At this time, I would like to welcome everyone to Capitala Finance Corporation’s Conference Call for the Quarter Ended June 30, 2019. 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 hosts 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 Corporation issued a press release on August 5, 2019 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 quarterly report on Form 10-Q. Capitala undertake 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, everyone, and thank you for joining us today. Yesterday, we released our results for the second quarter of 2019. Steve and I'll give you insights into the quarter and address any questions you may have.

Before we get into the specifics related to the current quarter, I want to remind you of our change in investor strategy. Early in 2016, we made the decision to adjust our investment strategy focusing on senior secured debt investments and moving away from mezzanine debt. After three years, we have successfully rebalanced the debt portfolio.

Firstly, debt investments are 78% of the total debt portfolio at June 30, 2019 compared to 46% at June 30, 2016 on a fair value basis. Net investment income for the second quarter was $0.25 per share in line with our quarterly distribution.

I'd like to point out that since the IPO, we've paid $142 million in regular distributions and have never had a return of capital. Net asset value was significantly impacted by several factors. During the quarter, we realized a $20.4 million loss on our mezzanine investment in AAE Acquisition LLC.

Several investor bankers were interview to sell the business and had given similar ranges of expected sales price which supported our prior fair value mark. Ultimately no buyers transacted in the ranges provided by the investment bank. The Senior Bank has since taken over responsibility for the company at this point.

This is not the outcome we foresaw earlier in 2019. US Well Services' equity value declined by $3.8 million during the quarter. This is a publicly traded stock with shares under lockup, with our shares our under lockup until November of this year. It is our belief that this decline is temporary.

Also we recorded $9.2 million of unrealized appreciation collectively on Portrait Studios, CableOrganizer Acquisition LLC, mostly related to the equity value rate --valuations resulting from declines in GTM EBITDA. As we look at the risk in our portfolio at June 30, 2019, a couple of observations.

We currently have four credits within a risk grade of a three. And on a fair value basis or 9.8% of the total portfolio. The lowest level since our IPO in 2013. Non-accrual balances on a fair value basis total $8.7 million or 2.2% of the total portfolio.

Our portfolio team continues to actively manage the entire portfolio, focusing on the reductions in [Indiscernible]fund credits. Since we changed our investment strategy in 2016, the BDC has invested $281.6 million in debt investments, 88% of which were first lien securities.

As stated earlier, we continued to rebalance our investment portfolio focused on senior secured debt investments and reducing mezzanine and equity investments.

We are confident that this strategy will produce a more stable net investment income in support of quarterly distributions and ultimately superior return on equity through lower realized and unrealized gains and losses resulting on a lower level of equity investments.

Our equity portfolio represents 14.2% and 19.1% of the investment portfolio on a cost basis and a fair value basis at quarter end. During the quarter, we recognized gains from our equity investments in US Bath Group LLC and Navis Holdings Inc.

Part of the rebalancing of our portfolio is the need to continue to monetize additional equity holdings and redeploy the proceeds into senior secured debt investments. We expect a significant reduction in our equity investments during the second half of 2019 resulting from normal exits and sales.

In summary, while we are not satisfied with a decline in NAV, we are very optimistic about future earnings results from a more senior secured debt portfolio. And anticipate equity monetization later in 2019. At this point, I'd like to ask Steve to provide some color on our first quarter financial results..

Thanks, Joe. Good morning, everyone. Total investment income was $11.6 million during the second quarter of 2019, $0.3 million lower than the second quarter of 2018. Dividend income for the second quarter of 2019 including $0.4 million distribution from Capitala Senior Loan Fund II, LLC.

PIK income decreased $5.2 million for the comparable periods and was 6.2% of total investment income for the current period, the lowest level since the fourth quarter of 2014. Total expenses for the second quarter 2019 were $7.6 million, a decrease of $0.1 million from the second quarter of 2018.

Incentive fees, net of waiver increased $0.2 million for the comparable periods. Net investment income of $0.25 per share for the second quarter of 2019 was in line with our quarterly distribution. Consistent distribution coverage will always an important measure of our performance.

Net realized losses for the second quarter of 2019 totaled $15.1 million, or $0.94 per share. We realized losses related to AAA acquisition and J&J Produce Holdings, partially offset by realized gains from US Bath Group and Navis Holdings.

Net unrealized depreciation totaled $17.4 million, or $1.08 per share, for the second quarter of 2019, compared to appreciation of $22 million for comparable period in 2018.

The net decrease in net assets resulting from operations totaled $29.1 million, or $1.81 per share for the second quarter of 2019, compared to a net increase of $4.9 million for the comparable period in 2018. Net assets at June 30, 2019, total $153.9 million, or $9.55 per share compared to $11.88 per share December 31st, 2018.

At June 30, 2019, we had $43.5 million in cash and cash equivalents. In addition, we had $5 million drawn and $109.5 million available on our senior secured facility priced at LIBOR plus 300 basis points. Regulatory leverage at June 30th, 2019 was 0.86 compared to 0.72 at year-end.

On November 1st, 2018, our Board of Directors approved the company be subject to a minimum asset covered ratio of at least to 150% effective as of November 1st, 2019. We do not anticipate a special shareholder meeting but have begun planning for the reduced asset coverage ratio to be effective in the fourth quarter of this year.

At June 30th, 2019, our investment portfolio included 41 investments with a fair value of $391.1 million at cost basis of $378 million. During the second quarter, we invested $13.8 million across one new company and five existing portfolio companies.

Debt investments totaled $13.4 million where first lien structures had a weighted average yield of 9.8%. The weighted average yield on the entire debt portfolio at June 30, 2019 was 12.2%.

First lien debt investments on a fair value basis at June 30, 2019 comprised 60.1% of the portfolio, while second lien and subordinated debt collectively represent 17.3% equity and warrant investments represent 19.1% and our investment Capitala Senior Loan Fund II represent 3.5%.

At quarter end we have two portfolio companies on non accrual status with the cost basis and fair value of $13.3 million and $8.7 million respectively. Lastly, our direct origination platform is focused on generating quality senior secured opportunities that satisfy the return profile of the Capitala platform including Capitala Finance Corp.

And we expect an active second half of the year in that regard. At this point, operator, we would like to turn it over for questions..

[Operator Instructions] And our first question comes from Christopher Nolan with Ladenburg Thalmann. Please proceed..

Hey, guys. The -- I saw an increase in the last first lien last out is what sort of portfolio yield are you guys targeting? Because I know it's 12% or so which is a little bit higher than what you'd normally see for first lien first out. And I guess that's my question..

Yes. I am not sure specifically what you're asking Chris. I mean this is part of our overall unitranche facility program where we've got the Capitala Senior Loan Fund I taking the first out and then other Capitala entities taking the last out piece.

The first out it will be priced differently clearly so that the other Capitala entities are benefiting from a higher yield in that regard. So I think we're expecting to see double-digit yields for Capitala Finance Corp when it participates in those unitranche facilities..

Okay.

So it's just a function CLF really?.

Most of the time, that's correct, yes..

Okay and then my follow-up is on leverage. You guys anticipate given that you can start increasing your regulatory leverage after November.

What is the plan in terms of your regulatory leverage ratios beyond that?.

Yes. Good question, Chris. So, look, our total leverage is 1.8; regulatory is 0.86 at the end of the quarter. The difference being our exempt SBA debentures. As we work with our bankers, we're certainly going to be mindful of how any future increases in our total regulatory leverage impacts our ability to deliver stable net asset value for share.

So we're going to continue to move towards making senior secured debt investments moving away from mezzanine and equity. And that should help support higher leverage bit in the meantime 0.86, there's not a lot of room there.

So we'll continue to again work with our bank and try to move towards that higher level as our board had approved and becomes effective November 1st of this year..

Final question. What's more normalized cash basis balance sheet cash for you guys..

It varies greatly. We have pretty active investment activity coupled with repayments. So I would say where we are at the end of the quarter is not unusual. We've got a fair amount of liquidity that we can put back to work and that's pretty normal actually. .

Our next question comes from Kyle Joseph with Jefferies. Please proceed..

Hey, good morning, guys. And thanks for taking my questions. Joe, I just wanted to touch base on the on a sales process you talked about in the quarter that impacted NAB.

How do we think about how that impacts NOI going forward? Was that investment on non-accrual or accrual? And is there anything left of it on your books?.

Kyle, this is Steve. I'll take that one. It was on accrual status because it has been current but going forward it should not have a meaningful negative impact on NII as we continue to put repayments and cash back to work. We've kind of restocked that but that investment is off of our scheduled investments. We took a fall right off on that at June 30th.

So it's no longer an active investment..

Got it, thanks. And then one follow-up for me, if you could just talk about the any changes in the competitive dynamic in the industry. Obviously, the rate outlook has been shifting.

We've seen the industry been able to increase its leverage but just sort of since we last spoke any sort of changes you're seeing in the industry?.

And this is Joe. I mean it's very similar to prior quarters in that. It's still a competitive industry but the lower-middle market seems to be trending on the less competitive side as some entrants have left or in the process of leaving. We've been able to generate some really nice loans of the last three years in our new first lien strategy.

The leverage on those loans is very reasonable we think. The average is less than 60% loan to value. And the average yield is right as Steve mentioned earlier on all those first lien loans are right around 10%.

Some little lower, some little higher and some in -- most of those loans are either they are all first lien first out, or if we do have a first out piece, we're taking a very small first out position to our captive senior loan fund of around 25%.

We're not very active in the market doing unitranche loans, where we're behind 50% to 70% of a first lien structure that's third-party. So we really do believe our unitranche loans or structured correctly. And we should still generate those type yields. Now our LIBOR has gone down a little bit with the recent cut.

We were proactive when we structured all these loans over the past three years. And we have actually have higher floors than we expect, our competitors do. Those often became negotiating points in each specific deal. So we feel good about the ability to find these deals in lower-middle market.

And we think having the amount of liquidity and the size of the team we have, and we expect to start to grow more this fall that we're in a good place when it comes to lower-middle market credit..

Our next question comes from Ryan Lynch with KBW. Please proceed..

Good morning and thanks for taking my questions. First one, I just wanted to fall back up on AAE. So it sounds like that that was in a process, a sales process and some bankers were giving you guys some quotes. The question was it seemed like that company was still paying you guys' interest income.

It was still on an accrual status and still had a pretty high fair value mark in the prior quarter. So was the whole basis of the mark that you guys had based on them being able to complete at the sales process or was there anything else driving that? Because it's just a pretty extreme mark to go from 85 to exit at a 0..

That's a great question. We've been trying to monetize or improve our risk free assets actively over the past few years. We actually did sell one that we haven't talked about. We sold J&J Produce over the same last quarter. It was a risk-free asset; it was in a process that we got 91% cost.

AAE, the size of the company actually had interest from many investment banks. We ran a full investment bank interview process. Most of those investment banks had a range, a tight range on the higher end enterprise value that we believe they could achieve. They believe they could achieve.

We obviously had our independent valuation team involved in this entire process. It went to market. We actually receive bids in that range. So we did have a third party bids in the range that the bankers believe. And then post diligence, the offers did decline and they declined to the point we were mezzanine in this particular transaction.

They declined to the point the bank has really taken over this operations and the responsibilities of this company. We were no longer involved. We do believe the bank would transacted if something that gets them out hold, but would not go much more than that to try to take care of us. So we did impair to zero.

But we believe is that the process was not the outcome we wanted. We were very confident in the banks, in the bank that we chose and they ran a good process that just did not transact at the original offers that were made for the company..

Okay and then you mentioned you guys expect exit some of your equity positions in the second half of the year, reduced that concentration in your portfolio. I know that's been a goal for at least the last several quarters maybe last several years to kind of reduce your guys' exposure as it is fairly high.

What gives you guys' confidence that you'll be able to further reduce your equity portfolio in the second half of the year? There are companies that are currently in the M&A process or the bid process or are there active markets for some of your investments?.

Yes. That's another great question. Equity continues to perform well. But if you look at what we're sort of focus is really the top three names that we publish on our equity holdings. One of the publicly traded company US Wells Services we talked about earlier, the stock has declined meaningfully over the past period of time.

But it's -- you can track that as publicly traded are lock ups as we mentioned do expire over time. So that when you can publicly just track how that would affect our equity valuations. Then we have two more large ones. One of the two large ones has already hired a banker. They're in process.

We have been communicated some very optimistic thoughts on that process in the early stages. We do believe that company transact between now and the end of the year. It is a larger asset that's held by other BDCs too. So we're excited that that one may monetize in the fall. And then the other larger one has been on books for a while.

We believe they will go to market in 2020 and then so you're looking at six months into 2020 for a process on that one.

But really it's US Wells to track and then also our larger one that's in market right now that's owned by other BDCs too that should monetize the fall and that really would make a meaningful conversion of equity to cash which we need to take it out and put it into these first lien yields.

And that's where our earnings, we're really optimistic about our earnings on that conversion. .

It rises. This is Steve. Remember on US Wells that we're still under lockup. So once we get to November all of the things equal we are free to trade. .

Our next question comes from Troy Ward with Ares Management. Please proceed..

Hey. Good morning, guys. Hey, Joe, I just had a real quick question on a following up from Ryan's question. You talked about how your value was based on the takeout. I have a couple questions.

First are there any other fair values in your portfolio that hinge almost solely on the value of a takeout? And second, how long were you in that investment and as an owner as an investor shouldn't your knowledge of those underlying fundamentals in that transaction should have been higher than any buyer.

So what was found in due diligence that surprised the buyers that lowered their bids, but also surprised you to wiped out your fair value..

Let me sort this sort of a multi-part question. Let me sort that sect in the few parts. The first part is familiarity with this investment. In fact, this investment we entered it the first time and I think 2003 back when we were private fund. We entered it. We sold it very successful investment. We got back in it.

So we've been familiar with this investment for almost 15 years now. Very familiar with it, very active in it. This company did have earnings. This was not a company that -- this company is a rental company, it has a lot of assets and equipment but it does have earnings.

So it's not as if the bankers in our process were basing anything on the potential time the sky transaction value, it was a multiple of trailing EBITDA that everyone was basing their valuation on. I think from what we understand happened in the process are the third-party buyers believed the CapEx needed to refurbish some of the fleet.

Some of that equipment was much greater than we believe and management beliefs. So they sort of reduce their bids accordingly. And then my opinion is the bank just got frustrated because they saw a path to where they could get much more recovery. And not worry about the junior debt in the capital scenario.

And once they see that path they do have their right that they can unless we want to take them out, that's the mezzanine lender wants to take them out, they have the right to start performing their remedies which they did.

So we were removed from the process, but in the equity sponsor obviously was completely impaired and but so we have familiarity with the deal. But it was not a transaction that we saw that was -- it was based on EBITDA. It was based on equipment values and EBITDA.

We did have multiple banks in the same range, but it was just a failed process at the end..

I see.

So it was much more to do with about your position in the capital stack and seniors ability to just run over you if you couldn't buy them out?.

Yes. And then the only -- you mentioned another question about there was anything else in the portfolio sort of valued owned pending sale. And it is not. And that goes for all-- both the ones that are performing; the ones that are over performing; the ones that underperforming.

So we have optimistic views on some of this equity monetization will occur at a value that's hopefully better than what we think is a multiple EBITDA. And really that happened in our last quarter with US Bath. So, yes, we've been a great return on that. It was a huge multiple on invested capital.

Unfortunately, all the good things that we did last quarter sort of it take second to focus and the bad things that happen on the related to NAV.

But we do believe that we're much further along on this rebalancing of the portfolio that started in 2016 and that when you look at assets deployed over the past three years, it really confirms the change in strategy and underwriting and portfolio management of those successful performing assets..

Okay and then one last question for me. And it relates to the SBIC. Can you speak to what or how much many of the assets that have been impaired and cost us a 17% write- down in NAV in three months? Were -- is the SBIC and what has your conversations with the SBI been that's such an important part of your ability structure..

On that Steve digging over here to try to get to answer on what's in SBIC. I will just say on a broad relationship with SBI. We have a lot of communications with them. We do have a private SBIC funds in addition to these BDCs. What you're referring to is also referred to as READ, Retain Earnings Available for Distribution.

It's a very much a big focal point for SBA and thing about READ that's unique. It's cost basis accounting versus fair value accounting. So they really focus on it. We have had some of this monetization happen. Like I just mentioned US Bath where we made 9x our money on the equity on that one half and last quarter.

Those things have helped READ over time, our READ is not to the point where SBA has communicated to us any concern over negative READ. And, in fact, we do believe that we will have some more positive READ events meaning monetization of the equity this fall.

Because you got to remember we keep, is this SBI accounting not -- we keep fair value books and SBA books. The SBA books, you keep all your equity positions at cost. So if we could have a cost of like in US Bath $500,000 was our cost. It was on our books for $500,000 so we sold it last quarter for $4.5 million.

Son once you monetize to realize it then you book the appreciated asset. So that's how the READ calculations in general work in SBA valuations. So we have -- we are in constant communication with them. We've been in the program since 1999. So we value the relationship and we do believe that our READ outcomes by the end of 2019 will be very favorable..

And we have a follow-up here from Christopher Nolan with Ladenburg Thalmann. Please proceed..

Hi, questions answered, thank you..

This is Steve. I want to come back and finish the last of Troy's questions related to which ones were SBIC investments. From a realized perspective AAE was an SBIC investment. So that will have a bearing there. On the unrealized side.

Certainly US Wells Services is not but the other two that we mentioned Portrait Studios and CableOrganizer they are in the SBIC program, but those again -- those are unrealized at this point, just fair value to class due to softness in earnings. End of Q&A.

Thank you. And I'm showing no questions in queue. I'd like to turn the call back over to Joe Alala for closing remarks..

We'd like to thank everyone for participating today. Steve and I around most of the day all week, exciting answer any more questions. Steve is sent some of the analysts a little summary. So if you want to follow up on that we more than happy to do that. We're around all day. Thank you for your participation. And look forward to next quarter..

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