At this time, I would like to welcome everyone to the Capitala Finance Corp's Conference Call for the Quarter Ended September 30, 2020. 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 Corps 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 November 3, 2020, with the details of the company's quarterly financial and operating results.

The 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 risk including those disclosed under the section titled risk factors and forward-looking statements and the company's quarterly report on the 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. Please go ahead..

Thank you, operator. Good morning. And thank all of you for joining us today. As noted in our third quarter earnings release, we were successful in executing on a number of topics mentioned in prior calls. One of the key areas of focus was to decrease leverage.

During the third quarter, we repaid $59 million of SBA debentures, and we purchased $2.2 million of our 6% baby bonds. The result was a total debt to equity ratio of 1.99 at September 30, 2020, down from 2.64 at June 30, 2020, and 2.72 at March 31, 2020.

In summary, we have reduced leverage over 27% since the end of the first quarter of 2020 and during a pandemic. Stability of NAV per share remains a key measure. For the second quarter in a row NAV per share increased to $39.99 per share at September 30, 2020, up 3% from the prior quarter and up 6% since March 31.

Our investment portfolio continues to improve from a credit quality perspective. Debt investments rated 3 and 4 collectively account for 8.4% of the portfolio on a fair value basis, the lowest percentage in over 4 years.

We currently have three debt investments on nonaccrual and a risk-rated 4 with a fair value of $18 million down from eight investments or $42.9 million at the end of the first quarter.

Equally as important is that we currently have four investments risk-rated 3, our internal watch list totaling $5.6 million down from seven investments or $39.3 million at the end of the first quarter. Cash balances are approximately $44 million at quarter end.

We anticipate using a portion of this cash to equitize an SBIC subsidiary, giving us access to low-cost long term fixed rate capital to be used to make investments in the lower middle market and grow our net investment income. Subsequent to quarter end, we are pleased to close on a senior secured credit facility.

This line will provide liquidity for new investment activity and general working capital. Distributions remain suspended for the fourth quarter of 2020. We understand the importance of resuming the payment of quarterly distributions.

Utilization of our dry powder for new investments, including equitizing an SBIC subsidiary will help us grow net investment income and generate future distributions. Looking ahead, we are in a great position from a liquidity standpoint, both the Capitala Finance Corp and across our entire platform.

Our direct origination platform and underwriting team are in various stages of reviewing investment opportunities in the lower middle market. We approach the end of the year with a lower leveraged company, a senior secured debt portfolio, stability of NAV per share and are working to resume quarterly distributions in 2021.

At this point, I'd like to ask Steve to provide some comments on quarter results..

Thanks, Joe. Good morning everyone. Total investment income was $6.7 million during the third quarter of 2020, $3.4 million lower than the third quarter of 2019. Interest and fee income declined by $2.1 million, resulting from a decline in average debt investments outstanding.

Dividend income declined by $1.2 million, as 2019 included $0.8 million dividend from a portfolio company and $0.3 million from Capitala Senior Loan Fund II which was wound down during the second quarter of 2020. Total expenses were $6 million for the third quarter of 2020 compared to $7.1 million for the third quarter of 2019.

Interest in financing expenses declined by $0.7 million, resulting from lower average debt outstanding, while base management fees declined by $0.3 million, resulting from a decline in total assets.

Net investment income totaled $0.7 million or $0.27 per share for the third quarter of 2020 compared to $3 million or $1.11 per share for the third quarter of 2019.

Net realized losses totaled $12.3 million for the third quarter of 2020 but did not have a material impact to NAV per share as realized amounts were in line with previously reported fair values. During the third quarter of 2020, we converted our Class B common shares of US Well Services Incorporated for Class A tradable common shares.

While the conversion to this new security generated a realized loss of $6.2 million, the number of shares and our continued equity ownership in US Well Services remain unchanged.

Net unrealized appreciation totaled $14.8 million or $5.46 per share for the third quarter 2020 compared to net unrealized depreciation of $1.3 million for the comparable period in 2019.

The net increase in net assets resulting from operations totaled $3.4 million or $1.24 per share for the third quarter 2020 compared to a net increase of $1.7 million for the comparable period in 2019. Net asset assets at September 30, 2020, totaled $108.4 million or $39.99 per share, compared to $54.84 per share at December 31, 2019.

At September 30, 2020, we had $43.7 million in cash and cash equivalents. Also as of September 30, 2020, total and regulatory debt to equity was $1.99 and $1.15 respectively. During the third quarter of 2020, we repaid $59 million of SBA debentures, $19 million that matured on September 1, 2020, and $40 million that was to mature on March 1, 2021.

In addition, we repurchased approximately $2.2 million of our 6% notes through our repurchase program. Lastly, subsequent to quarter end, we've announced a new senior secured credit facility. The $25 million line will provide liquidity to fund lower middle market investments and provide general working capital.

At September 30, 2020, our investment portfolio included 36 investments for the fair value of $280.2 million and a cost basis of $283.2 million. First lien debt investments are at fair value basis at September 30, 2020, comprise 66.7% of the portfolio. Second lien debt represents 13.4% and equity/warrant investments represent 19.9%.

At September 30, 2020, we had three debt investments on nonaccrual status totaling $18 million on a fair value basis, compared to $23.9 million at June 30, 2020. As Joe mentioned, we're in various stages of review on a number of investment opportunities and our pipeline is very active. At this point, operator, we'd like to turn it over for questions..

[Operator Instructions] Your first question is from the line of Christopher Nolan with Ladenburg Thalmann..

Steve, what was the driver for the realized losses aside from the U.S.

Wells conversion?.

Mostly California Pizza Kitchen..

Great. On a strategy basis, I noticed that you guys, according to my estimates made roughly $250,000 in new investments in the quarter and had about $10 million in repayments and you're deleveraging.

Is the strategy going forward to further deleverage?.

Chris, Joe here. We've been talking about deleveraging, I think we've done a really good job of deleveraging to under 2x GAAP leverage. We are sitting on cash. We do have a new revolver in place now. We see the best way to really grow and create earnings is through investing through another SBIC subsidiary.

Currently, the cost of capital issued through an SBIC is around 1%, slightly over. It's long term, it's fixed, it's very attractive financing. We received the green light as mentioned in prior calls, and I think, April-May of this year to pursue another SBIC license. We are in constant contact with SBA, although we don't control their timeline.

Our goal has always been to receive a subsequent SBIC subsidiary in Q4 of this year. We hope that's still the case. We don't control the timeline but the SDIC 3 and the BDC have performed as we have mentioned over the past two quarters. So we're confident it's coming our way. We just don't control the timeline.

That is really accretive to growing our earnings and producing dividends..

Chris, this is Steve. On that line, with the repayment we made on September 1, we've only got $6 million due on March 1, in SBA debentures maturing. We'll decide sometime before that day, whether we want to repay any of the remaining bonds, but they don't mature until 2022 beyond that, so to be determined..

My thinking is this right now the stock price is trading roughly 22% of NAV per share. I saw in the quarter that there really wasn't any incremental investments and possible strategy could be simply just to deleverage the balance sheet, and you're not paying a dividend also.

Deleverage the balance sheet, take it to cash and with that the valuations from the stock price will go up and you can fight another day, as it were..

Well, Chris, this is Joe again. As the platform we have actually been very active investing. We'll probably have the most active quarter of the platform Q4 of this year's we've had in the prior many years. We really prefer to invest our liquidity at the BDC through a new SDIC subsidiary.

That way, we can really enhance earnings growth and future distributions, but we have no intention of just not being active and providing capital to small businesses. We're very active on pools of capital and our platform and we expect the BDC to be active too in the future..

Got it. Then I guess final question on any consideration for shared purchases..

Not right now. Good question, but not at this point. We've talked to our board about that on a quarterly basis, but not at this time..

Okay, that's it for me, guys. Thank you..

Thanks, Chris..

Your next question is from the line of Kyle Joseph with Jefferies..

Good morning, guys. Thanks very much for taking my questions. Congrats on the progress in terms of credit performance, as well as the delevering. Joe, you talked about your pipeline being active.

I just want to get a sense per the deals that are in that pipeline, how they look on spreads and terms and how that compares to kind of deal you were seeing pre-COVID..

Kyle, that's a great question. The deals we're seeing now, it really depends some on the size. I think the largest companies $20 million-plus in EBITDA and the smallest is $5-ish million of EBITDA. I will say the pricing is materially better. Unless there's a few industries, maybe some tech or healthcare that pricing is probably about the same.

But in general, pricing is better, almost double-digit first-lien yields. Sometimes we're -- a few deals were actually getting warrants, pending warrants and the deals. We're very excited about the pipeline that's closing, and we've already closed two or three. This is outside the BDC.

We've already closed two or three and expect to close three to seven more by the end of the year or early next year. As soon as the BDC begins investing, again, which we expect that to be through a new SBIC subsidiary, it can begin co-investing in these deals immediately. So we have an active pipeline.

All first-lien, some equity co-invest, some warrants. It's a very good pipeline right now that's in the lower middle market..

Got it. Very helpful. Then I guess, a question for Steve. Obviously, your NII has been choppy.

There's a lot going on, there's a pandemic and everything but just in terms of modeling going forward, x kind of deployments to the SBIC, is this a decent run rate in terms of the NII right now? Are there some headwinds or tailwinds you highlight versus the level we got in the third quarter?.

I think that's a reasonable run rate taking all things into consideration. We've got some portfolio companies that are performing very well. It depends on whether we get taken out or not, debt repaid. So I think from a modeling standpoint, that's a reasonable assumption in the short term.

But again, longer term, as Joe mentioned, the real growth in NII comes from we can actually have some of that lower cost capital and invest that money in the long middle market..

Got it very helpful. Thanks for answering my questions and nice work turning it around..

Thanks, Kyle..

There are no further questions..

Thank you, everyone, for your time today. I'm sure everyone's watching the news. It's one of those interesting days, but we're here all day. Please contact us for any further questions and we'll be here watching the news and working hard for you. Thank you for your participation..

Thank you for your participation. This concludes today's conference call. You may now disconnect..