OFS Capital Corporation (NASDAQ:OFS) Q4 2022 Earnings Call Transcript

OFS Capital Corporation (NASDAQ:OFS) Q4 2022 Earnings Call Transcript March 3, 2023

Operator: Good morning, and welcome to the OFS Capital Corporation Fourth Quarter and Full Year 2022 Earnings Conference 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: Good morning, everyone, and thank you for joining us. Also on the call today are Bilal Rashid, our Chairman and Chief Executive Officer; and Jeff Cerny, the company’s Chief Financial Officer and Treasurer. Before we begin, please note that the 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 Capital 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: Thank you, Steve. Good morning. We closed out 2022 with another solid increase in net investment income in the fourth quarter. As the vast majority of our loan portfolio is floating rate, higher base rates and higher spreads have increased our earnings power. This helped us increase our distribution by 10% to $0.33 per share to be paid in March 2023. This represents an 18% increase compared to one year ago for the first quarter of 2022. This is also our ninth quarterly increase over the past 10 quarters. Our net asset value remain relatively stable, decreasing by less than 1% to $13.47 per share. This slight decline from last quarter was primarily due to unrealized depreciation. Our net investment income increased to $0.35 per share in the fourth quarter, up from $0.33 per share in the third quarter.

In the second half of the year, we were able to realize the benefits of positioning our balance sheet in advance of a rising interest rate environment. Our portfolio is primarily comprised of floating rate senior secured loans and is well diversified across multiple industries. Our balance sheet is primarily financed with long-term fixed-rate debt. We expect this combination will continue to provide tailwinds to our net investment income if the Fed continues to increase interest rates, as is widely assumed, as they continue to fight inflation. The overall credit quality of our portfolio companies remains solid and we are not seeing any systemic issues among them. Based on our interactions with these companies, we believe the cost of corporate borrowing remains manageable in this rising interest rate environment.

Our long-standing investment discipline has helped us to avoid investing in highly cyclical industries. We are defensively positioned with our largest sector exposures in manufacturing, healthcare, business services and technology. As has been widely reported, deal activity in the middle market has been slow as overall M&A activity has been muted. We expect that in the second half of the year, as we get more clarity on the Fed’s decisions and its impact on inflation, M&A activity will begin to pick up. In the meantime, we are being deliberate in putting capital to work. We continue to manage our portfolio conservatively as we have done through multiple credit cycles. Our financing continues to provide us with operational flexibility. At the end of the fourth quarter, 100% of our outstanding debt matures in 2025 or later and approximately half of our debt is unsecured.

As we have previously noted on our calls, last June, we extended the maturity of our $150 million senior loan facility with BNP Paribas by three years to June 2027. This facility is nonrecourse to the BDC. Our corporate line of credit is flexible with no mark-to-market provisions. And in 2021, prior to the Fed increasing rates at a historically high and fast rate, we locked in $180 million of fixed-rate unsecured debt at rates that are notably lower than current market pricing. This combination of financings has enabled us to benefit from rising interest rates and we expect to continue to see the benefits in the first quarter and beyond. As it relates to the economy, it is difficult to quantify the impact of rising interest rates and inflation.

However, we believe that being at the top of the capital structure with the majority of our loan portfolio being senior secured helps us in this uncertain economic environment. We also expect to continue to benefit from the experience of our adviser, which manages approximately $3.9 billion across the loan and structured credit markets, has experience in multiple asset classes and industries and has a 25-plus year track record through several credit cycles. 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.

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Jeff Cerny: Thanks, Bilal. Good morning, everyone. As Bilal mentioned, we posted net investment income of $0.35 per share for the quarter. This compares favorably to our prior quarter’s net investment income of $0.33 per share. Due to the continued strength of our net investment income, the Board once again increased our quarterly distribution to $0.33 per share, which is up 10% from last quarter’s distribution of $0.30 per share and up 18% from the prior year period. Comparing net investment income quarter-over-quarter, we are up over 8%, in large part due to the rising interest rate environment coupled with the thoughtful construction of our balance sheet. We saw improvements quarter-over-quarter with higher interest and dividend income, offset slightly by lower fee income.

The lower fee income was partly driven by our continued cautious approach to originations given the uncertainty and overall state of the economy. The positioning of our balance sheet will increase the likelihood that our performance will remain strong in this rising rate environment. Our net asset value per share decreased by less than 1% to $13.47 per share. As Bilal noted, despite the modest decline, year-end 2022 net asset value remains approximately 8% above its pre-pandemic level at the end of 2019. The decline this quarter was primarily related to some unrealized depreciation on our investment portfolio. Credit trends in our portfolio remained relatively stable, although we did see some incremental spread widening in the quarter which led to some unrealized losses.

We also had a few borrowers that showed some deterioration in credit performance, including placing a small loan on non-accrual. At fair value, we currently have just 2.2% of our total investments on non-accrual. Turning to the income statement. Total investment income was $14 million, up from $13.4 million in the prior quarter. As I previously mentioned, this was primarily due to an increase in interest income, reflecting the rising interest rate environment as well as an increase in our dividend income. Total expenses of $9.3 million were up from last quarter’s $9 million, primarily due to higher interest expense due to increasing interest rates on our variable rate credit facilities. As I mentioned earlier, net investment income was $0.35 per share for the fourth quarter.

This is a nice increase compared to last quarter’s net investment income of $0.33 per share. We continue to believe that earnings tailwinds exist given that the vast majority of our loan portfolio is floating rate while 69% of our liabilities are fixed at rates lower than current market levels for fixed rate debt. It is also worth noting that at quarter’s end, all of our outstanding debt matures in 2025 or later and approximately 54% of our outstanding debt at quarter’s end was unsecured. Excluding the SBIC debt, our debt-to-equity ratio decreased modestly quarter-over-quarter to approximately 1.58 times with slightly lower debt balances partially offset by lower fair value on our investments. Turning to our investments. We are pleased by the continued performance of our portfolio companies in this uncertain macroeconomic environment.

We remain committed to being senior in the capital structure and selective in our underwriting. While we remain cautious with regard to new originations, several of our portfolio companies continue to identify add-on opportunities for growth, for which we either fund it in the fourth quarter or are evaluating incremental funding in the first quarter. As we have said in the past, in our opinion, knowing the company and its management team especially in today’s macroeconomic environment gives us relationship and informational advantages in making these investments. The majority of our investments are in loans. And as of December 31, nearly 100% of the loan portfolio at fair value was senior secured. In addition, at quarter’s end, 94% of the loan portfolio was floating rate and there has been a meaningful increase in benchmark interest rates.

For instance, during the fourth quarter, three-month LIBOR increased by approximately 1% to 4.77% at quarter’s end and similarly three-month SOFR increased by approximately 1% to 4.59% at quarter’s end. The Fed increased rates twice during the fourth quarter for an aggregate increase of 125 basis points and the Fed increased rates by another 25 basis points so far in the first quarter of 2023 with the next FOMC meeting set for later this month. We continue to see an upward trajectory for interest rates so far this quarter in both LIBOR and SOFR, although less of an increase compared to the past few quarters. As a percentage of cost, our overall investment portfolio includes approximately 71% senior secured loans, 3% subordinated debt, 21% structured finance notes and 5% equity securities.

Our portfolio remains diversified. At the end of the quarter, we had 86 portfolio investments totaling approximately $501 million on a fair value basis with an average investment size of $5.8 million or approximately 1% of the portfolio’s total fair value. For the quarter that ended December 31, the investment income yield on the interest-bearing portion of the portfolio was 12.7%, which includes all interest and amortization of deferred loan fees. This 110 basis point increase from last quarter is meaningful, reflecting the floating rate nature of our portfolio in this rising rate environment. With that, I’ll turn the call back over to Bilal.

Bilal Rashid: Thank you, Jeff. We are pleased with our continued ability to grow net investment income in this rising interest rate environment. We are also pleased with how our balance sheet positioning has served us well with the vast majority of our loan portfolio being floating rate and 69% of our outstanding debt being fixed rate. In addition, we expect to continue to benefit from our focus on capital preservation with nearly 100% of our loan portfolio being senior secured at fair value, and we remain confident in the overall quality and fundamentals of our portfolio. Our financing is primarily long-term with all of our outstanding debt maturing in 2025 and beyond. As this uncertain economic environment continues, we will rely upon our long-standing experience and investment discipline to guide us.

Since the beginning of 2011, OFS has invested more than $1.9 billion with a cumulative net realized loss of just 2% over the last 12 years while generating attractive yields on our portfolio. Lastly, we believe the size, experience and reputation of our adviser will continue to benefit our business. With a $3.9 billion corporate credit platform within a more than $30 billion asset management group, our adviser has broad expertise, including long-standing banking and capital markets relationships. Our corporate credit platform has gone through multiple credit cycles over the last 25-plus years. It is also important to reiterate that OFS Capital’s adviser has a strong alignment of interest with shareholders with a 22% ownership stake in the BDC.

With that, operator, please open up the call for questions.

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Q&A Session

Operator: We will now begin the question-and-answer session. Our first question is from David Miyazaki with Confluence Investment Management. Please go ahead.

David Miyazaki: Hello. Good morning. I just have some questions for you regarding the changing interest rate environment. One of the larger BDCs who focuses on the upper middle market has made the comment that rising interest rates by themselves don’t cause defaults in the upper middle market. And I’m just wondering, how do you feel about that comment within the lower middle market and your portfolio and your target of potential buyers? Do you see that the higher interest rates are actually creating a bigger hazard in potential origination going forward? Or do you agree with that statement that it’s usually an operational issue that creates with the credit problems?

Bilal Rashid: Yes. I think that €“ David, thank you. That’s a very good question. I think that we generally agree with that statement. And I think it actually is a little more even positive for the lower middle market, and there’s a real technical or mathematical answer to that which is in the lower middle market, you generally will have a slightly higher spreads than the larger part of the middle market. And so the benchmark is a smaller percentage of the overall interest expense, and so the increase on a percentage basis in interest expense is slightly lower than what you would have on the larger part of the middle market. So I think that we are seeing that our companies at this point, with the rates increasing quite significantly over the last one year, are able to manage the higher interest burden.

And so I think we do agree that eventually if there are issues with the portfolio, that would be more related to overall weakness in the economic activity that may have been caused by higher interest rates. So €“ and certainly, we’re not seeing a recessionary environment right now. The economy is doing well. Unemployment is almost all-time low, and the consumer seems in pretty decent shape. So

David Miyazaki: Thank you. That’s interesting. I hadn’t really thought about the proportion of spreads being wider in the lower middle market. Do you €“ one of the things that you’ve obviously benefited from was managing floating assets versus fixed liabilities, which has been obviously very helpful for your company but also for the entire space. Do you €“ as you look forward, how do you feel about €“ I mean, first of all, I would think that your borrowers are also well aware of the Fed tightening phase. So was there any interest for them to perhaps fix out their borrowing? And if €“ as we look forward, would you have more interest in fixing out your assets given that we’re probably approaching the near €“ or nearing the end of the Fed’s tightening cycle?

Bilal Rashid: Yes. So that’s another very good question, David. So I think on the first point, we are not seeing any demand or any request from the borrowers in terms of fixing the interest rates. I think that’s not been part of any discussions that we’ve had and I’m not seeing that in the broader market. I think as it relates to €“ from an asset liability management standpoint, thinking about potentially having fixed-rate assets, assuming that interest rates are going to peak at some point. I mean, I think, we’re at this point, we’re not there yet. It seems like there is some still some room for the Fed to grow interest rates, but €“ so I think it’s hard to time that. But I think we always want to look at our assets and liabilities and see that we are looking at the matching there.

Certainly, the mismatch is helping us right now with fixed rate liabilities and floating rate assets in a rising interest rate environment. But looking forward, it’s something that we are certainly cognizant of and I think €“ but we haven’t reached that point yet as we look to originate assets. And part of it is also that we are not seeing any demand from our borrowers to have fixed rate assets.

David Miyazaki: Okay. Thank you. And I guess the last question I have would be €“ and I’m just kind of thinking about all these things from a structuring perspective in that, as rates of €“ as a Fed has tightened that it’s benefited your company. I kind of think about the whole cycle and if rates began coming down, one of the things that was helpful in the last easing cycle, of course, were the LIBOR floors and before the Fed was easing prior to the pandemic people were kind of setting in floors around a 100 basis points of LIBOR or SOFR, whatever the reference rate is. And it seems to me like right now with the Fed’s still in its tightening cycle and LIBOR or SOFR so far above that level that it would almost be somewhat costless or free to move the floors up much higher to 200 basis points and 250 basis points.

When nobody thinks that the rate is going to come back down, then you kind of get some free negotiating strength, I should in the documentation. And I’ve asked this of lenders in the upper middle market, and they really don’t €“ in general seem to think that’s a priority, ostensibly, because they don’t think that the rates are going to come back down again. But when you think about the whole cycle, is there an opportunity for you to underwrite loans in the lower middle market where you have more negotiating power and more ability to sort of individualize the loan documents? Do you think about putting in higher LIBOR or SOFR floors into your documentation?

Bilal Rashid: Yes, David, that’s another excellent question. We are looking at that as well. In fact, we were recently looking at a transaction where we were requesting a 2% floor, for example. So that’s something that we are definitely contemplating. And in fact as we look at new originations, we’re certainly asking for higher floors. So, perhaps going from 1% to 2%, I think as you said when rates are this high and nobody’s thinking about interest rates going down anytime in the near future, it’s something that is that people will be quite amenable to or I should say, they’ll be more open to. And so we’re certainly thinking about it and in fact asking for it. And then we’ll see how successful we are in that regard. But yes, certainly it’s on our mind.

JeffCerny: Hey, David, this is Jeff. It’s also a competitive issue and it’s one of many terms in a term sheet and yes, if we can push for a higher floor, we have attempted to do that. But it does become a bit of a competitive issue and as you’re negotiating a term sheet on a new transaction.

David Miyazaki: Okay. Great. Well, I appreciate all the details on a whole range of different questions I had for you. It helps and the nature of your underwriting and how you’re looking at the landscape going forward, so I appreciate your time.

Bilal Rashid: Thank you, David.

JeffCerny: Thanks, David.

Operator: The next question is from David Prosky, a private investor. Please go ahead.

David Prosky: Hi, gentlemen. How you doing? I just wanted to ask you about the equity investments and in particular, the Pfanstiehl. If you could give us a little color on how it’s doing and what your thoughts are?

JeffCerny: Yes, good morning, David. Yes, thanks for the question. This is Jeff. Yes, Pfanstiehl has been a very good performer. We’re certainly mindful of the concentration risk here, and we’re a minority investor in this entity, so we don’t control it. But we are continually looking for ways to monetize our investment and maximize value. I will note that this is a very conservatively levered company and a very conservatively run company. So they have a lot of flexibility to manage the business to manage through cycles. But it’s been a historically strong performer and it’s top of mind and we’re always looking at ways to monetize this investment and maximize its value.

David Prosky: Okay, fair enough. And any other major equity investments outside of Pfanstiehl?

JeffCerny: I think that’s €“ yes, that’s by far the biggest nothing that I would note. No.

David Prosky: Okay. Great quarter. Thank you very much.

Bilal Rashid: Thank you, David.

JeffCerny: Thanks, David.

Operator: This concludes our question-and-answer session. And the conference has also now concluded. Thank you for attending today’s presentation. You may now disconnect.