At this time, I would like to welcome everyone to Capitala Finance Corp.’s conference call for the quarter ended December 31, 2018. All participants 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 host for today’s call are Capitala Finance Corp.’s Chairman and Chief Executive Officer, Joe Alala, and Chief Financial Officer and Chief Operating Officer, Steve Arnall. Capitala Finance Corp. issued a press release on March 4, 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 sections titled Risk Factors and Forward-Looking Statements in the company’s annual report on Form 10-K. At this time, I would like to turn the meeting over to Joe Alala..

Thank you, operatory. Good morning. Thanks for joining the call today. I appreciate the opportunity to discuss Capitala Finance Corp's performance for the fourth quarter and full year 2018, and a look ahead at our priorities for 2019, at which time I will turn it over to Steve to discuss more about our performance and investment portfolio.

Our direct origination platform had a strong finish to 2018. During the second half of the year, our platform originated approximately $370 million of investments in lower middle market companies, $150 million of investments during the fourth quarter.

During the fourth quarter, Capitala Finance Corp invested $48.9 million, including $34.6 million of first lien investments, $13.6 million in Capitala Senior Loan Fund II and $700,000 into equity investments.

We remain active in the lower middle market and are pleased to have recently announced the opening of our Dallas, Texas office, which is our seventh direct origination office. We're very excited to have launched Capitala Senior Loan Fund II, a joint venture with our long-term investment partner, Kemper Insurance.

The JV does not pay management fees and is designed to enhance our ROE and reduce our cost of capital. We have jointly committed $50 million of capital to the JV and are finalizing over $100 million in leverage for that vehicle and hope to grow this program significantly over the next several years.

Our investment's focus changed in early 2016, focusing on senior secured structures, moving away from mezzanine structures. Since that time, Capitala Finance Corp has invested approximately $261 million in debt investments, with 89% being first lien debt structures.

At year-end 2018, on a fair value basis, 69% of our debt portfolio was first lien compared to 51% at year-end 2016. During the quarter, our net asset value per share declined by approximately 6%. Equity investment fair value depreciation makes up 64% of that decline.

Debt fair value depreciation makes up 31% and distributions in excess of our net investment income account for the difference. Non-accrual loans have decreased by 63% from the prior year-end.

Also, investments with an internal risk rating of 3 and 4 have collectively declined by 32% from prior year-end, a byproduct of much hard work by our portfolio monitoring team. Our portfolio group will continue to actively manage all of our investments and strive to reduce the number in dollar amount of investments rated 3 and 4.

As we move into 2019, management is focused on a number of priorities.

Consistent coverage of our dividends, maintain the dividend and continue to have no return of capital, continued reduction of nonaccrual risk rate 3 investments, stable and preferably growing our net asset value per share, meaningful reduction of our equity portfolio through monetizations.

We recently received $5.9 million for our warrant in B&W Quality Growers, our fifth-largest equity position at year-end, generating a realized gain for the same amount.

We've continued on to ramp Capitala Senior Loan Fund II and begin making distributions from that vehicle, continue to make quality senior secured debt investments and, as a platform, close on additional permit pools of capital to help us increase our presence in the lower middle market and by increasing our [indiscernible] across the platform.

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

Thanks, Joe. Good morning. Total investment income was $11.3 million during the fourth quarter 2018, $0.3 million lower than the fourth quarter of 2017. Fixed income decreased by $0.5 million for the comparable periods, resulting from continued efforts to earn and collect cash interest as opposed to fixed income.

Total expenses for the fourth quarter of 2018 were $7.8 million, an increase of $.4 million from the fourth quarter of 2017. Our status as an emerging growth company expired at the end of 2018 and, therefore, we incurred additional professional fees during the period and for the full year for internal control purposes.

Net investment income of $0.22 per share for the fourth quarter of 2018 were slightly less than our distributions made of $0.25. We fully understand the importance of consistent distribution coverage and are focused on providing such coverage on a quarterly basis.

Net realized losses for the fourth quarter of 2018 totaled $14.6 million or $0.91 per share. We realized a $16.7 million loss related to On Site Fuel Services, Inc., partially offset by a $1.9 million gain related to City Gear, LLC.

The loss related to On Site Fuel Services did not impact our net asset value as the fair value was zero at September 30, 2018. Net unrealized depreciation totaled $1.2 million for the fourth quarter of 2018 compared to depreciation of $17.3 million in 2017.

The net decrease in net asset resulting from operations totaled $9.2 million or $0.57 per share for the fourth quarter of 2018 compared to a net decrease of $0.6 million for the comparable period 2017. Net assets at September 31, 2018 totaled $190.6 million or $11.88 per share compared to $13.91 per share at December 31, 2017.

Stability and, ultimately, growth in net asset value per share remains one of our highest priorities. As December 31, 2018, we had $39.3 million in cash and cash equivalents. In addition, we had $10 million drawn and $104.5 million available on our senior secured credit facility priced at LIBOR plus 300 basis points.

Regulatory leverage at December 31, 2018 was 0.72x compared to 0.61x the previous year-end. On November 4, 2018, our Board of Directors approved the company be subject to a minimum asset coverage ratio of at least 150% to be effective as of November 1, 2019.

Lastly, on March 1 of this year, we repaid early all $15.7 million of SBA debentures outstanding for CapitalSouth Partners Fund II LP and relinquish the SBIC license. At December 31, 2018, our investment portfolio included 44 investments, with a fair value of $448.9 million at a cost basis of $420 million.

During the quarter, we invested $48.9 million across four new companies and seven existing portfolio companies. Of this amt, $34.6 million were debt investments of first lien structure, while $13.6 million was invested into Capitala Senior Loan Fund II and $0.7 million in equity investments.

First lien debt investments on a fair value basis at December 31, 2018 comprised 52.9% of the portfolio, while second lien and subordinated debt collectively represent 23.5%, equity and warrant investments represent 20.5% and our investment in Capitala Senior Loan Fund II represent 3%.

At year-end, we had two portfolio companies on non-accrual status at cost basis and a fair value basis of $20.7 million and $9.4 million respectively. On a fair value basis, non-accrual loans represent 2.1 of the portfolio at December 31, 2018, down 63% in the prior year-end.

Lastly, our direct origination platform included our new Dallas, Texas office that's focused on generating quality senior secured opportunities to satisfy their internal profile of Capitala platform, including Capitala Finance Corp. At this point, we would like to turn it over to questions..

[Operator Instructions]. Our first question comes from the line of Kyle Joseph with Jefferies. Your line is open..

Hey. Morning, guys. And thanks for taking my questions. Joe, just want to get your sense. You gave some 2019 priorities, but I want to get your sense of your outlook for the overall yield on the book. Obviously, you guys have a little bit more of a conservative strategy.

Sounds like you're eking off that – some of that with the new joint venture and then given market conditions and a little bit higher rate. Just give us a sense for where you see yields going this year..

That's a great question, by the way. Existing book is around 11.9%. I think, beginning of 2016, when we started shifting our strategy from mezzanine to first lien, it was probably high 13.

So, we've probably lost maybe 200 basis points of yield there, which is sort of what we forecasted when we announced the investment strategy, changed to more first lien back in 2016. So, what's helping us are a few things. One, we have a general rise in LIBOR, which has helped us. And two, we've been doing some bifurcation of the unit tranche.

Primarily those are going into our new joint venture, the Capitala Senior Loan Fund II. And what we're able to do there is lower our cost of capital through putting the first out allocation of the unit tranche into that JV, thus increasing our sort of net margin and yield on those deals. So, we think we can maintain double-digit yields.

Another thing we're very much focused on is loan-to-value. Our loan-to-value has really been decreasing over time.

On our last handful of deals on the credit side, not all these would be in the BDC, of course, but they are around 50%, 55% loan-to-value, which we think we have conservative structures still getting double-digit yields, still have all of the material covenants in our structures.

So, we're feeling really good about the new opportunities we've invested in in 2018..

Got it. That's very helpful.

And then, given the new strategy, can you just remind us your thoughts on kind of target leverage and any changes there?.

Target leverage for our company or…?.

Yeah. Your own debt-to-equity. Apologies..

Yeah. We are in the 0.7x at year-end. I think , historically, we said – somewhere around 0.8, to know more than 0.85, give or take, is probably a good spot for us. In the interim, we will continue to have initial conversations with our senior secured lender about our options for additional leverage as we approach November 1 and reset asset coverage.

So, somewhere in the mid-0.8x from a regulatory perspective is probably a good spot for us. .

Okay. Thanks very much for answering my questions. .

Thank you..

Thank you. And our next question comes from the line of Christopher Nolan with Ladenburg Thalmann. Your line is open..

Hey, guys. The weighted average on the debt book was 10.1% and last quarter was 12%. And just want to see what the difference was..

The weighted average portfolio yield at quarter end is 11.9%. The yield on the newer investments , maybe which we are talking about for the quarter, the weighted average yield on the book at the end of the year was 11.9%. .

Yeah. I was just looking at the debt investments. .

The only thing that really happened during the fourth quarter was the executive – City Gear was a pretty good evening asset during the fourth quarter. Same with US Well Services. Those are repaid. So, those were two debt investments that we got back during the fourth quarter.

If you look at what we reinvested during the fourth quarter and early 2019, which would not be reflected in here, is the Chicken Soup was just shy of 11. The US Biotech [ph] was 10. So, probably the money that we put back out was a little lower than what we got back in, but not materially so. .

Okay.

And the SLF, Joe, did I hear you correctly that you funded $30 million of it this quarter?.

Correct..

And then, the targets eventually roughly $50 million or so?.

Well, that would include our JV, Kemper, in that too. Yes..

And over what time period do you anticipate ramping up to that?.

Well, to the $50 million or for the full ramp? We will try to allocate as many unit tranche loans as we can into that JV in the sort of design now that ultimately holds 30 positions.

So, we should be halfway ramped at 15 positions, which if we can follow the activity we had in the second half of 2018 when we were very active, we can follow that for the next few quarters. We should – by fall, we should have 15 properties in there..

Great.

And then, the last question, on the leverage again, by November 1, any sort of anticipation getting shareholder approval for higher leverage?.

At this point, no, Chris. We're not planning to do that. .

And then, once November 1 happens, currently, you need to renegotiate with your debt providers.

But once that happens, is the intention to take the leverage up, release regulatory leverage up above 1.1?.

It's probably premature to give any guidance on where we think that might go. I think we will work with our lender group and determine what best fits our profile and what makes the most sense. But it would be premature to really give any guidance on that right now..

Got you..

Chris, this is Joe. What we're really focused on, which takes a while is, these risk 3, risk 4 assets, removing those from that rating, getting them improved, which we did, we felt, a good job last quarter by reducing that by a third. And also, we've got to rotate this equity. We had a nice rotation with B&W that happened a few weeks ago.

That was a warrant. We had really no cost in it. Netted $5.9 million. That was our fifth-largest equity position. We've got some other larger equity positions that we expect should monetize in 2019.

If we can get our equity percentage of the portfolio down and the risk 3 rated assets significantly reduced, if not removed, then we're in a much better position to address how we would do a portfolio leverage construct going forward.

But, right now, we're sort of laser focused on risk 3 rated assets, which we believe we are doing a good job, it's just taking longer, and equity rotation which again is taking longer, as we just saw in B&W, we're hitting our marks on these. We hit almost exactly on our mark on that monetization, which was all profit because it was a warrant.

So, that's what we're really focused on, and the big theme for 2019. .

Great. And then, I guess, final question is EPS did not cover the dividend this quarter.

Any consideration for 2009 (sic) [2019] reinstating the management fee waiver?.

Well, the waiver really has always been in place. We've never taken it away. So, we'll always rest the waiver when that situation arises, meaning that we're in a position to have to consider doing so. We didn't earn an incentive fee during the fourth quarter. So, it wasn't an issue. .

Okay. Thank you for taking my questions, guys. .

Thanks, Chris. .

Thank you. And our next question comes from the line of Chris York with JMP Securities. Your line is open..

Good morning, guys. Tom Wenk in for Chris York this morning. Thanks for taking my questions. Alternative Biomedical is an investment that was marked down rather meaningfully this quarter.

Can you guys talk a bit about the drivers of the mark prospects recovering debt service today? And perhaps, your comfort in the enterprise value supporting this investment?.

Yeah, this is Steve. We generally try not to go to deep into individual portfolio companies, but I thought somebody might ask about this. We've got it marked at 75% on a cost basis at year-end. The first lien debt is marked at 80% and the equity is at zero.

The valuation is really driven by declines in trailing 12-month EBITDA, which seems to have stabilized. The company's current on all the payments and the portfolio group really is engaged on a periodic basis to stay engaged with the company and keep monitoring going forward. So, that's kind of what I'll offer on them right now..

Got it. Your portfolio doesn't have much healthcare. But we noticed you've started to make some marginal investments in the sector recently.

What would you guys has caused you to be a bit more active in the sector?.

Generally, we're a generalist. We do have some healthcare exposure. We haven't – I think when you are referring to some new investments by US biotech, which we closed at the end of last year, which is a testing facility – it's a smaller investment for the BDC. It's an exciting equity sponsor opportunity.

But having said that, we have made good money in healthcare. The person we just hired to open our Dallas office has a sort of healthcare finance background. We do expect and want to have healthcare a larger percentage of the portfolio. I think in the economy, it's around 20%. Our portfolio, it's about 3%. So, less than 3% in the BDC portfolio.

I'm going to have to check that number on the BDC portfolio. But we've actually, historically, made significant returns, investing in different segments of healthcare. So, we expect that to grow. That's a 10% now. So, we expect that to grow more. But it's a large part of the economy.

And if you know what you're doing, you can make some good money in healthcare..

Got it. All right. Last question, your stock is traded at a pretty steep discount to the group NAV over the last couple of years. And we suspect many shareholders are wondering how and when the stock can begin to date back up closer to peers or book value.

So, what would you guys say is your plan today to unlock value in the stock and how might that necessarily be a bit different from past plans?.

Well, I really think – this is Joe. It's continuing to execute the same plan. It's just taking longer. We've got to get NAV stability. And we're going to get NAV stability by focusing on these risk 3 rated assets and also the equity monetizations.

A lot of our NAV declines or the majority of our NAV decline for this prior quarter was really just these companies – they are fine credits, but their earnings were just off in that quarter. So, if you're using the same enterprise value multiple, and you multiply it by trailing earnings that are less, you're going to lose value there.

So, luckily, for a long time, a lot of our companies on average have been growing consistently on a quarterly basis so that equity value appreciates.

We have quarter, Q4, all the uncertainty that happened in our portfolio as far as earnings, credits are fine, but the enterprise value is going down because the multiples stay the same and the earnings went down. So, we can reduce volatility by reducing the equity as a percent of the portfolio. Right now, it's 20.5%. We want to get it 10% or around.

So, I think we're doing the right things. I think you mentioned ABS. If you look at all the deals when we switch to a first lien strategy, back in early 2016, we really had hardly any credit stress, if any, until recently with ABS.

And there's more to that story that we can really discuss due to the pending or current litigation that the equity sponsor is involved in with the seller of that entity. So, we can't really talk about it. But really have had no credit stress as we move to a first lien strategy in early 2016. So, we think we've just got to continue doing what we can.

Just a reminder, to those who continue to ask this, most of our assets are still in the SBIC, Small Business Investment Company, subsidiary. You cannot use any of those cash, idle cash in that to do a share buyback.

We have very few, if any, sort of capacity at the parent to initiate any kind of meaningful share buyback – most of our liquidity is still in our SBIC subsidiaries. But we think we can continue focusing on the strategy change we started in 2016, reducing the risk-three rated assets and we should be trading closer to NAV..

Got it. Okay, great. Thanks, guys. That's it for me..

[Operator Instructions]. Our next question comes from the line of Ryan Lynch with KBW. Your line is open..

Hey, good morning. Thanks for taking my questions. The first one just has to do with the higher G&A this quarter. I think you guys mentioned some higher professional fees for the quarter and for the year. You guys also mentioned opening your Dallas office. I wasn't sure if that affected at all.

I was just trying to get a better understand of what your guys' – what's a reasonable sort of run rate for G&A as we look on a quarterly basis as we look into 2019?.

Yeah. I think, Ryan, if you look historically, now that we have not been emerging growth company anymore, somewhere in the $1.1 million range is probably a reasonable number, all things equal..

Okay..

[indiscernible]. Timing of somebody's professional fee invoicing is kind of out of our hands. But, historically, that seems to be a pretty good spot..

And, Ryan, this is Joe. Just to answer your specific about the Dallas office, the manager pays for all of this sort of growth of the office. We get the sort of a flat fee and admin fee from the BDC. Our growth in our private vehicles has enabled us to continue opening offices. About a year ago, we opened New York. We just opened Dallas.

So, we're able to subsidize the growth of the platform. I said subsidize – pay for that with the growth of our private vehicles versus adding any more expense to the BDC to grow our investment professionals..

Okay. And then, my next question has to do – I wanted to follow-up on some of the previous questions regarding leverage. I know you guys gave some guidance on regulatory leverage in kind of the 0.80 to 0.85 range. But what I wanted to talk about was total leverage or effective leverage, including the SBA debentures.

So, this quarter, your guys' total leverage bumped up to 1.59 times debt-to-equity. That's by far the highest debt-to-equity for any of the BDCs that I know of operating today. So, I just wanted to get your guys' view on how you guys view total leverage and where you guys think that should run.

I get that you guys have a significant amount of regulatory cushion from a regulatory standpoint, from a risk standpoint of managing the BDC.

What do you think is the total amount of leverage that the assets you guys are putting on today should have?.

Brian, this is Steve. We, historically, really have not gone down that road of giving guidance on the total side. I understand your question completely. I would remind you that we did just pay off $15.7 million on March 1 of SBA debentures which are exempt. So, that would reduce the total, but not have any bearing on the regulatory.

We are very sensitive to what you're asking. And it will be something that we work again in conjunction with our senior secured funding group. How we balance regulatory leverage and total leverage and how it fits within our operating model, understanding that the goal is consistent dividend coverage and stable NAV.

So, not prepared to offer any kind of guidance to you in terms of what we think is the cap investors are looking for..

Well, and I would just add, on our debt-to-equity ratio, we are not the highest right now. But close. But now with the repayment of the SBIC II that Steve just mentioned, we are sort of right in the center of a group of BDCs that have an SBIC. So, we're sort of right on the same target path there. We are by far not an outlier.

We are sort of median in the pack if you look at that. But, yeah, we are by far not the highest. And with our recent repayment, we are right in the middle of the pack of those who have SBIC's..

Sure, yeah. Just the reason I ask is just, with the additional JV that you guys are adding on, which a lot of BDCs have that sort of off-balance-sheet leverage. I view those as attractive entities for shareholders because they produce some really good returns.

But just we've seen total leverage at the BDC grow substantially really over the last year, one to two years. And so, with that trajectory, if that continues, this entity from a leverage standpoint just is – that's just adding risk.

So, I just wanted to – I don't necessarily need a cap, but I just kind of wanted to know, are you guys comfortable continually growing the total debt to equity even if the regulatory debt-to-equity doesn't change significantly?.

The only way we really grow total leverage is if we were able to get another SBIC license, which we would be interested in doing. But timing of that is really kind of to be determined. But I think, longer term, it depends on how the model works out, right, from an earnings perspective of what the makeup of the portfolio and what our yolk look like. .

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

Thank you, Ryan..

Thank you. And we have a follow-up question from Chris York with JMP Securities. Your line is open..

Hey, guys. Tom again. Just a quick follow-up.

So, to be clear, did you say the last 12 months, EBITDA growth for the portfolio was flat year-over-year?.

No. I think what I talked about is our equity depreciation and the equity securities of the BDC.

If you have an off quarter, even if your prior three quarters are the same, you're multiplying the same enterprise value multiple times a trialing – typically what we do or what our third-party process does is it multiplies the same multiple – maybe that multiple moves a little bit, but let's assume more or less they stay the same – times a trailing number.

So, if you have a quarter that's off on earnings, you have a decrease in your equity value, but that doesn't mean there is any credit stress whatsoever there necessarily. So, most of our NAV decline from last quarter was related to equity value depreciation, which you can get back.

One of our big equity positions that happened last quarter was when we exited US Wells. So, we got our debt back which is paying 14%. We also got 1.1 million shares of stock. And it's traded. The symbol is USWS.

So, as that stock appreciates – I think it's around $8, eight I haven't looked in a few days – so, say, if it goes above $8, that will directly increase our NAV related to that investment. And at 1.1 million shares in US Well Services, that can really move your NAV if that stock really starts to appreciate.

So, it's things like that that really affected the equity of the NAV versus all of our companies are flat for the year..

Got it. Okay, understood. And last one, you guys mentioned you're currently unable to implement the new share buyback program at this time.

It is that correct?.

We don't have board approval to do it. But, realistically, even if we did have board approval, we have really no capital to do it. So, most of our liquidities are in the SBIC subs. They're restricted. You can't use any of that cash to buy back stock. We just put a nice commitment into our Senior Loan Fund JV with Kemper.

So, we really have no free capital right now to do a meaningful stock buybacks..

Got it, okay. Understood. Thanks for the follow-up. Thanks, guys. That's it for me..

Thanks, Tom..

Thank you. And I'm showing no further questions at this time. I'd now like turn the call back to Joe Alala for closing remarks..

Just want to thank everyone for their time today. And we are around all day if you wanted to call and ask more direct questions or get into some details about anything that we didn't cover in this call. Everyone, have a great day. Thank you..

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