Gladstone Capital - Earnings Call - Q3 2019

Transcript

Speaker 0

Good day, ladies and gentlemen, and thank you for standing by, and welcome to the Gladstone Capital Corporation's Third Quarter Earnings Call. At this time, participants are in a listen only mode. Later, we'll conduct a question and answer session and instructions will be given at the appropriate time. As a reminder, today's conference may be recorded. It is now my pleasure to turn the call over to Mr.

David Gladstone. Sir, the floor is yours.

Speaker 1

Thank you and hello everyone. Thank you for calling in. This is David Gladstone, Chairman and this is the quarterly earnings conference call for Gladstone Capital for the quarter ending June 3039. Again, thank you for calling in. We're always happy to talk with our shareholders and analysts and welcome the opportunity to provide updates on the company and its investment portfolio.

Now we're going to start off with Michael LiCalsi. He is our General Counsel and make some statements with regard to forward looking statements.

Speaker 2

Thanks, David, good morning. Today's report 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 that are based on our current plans, which we believe to be reasonable. The main 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 in our Forms 10 Q, 10 ks and other documents that we file with the SEC. Can You find these on our website, which is www.gladstonecapital.com.

Specifically, look on the Investor Relations page or on the SEC's website, which is www.sec.gov. And we undertake no obligation to publicly update or revise any of these forward looking statements, whether as a result of new information, future events or otherwise, except as required by law. We also ask you to take the opportunity to visit our website, once again, gladstonecapital.com. Please sign up for our e mail notification service.

Speaker 3

You

Speaker 2

can also be found on Twitter. The handle there is gladstonecomps. And on Facebook, keyword, The Gladstone Companies. Today's call is an overview of our results. We ask that you review our press release and Form 10 Q both issued yesterday for more detailed information.

Those can be found on the Investor Relations page of our website. With that, I'll turn the presentation back over to Gladstone Capital's President, Bob Marcotte. Bob?

Speaker 4

Good morning. Thank you all for dialing in today to spend a few minutes with us this morning. And now let's get into the headlines for Gladstone Capital for the quarter ended June 3039. Originations on the quarter were strong at $58,000,000 as we referenced in our prior call and included two new proprietary investments and three syndicated investments. Exits and repayments were higher than anticipated at $41,000,000 and included the prepayment of our senior debt investment in IA Tech, which at $30,000,000 was one of our top five, which was prepaid at par plus a prepayment fee.

Net originations on the quarter thus were 17,300,000 after all other portfolio movements. Interest income rose slightly to $11,200,000 on the quarter from the prior as the decline in average yield on our investment portfolio to 11.8% was offset by a small increase in the average interest bearing investment portfolio from the prior quarter. Prepayment fees and exit prepayment fees, exit fees and dividend income rose on the quarter to $1,700,000 including the IA Tech prepayment fee of $900,000 which lifted our total investment income to $12,900,000 or 2.9% higher than the March. Our borrowing related costs were unchanged on the quarter as average borrowings fell slightly and commitment fees associated with the lower utilization of our credit line rose on the quarter. Net investment income was up slightly at $6,200,000 or $0.21 a share as operating expenses were unchanged and net management fees rose compared to the prior quarter as incentive fees increased with the increased investment income and incentive fee credit decline.

The net assets from operations rose to 8,900,000.0 quarter or $0.30 per share as a result of the $2,600,000 of net portfolio appreciation on the quarter. And NAV rose to $0.12 per share or 1.5% to $8.23 per share at June 30. With respect to the overall portfolio, the asset mix as of the end of the quarter shifted slightly with all the portfolio activity, resulting in the senior secured assets falling 3% to 46% of our investment portfolio at fair value, while the second lien investments rose to 42 of the portfolio. A major contributor to the portfolio appreciation in the quarter was the continued improvement in ADC's operating results and better visibility into the potential exit opportunities for that investment. Detracting from this momentum was a realized loss in the exit of a non core defense sector fund investment, FedCap, and unrealized depreciation of our equity interest in Lignetics.

During the quarter, there was no change to our two non earning assets, which represent an aggregate cost of $8,500,000 or 2.2% of all debt investments and an aggregate fair value of $2,100,000 or 0.6% of the fair value of all debt investments. Since the end of the quarter, we closed an additional $5,000,000 follow on investment And between repayments and exits, total investments have increased by $3,800,000 So our earning assets are up slightly as of today. We also expect to close a new proprietary deal in the very near term. With respect to the near term outlook, within our lower middle market focus, principally sub-ten million dollars EBITDA business, we have seen a healthy level of deal flow in the past several months. That said, competitive pressures have also increased, particularly for senior investments causing lending margins to inch down.

Between our current investment backlog and follow on fundings to our existing portfolio companies, we expect to be able to outpace some of the anticipated liquidity events on the horizon and continue to increase our average investments and core net interest income. Interest rates are not obviously expected to provide much near term lift to our interest income. However, we do expect fee and other income to remain elevated as our portfolio continues to mature and expected exits are realized. The flip side of the declining interest rate outlook is that we are optimistic that we'll able to refund our existing 6% Glad and Preferred early next quarter at a lower effective cost through some combination of capital market issuance or bank facility borrowings. This refunding is a prerequisite to clearing the last hurdle to be able to lift the 200% minimum asset coverage limitation.

However, given our 242% coverage as of June 30, we're probably several quarters of solid originations away from being in a position to utilize any of this additional leverage capacity. And now I'd like to turn the call over to Nicole Shelton Brown, the CFO for Gladstone Capital to provide some of the details on the Fund's financial results for the quarter. Nicole?

Speaker 5

Thanks, Bob. Good morning, everyone. During the June, total interest income rose 1% to $11,200,000 as higher average investments more than offset the 20 basis point decline in the average yield on the investment portfolio. Other income rose by $300,000 to $1,700,000 with the IA Tech prepayment fee as well as other exit fees and dividends received. Total investment income rose $400,000 or 2.9% to $12,900,000 on the quarter.

Total expenses for the quarter increased by 200,000 driven mainly by a $600,000 increase in net incentive fees, partially offset by a $400,000 decrease in net base management fees. The increase in net incentive fees was driven by both an increase in net investment income and a $400,000 decrease in advisor fee credits quarter over quarter. The 400,000 decrease in net base management fees was driven by the credits received associated with origination fees on our new investments during the quarter. Financing expenses were unchanged at $3,200,000 and other expenses were also unchanged at $800,000 or 79 basis points on average assets on the quarter. For the quarter ended June 30, net investment income was $6,200,000 or $0.21 per share and covered 100% of our shareholder distribution.

Moving over to the balance sheet. As of June 30, total assets were $415,000,000 consisting of $4.00 $8,000,000 in investments at fair value and $7,000,000 in cash and other assets. Liabilities rose by $8,000,000 to $169,000,000 and consisted of $59,000,000 in borrowings on our credit facility, 55,600,000.0 of our $6.8.20 23 senior notes and $52,000,000 of Series twenty twenty four term preferred stock. Net assets rose by $11,300,000 since the prior quarter end with 2,600,000 of net realized and unrealized portfolio appreciation and common stock issued under our ATM program, which generated net proceeds of $8,600,000 For the quarter, we issued 939,000 common shares at an average price of $9.34 per share or 113.5% of NAV. The accretive ATM issuance accounted for approximately one third of the $0.12 increase in NAV, which rose to $8.23 as of June 3039 compared to $8.11 as of March 3139.

Our leverage as of June 30 was unchanged from the prior quarter ended 69% of net assets despite the increase in assets for the period. As of the end of the quarter, we had an excess of $75,000,000 of current investment capacity and approximately $117,000,000 of available under our line of credit. With respect to distribution, Gladstone Capital has remained committed to paying its shareholders a cash dividend and in July our Board of Directors declared a monthly distribution to our common stockholders of $07 per common share per month for July, August and September, which is an annual rate of $0.84 per share. The Board will meet in October to determine the monthly distribution to common stockholders for the following quarter. At the current distribution rate for our common stock and with the common stock price of about $9.21 yesterday, the distribution run rate is now producing a yield of about 9.1%, which continues to be attractive relative to most yield oriented alternatives.

And now David will conclude the presentation.

Speaker 1

Okay. Thank you, Nicole. Good report and a good report from Bob and Michael as well. I think our shareholders and the analysts are well informed of what we're doing. This is another good quarter for Gladstone Capital, originated more than $60,000,000 in new investments to more than offset the spike in payments and continued growth of the assets, generating a record $12,900,000 of investment income aided by some significant fees, but nonetheless made good money.

Maintaining a strong balance sheet with significant dry powder to grow the investment portfolio in this area that we specialize in and that's the lower middle market businesses. And the company, we believe, has enough liquidity to weather any kind of recession should there be one. In summary, the company sees strength in the private businesses that are mid sized with a good management team. Many of these are owned by mid sized buyout funds that are looking for experienced partners that can lend money to the businesses they invested their equity in. This gives us a chance to make attractive interest paying loans which support our ongoing commitment to pay cash distributions to stockholders.

We have a great team here and they are doing a good job. And now I'm going to ask the operator to come in and get some questions from those out there that would like to ask us some more particulars.

Speaker 0

Thank you, Mr. Glassone. Session. Our first question in queue will come from the line of Henry Yaffe with Wedbush. Please go ahead.

Your line is now open.

Speaker 1

Henry, are you there?

Speaker 0

Mr. Goffey, your line is open. Please check your mute.

Speaker 3

Can you hear me now?

Speaker 1

Yes.

Speaker 3

Sorry about that. So with rates as low as they are, how are you managing around that challenge and how is market pricing being affected? And if prices if yields on investments were low, are there alternatives to in terms of cutting your funding costs to offset that and keep spreads where they need to be?

Speaker 4

Henry, as you know, obviously a significant part of our capital stack, about a third of our debt is floating rate bank debt. So that's obviously going down with it. The second piece, as I mentioned in my comments, we're going to call out our preferred, early next quarter and that's at a 6% yield on it. More than likely, there'll be some mix of floating rate funding that will come into that and that's going to be, significantly less expensive than the current dividend on that preferred. So those are certainly two parts of it.

The more challenging part in the marketplace today is there's clearly been some spread compression in the lower middle market, as it's continued to be an active buyout area, probably even more active than the larger middle market buyouts. So we've seen some incursion of other funds coming in, creating some pressure on margins. So we obviously are ramping up whatever we see in deal flow and very mindful of the competitive conditions that we're focusing. So at this point, I would say, hit rates are a little bit lower, but we're still in a situation where we're lowering our costs and managing to our current yields. And obviously, we would love a little bit of rate increase to be able to offset some of the compression.

But I think at this point, we're still seeing positive investment opportunities that are accretive to our current book. So it's tight, but I think we're still managing flow. And I think that's one of the reasons why you don't see our assets growing more dramatically. The incremental asset growth is coming from places where competitive pricing is probably less attractive.

Speaker 3

So look, there's obviously different sectors of the economy and there are different sectors of the economy that are affected by what the administration is up to, for example, soybean agriculture or something like that. But when you look at your portfolio companies, what sort of economic read do you get? I mean, if you're looking at the stock market, you'd be very negative. What are your portfolio companies telling you about how business conditions are and how the economy is going?

Speaker 4

Well, we've always had a healthy mix of manufacturing smaller manufacturing businesses. And there's certainly been in the past five, seven years, a significant outsourcing. But domestic manufacturing, which is what BDCs really focus on, actually are growing quite well. As people realign their supply chains, domestic manufacturing, plant expansion, migration to domestic production where automation, labor costs, delivery times, inventory requirements are all more favorable. So we're getting to a point where whether it's aerospace or maybe some auto related businesses, those have become a much more significant uptick in opportunity.

Obviously, each of those have their own challenges, but domestic manufacturing certainly is stronger. I think in some of the other areas, we're seeing services businesses continue to be strong. We see activity in software related businesses or things in other service categories are certainly positive and probably more positive than you would think given basic wage increases and some of the pricing pressures, their costs, but they're still very positive on their outlook. So I would say it's decidedly a domestic swing for businesses, that is creating some of the updraft for us.

Speaker 3

Great. Thank you very much.

Speaker 1

Okay. Next question.

Speaker 0

Thank you, sir. Our next question comes from the line of Mickey Schleien with Ladenburg. Please go ahead. Your line is now open.

Speaker 6

Yes. Good morning, everyone. Bob, could you give us a bit more background about the trends at alloy dye that supported its valuation increase? And also, how correlated is its business to a potential slowdown of the economy?

Speaker 4

ADC die casting business is symbolic of what I mentioned into Henry's question. It's a West Coast based manufacturer that serves aerospace, lighting and some auto related businesses. The business, when it was acquired, had some deferred capital expenditures. And over the course of time between those expenditures and some significant management changes, as you may know, that's a one of the few co investments we have these days and is controlled by Gain. So we have significant insight to what's going there.

Between capital and a swap out and management and a refocus on domestic customers and what we've seen is huge inflow of orders from large scale, multinational corporates that are lifting that business. The result has been significant sales increase, significant margin expansion. And at this point, the cash flow run rate in that business is up very dramatically over the last three years. So in today's market environment, they are building cash significantly and we feel is a business that has clearly turned the corner and is currently well above where the original investment was, and that's reflected in our equity adjustment on the quarter. So, I would say that's endemic of what I think is a very strong story in a domestic manufacturing business that is certainly well supported by the underlying fundamentals.

Speaker 6

So I guess I'll congratulate you and Dave Dullum on turning that around. I guess the downside, Bob, is that it sounds like that's a business that could potentially be a nice tuck in acquisition for somebody and this will go off your books or potentially, I guess, the cash flow profile is as nice as you're indicating, you could be refinanced. Is that reasonable?

Speaker 4

We're I guess, we're exploring options in those regards and between the accumulated liability and the ultimate ultimate value of that business, that's a fair assumption that Dave and his team are pursuing.

Speaker 6

Okay. Just a couple of questions on the risk profile of the portfolio. Could you tell us how your average borrower revenue and EBITDA compares for your first lien versus your second lien investments?

Speaker 4

We don't really break that information down. Obviously, each individual business can be very different. As you can imagine, when you're financing a manufacturer versus a software business versus a healthcare business, you come up with very, very different profiles. So we don't try to lump that. I can certainly follow-up with you directly and talk a little bit about specifically overall, but the blend across the portfolio on all of the underlying investments, which we obviously report and have very exacting metrics that are required by our secured lenders is approximately 3.7, 3.8 times leverage across the entire portfolio.

So when you think about market comps, that's probably closer to senior relative to where the middle market might be, that would be probably significantly north of that.

Speaker 6

That's helpful. Perhaps I could just follow-up and ask just conceptually, when you look at second liens, do you tend to prefer sponsored deals, with lower LTVs? Or is there a different approach in order for you to get interested in a second lien?

Speaker 4

That's an interesting question and probably moves a lot with the market conditions. I would say, when the leverage starts to increase, second lien certainly, become more challenging. You will note that we have closed a number of syndications in the last quarter because we felt the second lien marketplace, the lower leverage levels and the significant equity sponsorship and equity support, warranted that. So that's a clear example where sponsor and equity were a differentiating factor for us. As it relates to the only restricting our second lien investments to sponsor deals, that's not always the case in the proprietary transactions.

In the proprietary marketplace, many of the sponsors are looking for second lien to juice leverage and spike their return on equity. We don't necessarily look at that situation where we're comfortable taking on that level of investment. You also should know that when we classify it as a second lien and this is a bit of a detail, but there are times where we might originate a unitranche loan and we would sell off a strip of the first lien piece inside that loan. So, if we provided four turns of leverage in a buyout, we might sell off the first two turns of leverage to a bank at a much lower rate. We would then classify that as a second lien loan as you would expect, but it's really inside a first lien leverage facility.

So, from a collateral and control perspective and from an overall leverage perspective, we are going to be lower than what a traditional second lien would look like. So, we continue to work the second lien angle. It's certainly an important part of our portfolio. But for the most part, I think there is, in a syndicated fashion, either a large equity or in a proprietary deal, significant control that we continue to exert over those assets.

Speaker 6

I understand. That's helpful color, particularly labeling a second lien a second lien as opposed to many of your peers which don't. I appreciate your time this morning. Thank you.

Speaker 1

Thank you, Nikki. Okay. Do we have any other questions?

Speaker 0

I'm showing no additional questions in the queue. I'll turn the program back over to David for any additional All right.

Speaker 1

You all for listening to the presentation. The company is in great shape today and we look to see you in about three months. That's the end of this call.

Speaker 0

Thank you to our presenters and thank you to all of our attendees for joining us. This concludes today's call. You may now disconnect and have a wonderful day.