations for Rand Capital. You may begin.

Thank you, Shamali, and good afternoon, everyone. We appreciate your interest in Rand Capital and for joining us today for our second quarter 2021 financial results conference call. Here with me today are Pete Grum, our Chief Executive Officer; and Dan Penberthy, our Executive Vice President and Chief Financial Officer. You should have a copy of the release that crossed the wire this morning as well as the slides that will accompany our conversation today. If not, they are available on our website at randcapital.com. If you are following along on the slide deck and would turn to Slide 2, I would like to point out some important information. As you are likely aware, we may make some forward-looking statements during this presentation and during the question-and-answer session. These statements apply to future events that are subject to risks and uncertainties as well as other factors that could cause actual results to differ from where we are today. You can find a summary of these risks and uncertainties and other factors in the earnings release as well as in other documents filed by the company with the Securities and Exchange Commission. These documents can be found on our website or at sec.gov. During today's call, we will also discuss some non-GAAP financial measures. We believe these will be useful in evaluating our performance. You should not consider the presentation of this additional information in isolation or as a substitute for results in accordance with GAAP. We have provided reconciliations of non-GAAP measures with comparable GAAP measures in the tables that accompany today’s release and in the slide. So with that, if you would turn to Slide 3, I will hand the discussion over to Pete to begin. Pete?

Thank you, Deb. Good afternoon, everyone. We continue to execute our strategy as we focus on evolving our portfolio from equity investments to income-producing investments, with the goal of driving investment income and ultimately delivering higher cash distributions. For the quarter, our total investment income grew 20% to $811,000. Net asset value per share of $22.51 was up 7% and 26% from the sequential first quarter and year-end period, respectively. The sequential increase largely reflects unrealized appreciation of our investment in Open Exchange following their equity financing by new non-strategic outside investors. The change from year-end reflects the increase in fair value of our investments in ACV Auctions, which completed their IPO at the end of March. During the quarter, we sold our investment in GiveGab, a software company that we've owned since 2015. Our equity investment of $616,000 netted us a recognized gain of $1.8 million. This is consistent with our strategy of transforming our portfolio from equity into debt. During the quarter, we accrued $1.1 million in noncash expenses related to capital gains incentive fees, which were primarily a result of realized gains from the sale of GiveGab and the increase in unrealized appreciation mostly related to Open Exchange. The accrual will be adjusted on a quarterly basis. As a result, we reported a GAAP net investment loss of $0.31 per share. Absent this expense, adjusted net investment income was $0.10 per share. We announced and paid our regular quarterly dividend distribution of $0.10 per share during the second quarter. And at the end of July, we announced our third quarter dividend distribution also $0.10 per share. So far this year, we have declared $1.63 per share in dividends, including the $1.33 per share that was declared at the end of last year but paid in 2021. If you turn to Slide 4, we can discuss the progress we have made regarding the evolution of our investment portfolio to support our strategy. The 14% increase in fair value shown here reflects the impact of Open Exchange, which now has a fair value of $5.6 million, an increase of $4.9 million during the year. The fair value of all of our investments increased by $7.5 million. At quarter end, our portfolio was comprised of approximately 55% equity investments, 36% in fixed-rate debt investments and 9% in dividend-paying publicly traded BDCs. During the quarter, we made $4.6 million in new and follow-on investments and received $2.4 million from the one exit we discussed and the other loan repayments. These transactions are highlighted on Slide 5. The largest investment during the quarter was for ITA Inc and totaled $3.9 million; $3.4 million consisted of 12% term notes and $500,000 was in equity. ITA manufactures a wide variety of window covering components and finished wood treatments, including wood, faux wood, and fabric shades, shutters, and blinds for residential and commercial applications. The follow-on investment was provided to Mattison Avenue Holdings, LLC, a high-end salon suite business that provides customized fully furnished salon and spa studio space for lease in prime locations for individual stylists, barbers, massage therapists, nail technicians and estheticians, these works as well as for individualized services such as acupuncture. Our $667,000 follow-on investment consisted of a 14% promissory note. In total, we now have $1.8 million investment in Mattison at the end of the quarter. The charts on Slide 6 illustrate the diversity of our portfolio and the change in industry mix since the 2020 year-end. With the investment we recently made, the impact of the investments at fair value changes, software, and health care saw notable changes, while most of the other industries were within 1 point or so during that period. We like the diversity of our portfolio and believe it reduces our exposure to market risk. Slide 7 lists our top 5 portfolio companies at quarter end. There are 2 new companies on the list. Open Exchange, which saw a measurable increase in its fair value and ITA with the new investment. ACV's fair value came down about $1.7 million during the quarter, which followed the significant jump during the first quarter given their IPO. Their valuation on our portfolio represents 24% of net assets. Our ACV holdings consist of 147,645 Class A common stock and 442,935 of Class B common stock. The Class A shares are freely tradable, while the Class B are still restricted and non-tradeable through September 20, 2021. We have discounted our valuation due to these current restrictions. As a reminder, any proceeds for us above our investment of $163,000 will be considered a capital gain and treated as such, as it relates to any dividend or distribution. With that, I'm going to turn it over to Dan to review our financials in greater depth.

Thanks, Pete, and good afternoon, all. Slide 9 provides an overview of our financial summary and our operational highlights. Total investment income for the quarter was $811,000, a 20% increase over last year and does reflect the shift in our portfolio profile to more interest-yielding assets. In total, 23 portfolio companies generated income compared with 13 in the prior year period. This quarter's total investment income also benefited from approximately $137,000 of dividend income, which was up 45% over last year's second quarter. This was primarily comprised of dividends received from our BDC investment portfolio. Total expenses in the quarter were $1.6 million, up from $476,000 in last year's second quarter. The change was largely due to the addition of $1.1 million of accrued capital gains incentive fees during the quarter, which Pete has already discussed. This incentive fee accrual was a result of the sale of GiveGab and the unrealized appreciation on Open Exchange's portfolio value. As a reminder, a capital gains incentive fee accrual under GAAP is calculated using the cumulative aggregate realized capital gains and losses and the aggregate net change in unrealized capital appreciation and depreciation at the close of the period. Operating expenses in the quarter, of which a non-GAAP financial measure excludes the capital gains incentive fee accrual, increased $84,000 or 18%, mostly because of the increase in the base management fee payable to Rand's investment advisor resulting from the increased portfolio asset values. Net investment loss was $811,000 or $0.31 per share. Excluding the accrued capital gains incentive fees, adjusted net investment income per share was $0.10 compared with $0.08 per share in the prior year period. Even with the increase in expenses, net assets from operations increased $4.5 million or $1.74 per share. Slide 10 provides a waterfall graph for the change in NAV for the quarter. The increase was primarily due to the change in the fair value of Rand's investment in Open Exchange, which was reflected in the $3.5 million net change in unrealized depreciation on the portfolio investments. Also contributing to the NAV increase was a net realized gain on the sale of GiveGab, which Pete has discussed. We also paid out approximately $260,000 of cash dividends. Slide 11 highlights the strength of our balance sheet. We have approximately $16 million in liquidity for new investments. This includes $3 million of availability for borrowing under our SBIC debentures. The $10.8 million currently owed to the SBA matures over a long multi-year period. However, that begins next year in September when $3 million is due. As required to maintain our RIC status, we will continue to distribute at least 90% of our calendar year qualified income to our shareholders in the form of dividends. Our annualized dividend rate of $0.40 is based on our initial conservative estimates of our 2021 net investment income and is reviewed quarterly based on our actual year-to-date GAAP and estimated tax results. Later in the fourth quarter, we will then review all sources of GAAP and tax-based income, including those from short- and long-term capital gains which may result in additional 2021 distributions over the previously distributed regular quarterly cash dividend estimates. The final determination and calculation of our tax-based distributable income for each year are finalized in September of the following year in conjunction with our corporate tax return filings. This is commonly referred to as a spillback dividend. Our current share repurchase program authorizes the purchase of up to $1.5 million in stock and expires next year in April of 2022. We did not repurchase any stock during the second quarter. As we look forward, with the support of our strong liquidity position, we believe we can continue to execute our strategy to grow our portfolio, drive investment income and support a growing dividend. That completes our prepared remarks. Operator, please open the lines for questions.

Our first question is from Sam Rebotsky with SER Asset Management.

The ACVA, which is currently valued at $23.62, what was the value on June 30 that we used?

We recorded a write-down of $1.7 million, which was partly due to changes in market value and partly due to adjustments in the discounts we applied because of limited marketability at that time.

Sam, the Class A at June 30 was $24.85 and the Class B was $23.61.

So out of the $1.60 million in capital gains, we paid the $3.6 million. How much is that related to the ACVA?

Well, I don't think we've paid anything. We have accrued.

Accrued, right, Okay. What amount that we accrued would you say is attributable to the ACVA?

I can't do that off the top of my head, but I'll certainly get back to you.

Sam, I think you're mixing up a couple of items here. The $1.6 million in gains is primarily driven by GiveGab, so I apologize for the confusion regarding the realized gains. There is a capital gains incentive fee of $1.60 million that was accrued during the quarter, most of which is due to unrealized appreciation on Open Exchange, along with some offset by the depreciation in ACV during the quarter. If you recall, we had ACV valued at $26.79 at the end of the March 31 quarter, which was adjusted downward to the $24 figures that Pete mentioned based on the closing stock price at June 30.

Okay. And the $3.6 million?

That includes the total capital gains incentive fee if, in theory, the portfolio were to liquidate at its closing values at June 30 based on the realized gains and losses and unrealized activity.

Okay. So are we satisfied with whether we have another ACVA in our portfolio?

Sure. Of course, we do, Sam. We have a...

Sam, the portfolio is assessed quarterly based on market value, which reflects the corporation's estimates of fair value at that time. We cannot predict with certainty where things will be on September 30, 2021, let alone where they will stand in three to five years.

Okay. When the stock ran up 26, 27, what was that attributable to?

We were not responsible for that. We didn't have any news in there. This has happened periodically during my time here. When you have a thinly traded stock, people start talking about it, but we have no idea why. We do communicate with NASDAQ surveillance, and there was no information that we released to the market. So I don’t know, Sam, and I didn’t receive any calls before or after that.

Yes, I heard someone compared you to Warren Buffett's stocks. But we need to wait for shares. Did you hear those rumors?

No.

And our next question is from Brett Davidson, who is a private investor.

And forget about whether you heard the rumors, are they true?

You mean that I'm the next Warren Buffett?

There you go. That's the important answer I want to hear. Is it true? I got a couple of questions. So I heard in the presentation and tried taking all into account as far as adjusting the dividend. And so it looks like yearly, it's going to be done after the close of the year. Any adjustment would be done later, but subsequent year, how will that play into adjusting the quarterly dividend? Or are most of these adjustments going to be done on a one-time special, sometime later in the subsequent year?

I'll respond based on what I believe I heard. We intend for the quarterly dividend to be set conservatively, aligned with our projected net investment income. We plan for the future and the Board along with management reviews this to ensure it is a sustainable dividend, with the expectation that it will increase over time. I'll hand it over to Dan to discuss the processes involved, especially concerning capital gains, as this relates to tax implications which can result in some timing variations.

Yes. So at the beginning of the year, we project out what we think is going to happen for the year based on our investment portfolio. Since we are in a debt portfolio, we do experience more debt repayment, which often happens unexpectedly, which does have a negative effect on the deterioration of our income, obviously. And so we monitor that quarterly, and we prepare an analysis and determine where we think the year will end up. And then so that is done each quarter. And then as we get to the fourth quarter, we'll then tighten those numbers down as we prepare an initial tax estimate based on our actual projected results for the full calendar year 2021. And as Pete mentioned, those will have two components. The first will be a capital gains component, which will be more kind of just a one-time type dividend annually because that's based on capital gains, net capital gains, offset by losses, obviously, that we may have had. And then we also look at operating income for the year, and we do an initial tax calculation with our third-party tax advisors trying to get as precise a tax model as you can on your income because we strive to make sure we distribute out at least 90% of our income during the calendar year or in the immediately January following the conclusion of the year, and all that is attributable to 2021. Then what happens is when the final tax returns are done, hopefully, we've done our job well enough with our outside advisors that there's minimal adjustment that's needed for 2021 on a tax basis based on our final tax return calculations. And that work will be done is being done currently with an expectation of our tax returns being filed typically in September. And that is what I referred to as that spillback dividend. And we would think that would be a minor amount, but we don't know until we're to the conclusion of the tax returns, and that would be included as a one-time adjustment to the upcoming quarter's tax numbers. This is now the first time through all these RIC calculation processes on a tax basis. So some of this is still subject to change, but that is the fundamental thesis. Well, we look at it quarterly, we tighten it down in December for the calendar year and then we go back and proof our numbers in August and September to see if there's a plus or minus adjustment that needs to happen for tax purposes.

My particular interest is in how that's going to be paid. So capital gains, that's going to be a one-time thing. So say that the estimate for the income that was used to base that $0.10 quarterly dividend is wrong by a dime. So is that going to result in a one-time $0.10 dividend? Or is that going to be spread over the subsequent year's quarterly?

I believe that it has to be paid during the year. Also, you would lose your RIC status. So it would be paid, and it won't be distributed over the following years.

Yes. I don't believe it will be spread. However, I will stress again that this is in consultation with our third-party RIC tax advisors. And so we need to take that into consideration. But I also believe it would be a one-time adjustment to the dividend. And the Board at its election can determine whether that be a cash stock or other form of distribution.

Well, I would think it would need to be a cash, wouldn't it, if it requires the distribution of the earnings?

You can do cash or you can do a combination of the cash and stock with some limitations.

There's minimum cash requirements that have to go out, but that is also to be discussed at the Board level on a quarterly and annual basis.

All right. So correct me if I'm wrong here. So then the dividend for the subsequent year will be set prior to that year, and it will result in up or down adjustment in the quarterly dividend. And then for the spillback and any capital gains, those would ordinarily result in one-time dividends.

Yes, it would be an adjustment to the third-quarter dividend, most likely.

Okay. So it will be an adjustment to one quarter's dividend then?

But we'll differentiate when we...

That's right.

Yes. We'll make it very clear. This is the regular quarterly dividend.

Here's our $0.10 plus whatever the adjustment is; just this is the $0.10 we just issued in July. Here's $0.10 plus the extra amount or we have to offset the number because the net real number for last year was make up, subtract if any. We don't know what the number is until the final tax calculations occur.

Yes. Understood. Next question I'm interested in. Is there any kind of exit strategy for ACV?

Yes, we examine our liquidity and upcoming needs along with our expectations for price movement, using our own analysis. However, we are not focused on holding public shares. Historically, we plan to divest over time, as we have done in the past.

So you said over time, that means this isn't like an all or none operation here?

Of course, you wouldn't want us to give you insight or information. Would you?

No, no, no. I'm just talking about the character of the transaction as I'm not looking for specifics or any timing.

Our goal is to convert equity investments into cash and use that cash to fund interest-paying debentures or loans, among other options, in order to enhance our ongoing dividend by changing equity into debt.

Yes. From an all or none perspective, this won't be a quick decision where we exit ACV in just a day or two. This process might take place over a span from the start of one year to the end of the next. Is that a fair characterization?

I wouldn't characterize it either way. We own 500,000 shares. It's a $4 billion company. Our decision will depend on the alternatives for investing the money, considering our assessment of the current price compared to our expectations.

All right. Let me rephrase it. Is there a certain time period that this has to occur over? Is there an end date that this has to occur by?

No.

Okay. So this could conceivably take place over a period of time and not necessarily, once you decide to sell, it has to be completed within a week or whatever.

Right.

Okay. Are you aware of any other investments that are currently looking to take advantage of the atmosphere in the public equity markets? Is there anybody that you've got feedback from that's looking to maybe do an IPO? Or is something you guys wouldn't ordinarily be privy to?

We wouldn't disclose it in the conference call.

I'm looking for some clarity on the transaction that led to the sale of the GiveGab position. Was it a decision made by them, or did you find a buyer for your investment?

The company completed the sale, and that was our share of it. As you might expect, COVID affected each company differently. They were involved in online fundraising and had been experiencing consistent growth. Overall, we are in a good position and had several opportunities to provide liquidity, and they chose this option until the entire company was sold.

Is that information available online? Or can you give some idea what that transaction involved? Was it private equity? Or...

It was acquired, and all the information is available online. If you search for GiveGab on Google, you'll find details about every action and acquirer related to it, specifically from April 15 from the nonprofit perspective. No transaction price was disclosed, but you can likely discover a lot if you look it up.

Yes. Yes. I think I can probably figure that one out. So thanks so much. And I appreciate it, and that’s pretty much all I had. Thanks, guys.

Our next question is from Ross Haberman with RLH Investments.

I had just 2 follow-up questions about ACV. I got on a little late. If I understand right, you have about 353,000 of the B shares currently?

I'm going to tell you, not approximately I'm going to tell you exactly. We have 147,645 shares of the Class A and 442,935 of the Class B.

When can you register the B to sale?

I believe that the B sales will become freely tradable after September 20.

And if I understood it right, you marked the whole position of roughly, I don't know, $23.5 to $24 as of the end of the quarter. Is that correct? Or was this...

We used the last three trading days of the quarter for our valuation. For Class A, there is no discount since it is freely tradable. However, for Class B, we applied a 5% discount to account for the restrictions.

I understand your point. The total carrying value is $14 million at the end of the quarter.

Yes, sir.

Operator?

We have reached the end of the question-and-answer session. I'll now turn the call over to Pete Grum for closing remarks.

Thank you very much, and thank you for joining us today and for your interest in Rand Capital. We look forward to updating all of you on our third quarter 2021 results in November, and have a great day.

This concludes today's conference, and you may disconnect your lines at this time. Thank you for your participation.