Joseph Alala - President and Chief Executive Officer Stephen Arnall - Chief Financial Officer.

Kyle Joseph - Jefferies Christopher Nolan - Ladenburg Thalmann Chris Kotowski - Oppenheimer and Company Ryan Lynch - KBW.

At this time, I would like to welcome everyone to Capitala Finance Corp.'s Conference Call for the quarter ended June 30, 2018. All participations are in a listen-only mode. A question-and-answer session will follow the company's formal remarks.

Today's call is being recorded, and a replay will be available approximately three hours after the conclusion of the call on the company's website at www.capitalagroup.com under the Investor Relations section.

The hosts for today's call are Capitala Finance Corp.'s Chairman and Chief Executive Officer, Joe Alala; and Chief Financial Officer, Steve Arnall. Capitala Finance Corp issued a press release on August 6, 2018 with details of the company's quarterly financial and operating results. A copy of the press release is available on the company's website.

Please note that this call contains forward-looking statements that provide information, other than historical information, including statements regarding the company's goals, beliefs, strategies, future operating results, and cash flows.

Although, the company believes these statements are reasonable, actual results could differ materially from those projected in the forward-looking statements.

These statements are based on various underlying assumptions and are subject to numerous uncertainties and risks, including those disclosed under the section titled Risk Factors and Forward-Looking Statements in the company's quarterly report on Form 10-Q. Capitala undertakes no obligation to update or revise any forward-looking statements.

At this time, I would like to turn the meeting over to Joe Alala..

Thank you, operator. Good morning and thank you for joining us today. As we discussed the results for the second quarter of 2018 announced yesterday, my comments will focus on progress made on our priorities outlined to you in previous calls and fall from the second of the year. And Steve will provide additional inside into our financial results.

A little bit over two years ago, we changed our investment focus to senior secured structures moving away from second liens and subordinated debt. Since that time, we have invested approximately $207 million of debt investments, 86% which are senior secured structures bring a weighted average interest rate of 11.5%.

Investment activity during the second quarter of 2018 include a one new investment and several add-on investments. All senior secured debt investments. More on investment activity in a moment. We also have been reducing balances of non-accrual investments and that remain the focus of the management and our portfolio team.

Total non-accrual investment as a percentage of total investments on a cost basis decreased from the previous quarter. We also anticipate several significant equity exists during the normal course of business during the second half of the year and continue to evaluate other opportunities to reduce equity as a percentage of our investment portfolio.

Along those lines, I am happy to discuss two such pending exits. During July, the pending sale of Western Windows Systems to PGT Innovations was publicly announced.

Based on the sale price, we anticipate $23.3 million in proceeds which includes full repayment of our debt at $10.5 million and $12.8 million for our equity which had a cost basis of $3 million, producing over a 4x return on our equity investment. Also during July, we were informed that U.S.

Wells Services was entering into a business combination with Matlin & Partners also public information. At that time - at the time of the combination most likely in October, our first lien debt will be repaid at $11.9 million and we'll receive equity in the newly formed public entity.

The decrease in valuation from March relates to the enterprise value for the transaction being lower than anticipated. Our shares of the publicly traded vehicle will be locked out, one half of the shares will be locked out for six months, the other half of the shares be locked out for an additional six months.

We do expect nice potential for equity appreciation post half year. We will announce publically additional equity and debt exits as they happen over the remainder of the year. Liquidity for CPTA and for the firm overall will allow us to be active investors in the lower middle market.

Our pipeline is as robust as it has ever been, thanks to the collective efforts of our business development staff including our recently opened New York office. Our focus will continue to be on senior secured structures where we can invest between $25 million and $74 million across our platform including the BDC.

The BDC has begun co-investing with Capitala Specialty Lending Corp having closed three deals already with several others pending. Our underwriting and portfolio processes as previously announced have been refined with the addition of Peter Sherman as our Chief Risk Officer.

At this point, I'd like to ask Steve to provide some color on our second quarter financial results..

Thanks Joe. Good morning and thanks for taking time to listen to our call today. Joe has provided you with a good summary of company priorities and a view on investing in platform matters. At this point, I would take a moment to talk to you about our second quarter financial performance and then we'll be glad to answer any questions that you may have.

Net investment income was $0.26 per share at a cover to distributions of $0.25 per share for the second quarter of 2018. We fully understand the importance of consistent distribution coverage. Pick [ph] income over the past two years as a percentage of total income has been elevated relative to our peers.

That being said, pick income to travel [ph] income is at its lowest level in eight reporting periods at 8.2% for the most recent quarter. I would like to note that previously accrued pick related to Vintage Stock Inc. totaled $918,000 and was collected in fall as a result of the repayment of the debt during the second quarter.

Told expenses for the second quarter of 2018 were $4.0 million lower than the comparable period in 2017. During the second quarter of 2017, there were two items that were onetime in nature but had a material impact on our earnings.

First, we recorded a $2.7 million loss on extinguished of debt related to the early redemption of the 7.18% fixed rate notes. Also interest in financing expenses during the second quarter of 2017 included approximately $0.6 million of interest on the redeemed notes during the notice period while both the 2022 notes were issued and outstanding.

Net realized losses for the second quarter of 2018 totaled $22.6 million driven by the restructuring of our subordinated debt investment in Cedar Electronics. This realized loss did not have a negative impact on NAV per share as evidenced by previously recorded depreciation on this investment.

The net increase in net assets resulting from operations totaled $4.9 million or $0.31 per share for the second quarter of 2018, compared to a net decrease of $5.5 million for the comparable period last year.

Net asset to June 30, 2018 totaled $219.3 million or $13.71 per share, an increase from $13.66 per share at March 31, 2018, and a slight decrease from $13.91 the prior year end. Stability and ultimately growth in net asset value per share remains one of our highest priorities.

In order to achieve that goal, we need continued success on the point Joe made earlier, most notably making quality senior secured investments, reducing balances on non-accrual status, and reducing the mix of equity investments, reinvesting proceeds from monetization into senior secured investments.

At June 30, 2018, our investment portfolio includes 43 investments but the fair value of $483.3 million and cost basis of $426.7 million.

First lien debt investments on a fair value basis at June 30, 2018, comprised 50.9% of the portfolio while second lien represent 6.6% subordinated debt represents 16.6%, and equity warrant investments represent 24.9%. On a cost basis, the equity investments comprised 13.5% of the portfolio.

And further into Joe's point about our strategy ship mid-2016 to senior secured structures. On a cost basis, senior secured loans comprised approximately 39% of our portfolio at June 30, 2016 compared to 60% at June 30, 2018.

At quarter end, we have three portfolio companies are not accrual status with a cost basis and fair value of $31.9 million and $25.8 million respectively. On a cost basis, non-accrual loans represents 7.5% of the portfolio at June 30, compared to 9.5% at March 31.

Again as mentioned previously, reducing balances on non-accrual status is an interval step in fulfillment of our performance goals. At June 30, we have $40.8 million in cash and cash equivalents.

There were no changes in the composition of our interest bearing liabilities including our fixed rate SBA debentures, our fixed rate notes, convertible notes and our senior secured revolving credit facility. At quarter end, we had $5 million drawn on our credit facility with $109.5 million available.

Regulatory leverage at June 30, 2018 were 0.6x compared to 0.61x at year end. At this time, we have not asked our board or our shareholders for a reduction in our asset coverage ratio but rather remained focused on improve financial performance. We will continue to discuss this topic with our board.

And lastly, two items that we included in our press release subsequent to June 30. July 31, we sold our investment in Kelly's Transport System at our June 30 valuation of $13.3 million. The reinvested of these proceeds should be highly accretive from this recently restructured investment.

And lastly on August 2, we invested $13 billion in the first lien debt of Sunset Digital Holding yielding one month LIBOR plus 7.25%. At this point, we'd like to open up the line for questions..

Thank you. [Operator Instructions] Our first question comes from Kyle Joseph of Jefferies. Your line is now open..

Hey, good morning, guys, and thanks for taking my questions.

I just want to get a sense for your thoughts on portfolio yields going forward given where you guys are in the portfolio rotation and kind of the new strategy moving up to capital spectrum and your outlook on yields for the portfolio?.

Hey Kyle, this is Joe. That's a great question. You know we did shift the strategy you know couple years plus ago and at that time, we realized that going higher in the balance sheet, yields would compress. We still target double digit yields in our unit structures.

Primarily we get those at our first out first lien structure and sometimes we do a last out first lien structure. But we want to average a double digit yield. What has helped is the rising interest rate environment. And I think you'll see that our yields are continue to be double digit but we're in a much more secure position on the balance sheet.

We can control the balance sheet if we need to. But we'll do double digit yields and we will still continue to seek selective equity participation, no more than 10% on a cost basis. We are focused obviously on reducing equity in the BDC portfolio from 26% where it is now.

But the strategy seems to be working and we can get double digit yields and get some equity participations and hopefully get mid-teens total returns on these investments over time..

That's helpful. Thanks Joe. And then last one for me. It sounded bullish on the pipeline and I know you mentioned that these were primarily senior secured investments.

Can you give us a little more color in terms of which industry you seen the best investment opportunities in?.

You know we have a very robust pipeline. I think the marketing campaign around our new liquidity has made a substantial difference to the pipeline.

We're able to go to the market in a whole $25 million to $75 million unit tranche positions, the BDC through its FCC co-investment process takes its allocation of those are, at least has the right to take its allocation of those. That's opened up a lot of opportunities for us. The pipeline is very diverse coming in from all six offices.

We are typically focused on sort of 30 million - $60 million unit tranche deal in the current pipeline and we just announced we closed Sunset Digital, which is telecom deal that ended up being a $45 million dollars total unit tranche deal with the BDC holding $13 million of that. We have some healthcare deals in the pipeline.

The deal we closed at the end of Q2 is a logistics deal. That was a $37 million to $40 million dollars unit tranche deal with the BDC participated I believe $7 million of that.

So the ability to go into these lower middle market companies both the sponsor and non-sponsor and say we can hold and/or lead up to $75 million of the cash flow unit tranche needs has been very effective. And also the addition of another full service office in New York is really helped.

And our pipeline is it as large as it's been in many, many years and it's primarily all first lien structured pipeline..

That makes sense and that's helpful. Last one for me.

Just trying to get a sense for the health of your underlying portfolio companies to talk about tranche and revenues, EBITDA and as well as leverage?.

This is Steve. Fill in for Jack, he is not here this week. You know I think our portfolio group is actively engaged and meets periodically to discuss all portfolio matters including earnings and leverage and those types of things. I would from my perspective, it feels like you know there's some optimism.

We understand that we've had some prove to the market that we've stabilize the credit situation and stabilize NAV accordingly. It feels like how we're getting there, but we've got three investors are non-accrual right now, we're closely monitoring those. We're hopefully we'll have some resolution to those soon.

If you go below that again I think that the tranche seem to be good generally speaking, you know when you're in the lower middle market. You've got some volatility in earnings you know every 90 days when you're looking at those. But I would just say in general, it feels like the overall support and earnings is improving..

This is Joe. The only thing I would add to that is typically in your portfolio, you know when things are about to monetize because you see bankers being hired or registration statements been filed.

We do see a lot more activity in the portfolio and we do expect we'll have continued monetization of our equity positions and between now and the end of the year. You know we just announced two of them, which is there but public Western Windows and U.S. Wells. We will expect to announce several more of those between now and the end of the year.

And I think that's really you're seeing these portfolios really in the kind of returns in these equity positions, Western Windows 4x, U.S. Wells those want to restructured energy alone. And also they are going to make significant return on and at one time it was impaired.

And we have many more in the portfolio that are in those processes of hiring or have hired investment banks or filing registration statement that will monetize. And we will announce those as soon as we can, but I think that's the health of the underlying lower middle market companies where we have a significantly appreciated equity position.

And the good news is these marks that we have in our portfolio, we're obtaining these marks on these exits. And I think that's very important because you know our cost basis in these equity positions about 13%, the fair value is about 26%.

If we can continue doing that in our strategy, attaching those kind of equity returns of first lien structures, it works and that's what we've been focused on the past couple plus years and we continue to focus on that as far as our investment strategy..

Great. That's all for me. Thanks a lot for answering the questions..

Thanks Kyle..

Thank you..

Thank you. Our next question comes from Christopher Nolan of Ladenburg Thalmann. Your line is now open..

Hi, guys. The yield on new investments was 9% versus 10.8% last quarter, I know it's only one investment.

But are you to track quality deals, you have to sort of give up on price?.

Chris, we're not giving up on pricing and these are sort of - these are market rates. A lot of these you know we get better pricing on some of our directly originated non-sponsor activity, which you will get a little bit premium and price in there and better structures, lower leverage out of the gate.

The equity sponsor part of our business is still is very competitive even with the ability to hold a $60 million dollars unit tranche, it's very competitive. What we will pursue as most of these first out structures right now are first out first lien. That means you own the balance sheet, there's no one else in the deal with you.

What can be achieved is to go and create a first out security with that with another co-party to the unit tranche and blend up a last out yield. We will have - we do have the ability to do that and we've been selective on how we do that.

We hope to in the future do more of a regional first out bifurcate unit tranche where we can blend up our last out yield and increase our basis points. And we will hopefully have that fully in effect by the end of the year.

In that way, we can be doing the same deals, have a little bit of financial engineering on the top stack of the unit tranche and blend up your yield safely into the double digits with current interest rates. And that's our goal here.

But the all the last loans we've been looking at, we've held the whole loan first out first lien which is really top of the stack lending..

And Joe as a follow-up, what percentage of your deals now have equity sponsors?.

You know if you look back over the past deals close, I think it's about 60% sponsor, 40% non-sponsor. Sponsor activity is very competitive. You're seeing very low interest rates and very aggressive structures, but we are doing some sponsor activity being very selective.

We also have the ability which we think is something unique to our platform is do non-sponsor deals. A lot of groups do very little non-sponsor activity. We like non-sponsor activity, you get better structures typically get better pricing and it really blends well with our sort of other controller type investment strategies on the platform.

We don't - we're not afraid of getting active in these portfolio companies if we need to. But it's about 60%, 40% right now..

And then this is the second quarter in the last three were you exited non-accrual investment at a loss and then you immediately replaced it with the new non-accrual business. Does this reflect a tightening up of the credit quality of the group? You're just trying to weed up portfolio or is this you're basically calling non-accruals as a right.

I am try to get an understanding as to why we're starting to see over the last few quarters a large exit of a non-accrual going to be immediately replaced with the new non-accrual?.

Chris. This is Steve. Yeah, good question. First it relates to Cedar, on April 1, we had announced that as a subsequent event for Q1. We restructure that investment into equity and that - that transaction happened. And we reported that and that was that. Whereas relates to the new addition this quarter, we put American Clinical Solutions on non-accrual.

But if you go back to March, we already had that asset value at about 74% of the cost basis.

So it was having some liquidity, it related matters and earnings related matters, previously we've got the June 30, there's not uncertainty about the future collectability of all the principle and issues that we felt it was the right thing to do to put in on non-accrual.

I don't think there's any correlation or any conclusion you can make that one went off and one came on and that were typing things. I think we addressed these on a monthly basis with the entire management of the company and look at asset quality and all the related risk rates and make these terminations prior to each quarter end.

So just count the way things fell out..

Okay. That's it for me. Thanks, Steve. Thanks, Joe..

Thanks Chris..

Thank you. Our next question comes from Chris Kotowski of Oppenheimer and Company. Your line is now open..

Yeah. Good morning. I'd like to kind of get a sense for the speed at which you can redeploy some of these equity proceeds into debt investment and I just wanted to make sure I heard it everything.

So what sort of Window System, there you're going in the third quarter just get the $12.8 million and that will then be immediately available? Is that right, is that what you said?.

Yeah, correct..

Okay. And the other one U.S.

Well Services, they are merging into another company and is it already publicly traded security that they're merging into or they doing an IPO?.

Steve, that's correct. Yes..

Oh, sorry, it is already a publicly traded company?.

No, I think it's a formation of a new company and the shares that we will own will be in the new entity. But it's very complicated transaction. I don't think it's public right now..

Okay.

So but the basic answer is we shouldn't expect that to be redeployable for another year or so?.

Well, the debt will get back in October, the equity, we will receive the equity in October but half their shares all the shares are locked up for six months, half of are locked out for a year. And so that would be 2019 event at the earliest depending on how well the company performs and how well the shares trade..

Okay.

And on some of the other ones I know you can't talk about the specifics, but I'm curious is that in general again the same kind of structured exits that we have with these two cases?.

I think they are more going to be structured more like a Western Windows, where you get all your debt obviously and you get all your equity out at closing versus the U.S. Well structure that is what where you get your debt and then you've got publicly traded stock, is restricted for 6 to 12 months as Steve mentioned.

Most of these will get much more like you get all your money out including your equity payments of the majority of your equity valuations at closing. And then we look to redeploy both the debt yields from that and the equity yields from those monetization into first lien securities..

Okay.

And just on American Clinical Solutions, I mean it doesn't sound like the kind of industry that is normally economically sensitive, so is that not an economy sensitive issue on going into non-accrual?.

There's a lot of regulatory dynamics in that segment of the healthcare testing industry. But it is typically not economic correlated to the economy, but we'll work through that one as we work through KTS. I think KTS has been on non-accrual for a year. We worked hard there doing restructuring, got to top of the stack and we just exited.

That's just a big win. We exited at our mark. We spent a year plus working with that company, we've got out. Now we can take that money put it into a 10% yield, really grow earnings.

We would expect and try to do the same thing with an ACF to somehow continue working on top of the stack there, work with our other partners in the deal and create a solution where we that can get out closer on mark or put in the right capital structure, fixed underlying operational issues and start growing earning again..

Okay. All right. That's it for me. Thank you..

Thanks, Chris..

Thank you. [Operator Instructions] Our next question comes from Ryan Lynch of KBW. Your line is now open..

Good morning. First question relates to just the allocation process for investments across your guidance platform, obviously with closing the $1 billion the capital especially in the corporate issue, a lot more try powder across the platform to commit to larger or hold sizes and become more relevant to borrowers.

But with that large other sign versus the amount of capital you guys have in your CPTA, I was just wondering how is that allocation process work when you guys look to commit to a new deal, does - is it based on available capital because it seems like now at least CPTA with a fairly small allocation?.

Yeah, that it - Ryan, that's a great question. We do have the SEC exempt to relieve and these are pools of capital. We all set sort of portfolio construction limits in there. And you base that really on your alternate portfolio construction, expectations and your available capital.

So as we're looking at the current deals in the BDC, I mean we want to hold with our current availability $8 million to $15 million per deal and that's really what it is, it's obtaining the larger actually allocations right now in these deals.

And what would happen over time is if your availability in the BDC were to contract in the redeployed all your liquidity and your recycle, your whole charges would go down but that's because you're getting to really fully funded and sort of max leverage capacity.

But all the different vehicles and we've got more than one that we're come investing on the lower middle market platform, we do have a large vehicle but we also in that vehicle have said hold limit because you want to build out a very diversified 60 to 70 name portfolio.

So even though the vehicles rather large, it is a permanent capital structured vehicle. So that has no intention of being deployed in one year, two years or three years.

It's a multi-year vehicle where you set allocation limit sort of annually and it's really it's working out very well with the BDC and our other coming of funds in the lower middle market strategy where everyone's getting there sort desired allocations.

And if anything, we can hold more in a deal with some other funds participating in our lower middle market strategy because we're keeping our whole sizes very low. And I think that's a really good trend that we keep reiterating in the BDC is for a while the whole sizes we're getting close to 20, we had several over 20 in the whole side.

And for that size of that portfolio that is just too large. So we based almost cut those in half. At the end of the day, when we redeploy the current liquidity and recycle the deals that are coming in, you'll have a much more diversified portfolio on the BDC with a lot more names in it which is makes it better portfolio. So that's how we do.

We set whole limits at each vehicle, give it a range and then we allocated per deal, the BDC has the right not out obligation to co-invest in every deal and then you take it to your board. This is a standard sort of SEC exempted relief process and today now we're going on three deals, we got a lot more common. It worked very well..

Okay. That's very helpful commentary on that process. Touching on year kind of bullishness on the ability to monetize some equity investments maybe in the back half of the year, sounds like you've already done some in a third quarter.

Can you just talk about I think you said several of the portfolio of a company have, equity investments have hired, investment banks are in the process of hiring bankers. I would assume that that's why you're more bullish on monetizing those equity investments.

But my question would be, why do - I guess why do you believe that those companies are now in the process of starting to maybe look for a transaction during the back half of the year, is it just higher equity evaluations or what is kind of change there? And do you have, I would assume you don't have any kind of minor or majority interest in any of these equity, so I would assume did you probably don't have much control over these exited processes, is that correct?.

Yeah, they are - you're correct about that in fact that we are minority positions in every securities. I think if you look at our say our top 5 or 6 holdings, you really look at how long they've been in the portfolio and these are sort of natural whether it's sponsor or non-sponsor and we put this on the endorsing see our cost basis.

And if you're looking at a 3x to 8x multiple return on your committed equity capital and you're a sponsor and or non-sponsor, now is a very good time to monetize these investments, you got very healthy credit markets, you got a very nice multiple expansion that's happened over the years. And we're just seeing a lot of these groups go to monetize.

They're going to make great returns. I mean Western Window is a great example. You make it over 4x return on your equity and I think is a 2.5, 3 year hold. So we see other groups and as a diversified across our portfolio, they want to go monetize that equity appreciation.

And so they're hiring bankers, it's a very active M&A market, the credit markets are very liquid.

So we do expect to now several more of these exits between now and the end of the year and that's the key to us is taking those nice appreciated equity asset, booking at very nice realize return and then redeploying that in the first lien security, hopefully yielding double digits. And then you see a nice past to in NII growth..

Okay, that's helpful. And then just one more. You might have mentioned, I dialed in a couple minutes late.

But can you just provide a little background on what drove you opening the New York office and hiring Kelly and what that really brings to that the Capitala strategy?.

Yeah, I think we've always had this direct origination program of opening offices in different cities where all the underwriting and portfolio manager takes place in Charlotte.

Once we did secure this big allay new fund, the Capitala Specialty Lending Corp, we realize that in order to do that we need to return to deploying $100 million to $150 million every quarter.

And we thought opening an office in New York would really contribute to those directly originated deals and getting back to $100 million-$150 million of quarterly deployments. We will also look to opening full service offices in other cities. We've been in Dallas before that was a great office historically for us.

Chicago is a great market, we don't spend enough time there. So we will open more offices as we continue raising capital and continue wanting to hit our deployment numbers of $100 million to $150 million a quarter.

And it's been - these are been in the industry a long time, have both credit and origination background and we think that will be a great office for us..

Okay. Those are all my questions. I appreciate the time today..

Ryan, thank you..

Thank you. And we do have a follow-up from Christopher Nolan of Ladenburg Thalmann. Your line is now open..

Joe, should we expect incentive fee accruals to start to grow in the second half of the year and any guidance on operating expenses in the second of the year?.

Chris, this is Steve. I can't provide guidance on that. It's our - surly hope that that will be the case, but I can't give you any guidance on that. Operating expense wise, I think if you look at our expense history, it's pretty fixed, so I don't foresee any material changes in the expense right there at all.

So you can probably use past history as a good guide there..

Great. Thank you, Steve..

Thank you. And ladies and gentlemen, thus that conclude our question-and-answer session. I would now like to turn the call back over to Joe Alala for any further remarks..

Thank you, everybody. Appreciate your time. We will continue to announce deals as they close and then deals when we can upon any exit or now it's public exit. And I think you'll see that we're continuing to work hard and seeing that we're focusing on three things, we're achieving them.

And we think the second half of the year will be a very active year for us as far as deployments and realizations. Thank you for your time today. We're around all day, if you want give us a call..

Ladies and gentlemen, thank you for participating in today's conference. This concludes today's program. You may all disconnect. Everyone, have a great day..