At this time, I would like to welcome everyone to Capitala Finance Corp’s Conference Call for the Quarter Ended December 31, 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 3 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 March 2, 2020 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. 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 and thank you all for joining us today. I would like to talk through actions taken by management in 2019 to position the company for improved financial performance in 2020, then Steve will provide detail on our fourth quarter performance, after which we will welcome everyone’s questions.

Since we changed our investment strategy in early 2016, our portfolio mix has changed. First lien debt investments account for 81% of the total debt portfolio on a fair value basis at year end compared to 46% at the end of 2015.

Since the first quarter of 2016, the BDC has invested approximately $390 million of total investments, 76% in first lien debt structures, 17% in second lien debt structures, 4% in equity and 3% related to our investment in Capitala Senior Loan Fund II.

Equity as a percentage of total investments is 17.6% at year end and on a fair value basis compared to 20.5% the previous year end. During the fourth quarter of 2019, we partially exited our investment in Nth Degree, Inc. and realized a $25.9 million capital gain for CPTA.

While it is our plan to continue to reduce equity as a percentage of total investments through normal exits, we will continue to make new equity investments as part of our normal underwriting and investing to provide NAV upside. We ended 2019 with no zero that is non-performing loans.

I would like to thank our very talented portfolio management team for this accomplishment. Credit quality is of the utmost importance and our focus on zero secured debt securities.

While senior secured debt securities are proved to be helpful in this regard, we are pleased to report that our class action lawsuit was officially dismissed during the fourth quarter of 2019 without a settlement.

Also during the fourth quarter, we announced that Mitsui USA has purchased a minority investment in the external advisor providing resources for growth of our credit and equity strategies both focused on the lower middle-market. We are also actively pursuing an additional SBIC license within the BDC.

The benefit of an additional license is access to low cost, long-term fixed rate debentures that are exempt from regulatory debt ratios. This will provide additional dry power for us to grow our investments and ultimately, our earnings. We will provide more information on this process as we move further along in it.

The BDC continues to benefit from being part of a larger credit platform by having the ability to co-invest in lower middle-market unitranche deals ranging in size from $25 million to $90 million, where the BDC typically invests $5 million to $15 million per transaction. We enter 2020 with significant liquidity across the platform.

Our cash balances from recent repayments coupled with our recently renewed line of credit, the company can remain active in the lower middle-market allowing our direct origination offices to continue to source new opportunities. Our pipeline consists of number of quality opportunities and we expect to have a very solid first quarter of 2020.

At this point, I would like to ask Steve to provide some color on our first quarter financial results..

Thanks, Joe. Good morning, everyone. Total investment income was $9.6 million during the fourth quarter of 2019 $1.7 million lower than the fourth quarter of 2018.

Interest and fee income declined by $1.5 million for the comparable period resulting from a decrease in debt investments outstanding along with the decline in the weighted average yield on our debt portfolio resulting form our continue first-lien investment strategy.

Dividend income increased by $0.2 million for the comparable periods, while PIK income decreased by $0.3 million. Total expenses for the fourth quarter of 2019 were $7.7 million, a decrease of $0.1 million from the fourth quarter of 2018. There are no material variances to report.

Net investment income for the fourth quarter of 2019 was $0.12 per share compared to $0.22 per share for the fourth quarter of 2018. Consistent distribution coverage will always be an important measure of our performance.

We are focused on deploying our dry powder into lower middle-market first lien investments, debt investments and certain situations equity to help grow our net investment income and ultimately our return on equity.

Net realized gains totaled $1.7 million or $0.07 per share for the fourth quarter of 2019 compared to net realized losses of $14.6 million or $0.91 per share for the same period in 2018.

During the fourth quarter of 2019, we realized a $25.9 million gain on the partial exit of Nth Degree partially offset by realized losses on Vology Inc., Portrait Studios LLC, CableOrganizer Acquisition, LLC and American Clinical Solutions.

I would like to note though that the net realized gains during the fourth quarter of 2019 did not have a material impact on our net asset value per share as realized amounts were in line with previously reported fair values.

Net unrealized depreciation totaled $3.1 million or $0.19 per share for the fourth quarter of 2019 compared to appreciation of $1.2 million for the comparable period in 2018.

The net decrease in net assets resulting from operations totaled $0.1 million for the fourth quarter of 2019 compared to a net decrease of $9.2 million for the comparable period in 2018. Net assets at year end 2019 totaled $148.1 million or $9.14 per share compared to $9.40 per share at the end of September 2019.

At December 31, 2019, we had $62.3 million in cash and cash equivalents. In addition, we have zero drawn and $60 million available on our senior secured credit facility priced at LIBOR plus 300 basis points. Regulatory leverage at December 31, 2019 was 0.86 compared to 0.72 at December 31, 2018.

On November 1, 2018, our Board of Directors approved that the company be subject to a minimum asset coverage ratio of at least 150% to be effective as of November 1, 2019 so that change is now effective.

During the fourth quarter of 2019, we amended our senior secured line of credit rightsizing our commitments to $60 million and giving us additional flexibility related to the change in asset coverage requirements.

At December 31, 2019, our investment portfolio includes 43 investments with a fair value of $362.5 million on a cost basis of $353.9 million. During the fourth quarter of 2019 we invested $29 million across 3 new companies and 5 existing portfolio companies.

Of this amount, $27.4 million were first lien debt investments with the weighted average yield of 9.0%. The remaining $1.6 million were equity co-investments. The weighted average yield on our entire debt portfolio at December 31, 2019 was 11.5%.

First-lien debt investments on a fair value basis at year end comprised 63.8% of the portfolio, while second lien and subordinated debt collectively represent 14.8%, equity and warrant investments represent 17.6% and our investment in Capitala Senior Loan Fund II represented 3.8%.

Please refer to our fourth quarter investor update on our website for additional information regarding the trends in our portfolio composition since we changed our investment strategy in early 2016. At quarter end, we have no – at year end we have no non-accrual loans.

Our portfolio management group has been active with the entire portfolio, with particular attention to underperforming credits.

Our direct organization platform is focused on generating quality senior secured opportunities to satisfy the return profile of the Capitala platform, including the BDC and we expect several deals currently under terms to close soon.

Lastly, we are in the process of developing a responsible lending policy for our platform something we plan to rollout as soon as possible and will be included on our website. At this point, we would like to open it up for questions..

[Operator Instructions] Our first question comes from Christopher Nolan of Ladenburg Thalmann. Your line is open..

Hey, guys.

Is it correct that given the amendment of the bank facility that you guys are now cleared in terms of your competence and so forth to increase your leverage – your regulatory leverage ratio above 1:1?.

That’s correct..

What’s the plan in that respect? Is there plan in 2020 to take it above 1:1 or what’s your thinking?.

Chris, I would say in the short-term, I would say, let’s move it up to about 1:1 and see how we are doing there I would not forecast this go too much beyond there in the short-term..

Okay, great.

And then in the quarter, you had lower dividend income Q-over-Q I mean just curious what was affecting that?.

Yes, last year – last quarter we had a large dividend that was non-recurring. So I think this quarter’s dividend income looks little more normal..

Great.

And then the resources that Mitsui is providing, what are those specifically beyond cash I mean?.

Well, the resources other than investing in the manager and providing working capital continue to expand the platform as we have hired – almost a dozen, half a dozen or dozen people since October, very skilled professionals that we have brought to the team.

So, other than the working capital grow the team, they are helping us attract private pools of capital and best product pools of capital on the platform and then also with their expansive – global investments in several 460 companies, they really helped at the portfolio level with some industry expertise.

And also as you can imagine some of these small businesses where we invest in getting access to some of the larger companies on the Mitsui family and portfolio can have a material impact on the outcomes of their performance too. So, it’s been a great partnership today and we look forward to many years up..

Great. Thank you for the color, Joe.

Final question, given the market turbulence over the last couple of months, can you give a little color in terms of what you are seeing in terms of deal terms for the lower middle-market space from your perspective?.

As far as we have continued to see somewhat a compression and yield in the lower middle-market, especially sponsor activity is where we are seeing the most compression.

However, what I do believe we do have in the lower middle-market, which is maybe not as robust in other larger middle-market and large syndicated loans is we still have great covenants and structures.

I think our loan to values in our portfolio is still trended at 50% and under, loan to values over the past many quarters and forecast this quarter too so we are seeing nice loan to values they are on the lower side typically three to four covenants per transaction so these are not any definition covenant like deals but we have seen our compression and pricing on the sponsor activity but I will say only non sponsor activity to still from very attractive pricing we pursue both sponsor and non sponsor activity and we are trying to blend that to sort of keep yields up as we are continuing to see compression on the sponsor activity side but the structures are very good our loan to values actually been decreasing over the past many quarters which we believe puts us in a great situation as the downturn hits this portfolio..

Great. Okay thanks for the detail..

Thanks, Chris..

Our next question comes from the line Ryan Carr of Jefferies. Your line is open..

Good morning guys..

Good morning..

So, yes, the first question for you is related to portfolio growth you in the fourth quarter this year you had your transition towards the first lien is largely come above 80% I am just curious in 2020 what is your outlook for portfolio growth and when do you expect that to resume in the near-term?.

Well, we did have a nice Q4, we expect to have a solid Q1 as sort of mentioned we had many professionals since October we opened in LA office we had another origination partner with significant experiences joined us opened the Dallas office last year and then continued to expand in the Charlotte office so deal flow is actually increasing we put a lot of private vehicles on the platform so we are able to hold much larger deal than ever before we can go up to $90 million arrange and leave those deals we have never had that capacity before so we are excited we think we are setting our internal sort of goals at 3 to 4 investors per quarter and we expect that to be the pace and the BDC will have the right obviously to take its pro rata portion of all those deals and I cannot think of a deal I have not taken its pro rata right yet but we do we have a lot of liquidity although we are being very prudent we are not giving our structures we are not giving all covenants we will move down in pricing because that’s where especially the sponsor activity is and we are helping to adjust the yield compression there with our Capitala Senior Loan Fund to which is our JV with Kemper we were able to put a first out allocation there and blend up our yields in the BDC so we are doing all the right things we think this will be an active year we do think that lower interest rates may happen and sort of factoring that into all of our decisions to but we think this will be a strong year of deployments for the firm..

And on the quarter-to-date investment activity year, are you able to give any color on what that looks like end of the quarter so far?.

Which quarter it would be premature to do that. I think to Joe’s point we do anticipate having several investments closed but at this point it is premature to discuss any details..

Okay.

And then next question obviously with the rate environment yield outlet gets a forward rate cuts are continued to be expected with respect to your structures your loans what percentage of them have LIBOR floors and what are you what steps are you taking really to address the rate cuts?.

Yes, this is Steve. Most of our floating rates investments have floors in them looking to see from a variable. So at the end of the year 63% of our loans were variable rates so the remainder are fixed rate. And again, that goes back to our legacy routes from SBIC world.

So if you look at our sensitivity analysis in our 10-K if rates drop 100 basis points all things equal, I think reflect maybe a $0.05 to $0.06 impact of net income over the course of the year again all other things equal so we are keeping an eye on that, we have identified all the assets that are variable rate and what that impact for rate cut would do I think we would be fine..

Okay thank you guys very much for answering my question..

Thank you.

[Operator Instructions] We have a follow-up from Christopher Nolan of Ladenburg Thalmann. Your line is open..

Hey Steve.

Did you indicate that there could be additional major acuity realizations in the first half of ‘20?.

I did not I think we always anticipate in the normal course of business to have some repayments. So we did not say that no..

Okay, great. Thanks for the clarification.

Also your investment yields for the portfolio are pretty steady Q over Q I mean given the decrease in LIBOR how are you guys maintaining your yields and what is the strategy around that going forward?.

One thing we are doing is especially its gotten more competitive in the sponsor activity as we do have a JV with Kemper in the BDC, our Capitala Senior Loan Fund II, we are able to take reasonable allocation of that unitranche call it 25% on average put in our JV blend up our yields so there is a little sort of own platform financial engineering there that self maintain yields and also a big component of our strategy is non sponsor deals or you can still get much higher spread than you can on sponsor deals and we are continuing to close and pursue non sponsor activity so we are proud that we have kept our yields higher in this environment.

Great. Thank you for the detail, Joe..

There are no further questions. I'd like to turn the call back over to Joe Alala for any closing remarks..

Thank you everyone for your time. Steve and I are around all day, please call us if you have any further questions and we will hope to be very responsive and we will talk to you in next quarter everyone have a great day..

Ladies and gentlemen, this concludes today’s conference. Thank you for participating. You may now disconnect the program. You may now disconnect. Everyone have a great day..