OFS Capital (NASDAQ:OFS) Q3 2022 Results Conference Call November 4, 2022 10:00 AM ET
Company Participants
Steve Altebrando – Vice President, Capital Markets
Bilal Rashid – Chairman and CEO
Jeff Cerny – Chief Financial Officer and Treasurer
Operator
Good day, and welcome to the OFS Capital Corporation Third Quarter 2022 Earnings Call. All participants will be in listen-only mode. [Operator Instructions] After today’s presentation, there will be an opportunity to ask questions. Please note that this event is being recorded.
Now I’ll turn the call over to Mr. Steve Altebrando. Please go ahead, sir.
Steve Altebrando
Good morning, everyone, and thank you for joining us. Also on the call today are 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 third 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 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. In the third quarter, we began to see the greater benefits of our balance sheet positioning in this rising interest rate environment. Our portfolio is mostly comprised of floating rate senior secured loans and our balance sheet is primarily financed with long-term fixed-rate debt.
With the Fed continuing to increase interest rates, we expect these tailwinds to continue. Our adjusted net investment income increased to $0.33 per share in the third quarter, up from $0.24 per share in the second quarter. This increase was primarily due to rising interest rate coupons on our loan portfolio.
As a result of this solid performance, the Board increased the distribution to $0.30 per share, a 3.4% increase over the prior quarter and a 20% increase over last year’s fourth quarter distribution. We believe our portfolio remains well positioned.
At the end of the third quarter, as a percentage of fair value, approximately 99% of our loan portfolio was senior secured and is well diversified across multiple industries. There were no new nonaccruals this quarter. Our largest sector exposures are in health care, technology, business services and manufacturing. Equally important is our long-standing avoidance of highly cyclical industries.
Additionally, we recognize that while interest rates have increased compared to the historically low levels since the great financial crisis, we believe that the cost of corporate borrowing for our portfolio companies remains manageable. We continue to manage our portfolio conservatively as we have done through multiple credit cycles. Our financing continues to provide us operational flexibility.
At the end of the third quarter, 99% of our outstanding debt matures in 2025 or later and approximately half of our debt is unsecured. As we noted on last quarter’s call, in June, we extended the maturity date 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. Lastly, as you may recall, last year, we locked in $180 million of fixed rate unsecured debt at historically low rates, which we believe has also enhanced our strong positioning in this rising interest rate environment.
Turning to our net asset value per share. At quarter’s end, it stood at $13.58 down from $14.57 last quarter. We would like to note that despite the decline, our third quarter net asset value represents a 9% increase compared to its prepandemic level at the end of 2019.
The decrease last quarter was primarily due to unrealized depreciation as a result of markdowns on the equity portion of the portfolio, especially one equity investment in particular.
Jeff will discuss this in more detail. While we primarily invest in senior secured loans, we continue to believe that selectively making equity investments help us create additional value for our shareholders over the long term.
Since our IPO, we have invested $45 million in the equity, including warrants of more than 40 portfolio companies.
To date, we have net realized gains of approximately $23 million, which equates to 1.8x multiple on invested capital. As of September 30, our net unrealized gain is approximately $77 million on the remaining invested capital of approximately $18 million, which equates to a 5.4x multiple.
We remain disciplined in making investments and utilizing the strength of our balance sheet in this uncertain economic environment. In addition, we also expect to benefit from the experience of our adviser, which manages approximately $3.8 billion across the loan and structured credit markets has expertise in multiple asset classes and industries and has a 25-plus year track record.
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
Thanks, Bilal. Good morning, everyone. As Bilal mentioned, for the quarter, we posted net investment income and adjusted net investment income of $0.33 per share. This compares to our prior quarter net investment income of $0.47 per share and adjusted net investment income of $0.24 per share. Comparing adjusted net investment income quarter-over-quarter, we are up more than 37%. Not only did the rising rate environment contribute to our strong results, we saw improvements quarter-over-quarter in all categories of investment income, including higher interest income, dividend income and fee income.
We continue to take a cautious approach to originations given the uncertainty and overall state of the economy. We believe 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 to $13.58 from $14.57 last quarter.
As Bilal noted, despite the decline, our third quarter net asset value remains approximately 9% above its prepandemic level at the end of 2019. The decline this quarter was primarily related to some company-specific unrealized depreciation, in particular, in the equity portfolio. We had one investment in the post-secondary for-profit education sector that experienced a decline in fair value due to a decision by the U.S. Department of Education. It is worth noting that the investment was made nearly eight years ago, and it is the only investment in our portfolio in the post-secondary for-profit education sector.
We view this as a one-off situation and the investment was an equity appreciation rate with a cost basis of zero. We are not accruing any investment income on this position. We had no new nonaccruals during the third quarter and at fair value, we currently have just 2.4% of our total investments on nonaccrual.
Turning to the income statement. Total investment income was $13.4 million for the quarter, up from $10.4 million in the prior quarter. As I previously mentioned, this was primarily due to an increase in investment income reflecting the rising interest rate environment as well as increases in both dividend and fee income.
Total expenses of $9 million were up from last quarter’s $4.2 million, primarily due to the accounting for a noncash reversal of a portion of our capital gains fee last quarter.
As I mentioned earlier, adjusted net investment income was $0.33 per share for the third quarter. This is a significant increase compared to last quarter’s adjusted net investment income of $0.24 per share after adding back the reversal of the noncash capital gains fee accrual I just discussed.
Earlier this morning, we announced a distribution of $0.30 per share, an increase from the $0.29 per share from the prior quarter due to a stronger adjusted net investment income.
Compared to the fourth quarter distribution last year, the distribution has increased by 20%. We believe earnings tailwinds from higher interest rates benefited us in the third quarter with our loan portfolio being largely floating rate and our outstanding debt being primarily fixed rate.
It is worth noting that at quarter’s end, approximately 99% of our outstanding debt matures in 2025 or later and 51% of our outstanding debt at quarter’s end was unsecured.
Excluding the SBIC debt, our debt-to-equity ratio increased modestly quarter-over-quarter to approximately 1.66x. Much of this was attributable to unrealized depreciation on our investments as our debt balances were lower this quarter.
We continue to target our long-term debt-to-equity ratio of approximately 1.3 to 1.4x.
Turning to our investments, we are pleased by the continued performance of our portfolio companies in a tough macroeconomic environment. We believe that our underwriting selectivity and seniority in the capital structure will benefit our portfolio in the future.
While we remain cautious with regard to new originations, several of our portfolio companies continue to identify opportunities for growth, for which we are evaluating incremental funding. In our opinion, knowing the Company and its management team, especially in today’s macro environment, gives us relationship and informational advantages in making these investments.
The majority of our investments are in loans. And as of September 30, 99% of the loan portfolio is senior secured. In addition, 94% of the loan portfolio was floating rate and there has been a meaningful increase in benchmark interest rates.
For instance, over the last quarter, three-month LIBOR increased by almost 1.5% to 3.75% on September 30. And just this week, the Fed increased rates again by an additional 75 basis points, which continues to impact this quarter’s LIBOR.
Given this meaningful run-up in interest rates and the fact that 65% of our outstanding debt is fixed rate, we anticipate continued tailwinds on our net investment income for the fourth quarter and beyond.
As a percentage of cost, our overall investment portfolio includes approximately 73% senior secured loans, 5% subordinated debt, 17% structured finance notes and 5% equity securities. Our portfolio remains diversified. At the end of the quarter, we had 92 portfolio investments totaling approximately $517 million on a fair value basis with an average investment size of $5.6 million or approximately 1% of the portfolio’s total fair value.
For the quarter ended September 30, the income yield on the investment portfolio was 11.1%, which includes all interest and amortization of deferred loan fees. This meaningful increase of 250 basis points from the last quarter is substantial and is reflective of 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. In closing, we are pleased to see that in this rising interest rate environment, our balance sheet positioning has served us well with the vast majority of our loan portfolio being floating rate and 65% of our outstanding debt being fixed rate.
We expect to continue to benefit from our focus on capital preservation with 99% of our loan portfolio at fair value being senior secured. We believe the overall quality and fundamentals of our portfolio remain solid. Our financing is primarily long term with all of our outstanding debt maturing in 2025 and beyond.
In addition, approximately half of our outstanding debt is unsecured. We believe that this gives us operational flexibility to execute on our business plan. Through this uncertain economic environment, we believe our long-standing experience will continue to guide us.
Since the beginning of 2011, OFS has invested more than $1.9 billion with a cumulative net realized loss of just 1.9% over the last 11.5 years while generating attractive yields on our portfolio. Our net asset value has increased approximately 9% from prepandemic levels.
And lastly, we believe the size, experience and reputation of our adviser will continue to benefit our business.
With a $3.8 billion corporate credit platform within a $30-plus 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 years.
It is also important to reiterate that OFS Capital’s adviser has a strong alignment of interest with shareholders holding a 22% ownership stake in the BDC.
With that, Operator, please open up the call for questions.
Question-and-Answer Session
Operator
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