Good morning, and welcome to OFS Capital Corporation's First Quarter 2014 Earnings Call. It is my pleasure to turn the call over to Ms. Mary Jensen, Vice President of Investor Relations. Ms. Jensen, you may begin. .

Thank you. Good morning, everyone, and thank you for joining us. With me today is Glenn Pittson, our Chief Executive Officer; and Bob Palmer, our Chief Financial Officer. Please note our earnings announcement was released this morning and can be accessed via the Investor Relations section of our website at ofscapital.com.

We will plan on filing our 10-Q this evening. .

Before we begin, please note that statements made on this call and webcast may constitute forward-looking statements within the meaning of the Securities Act of 1933 as amended.

Such statements reflect various assumptions by OFS Capital concerning anticipated results are not guarantees of future performance and are subject to known and unknown uncertainties, uncertainties and other factors that could cause actual results to differ materially from such statements.

The uncertainties and other factors are in some ways beyond management's control, including the risk factors described from time-to-time in our filings with the Securities and Exchange Commission. Although we believe these assumptions are reasonable, any event assumptions could prove to be inaccurate.

And as a result, the forward-looking statements based on these assumptions also could be incorrect. You should not place undue reliance on these forward-looking statements. OFS Capital undertakes no duty to update any forward-looking statements made herein, and the forward-looking statements speak only as of the date of this call. .

A replay of this call will be available until May 30, beginning at approximately 2 hours after we conclude this morning. Alternatively, the webcast will be available for the next 30 days. To access either replay, please visit our website at ofscapital.com. .

With that, I will turn the call over to Glenn. .

first, the reduction of our management fee; second, our dividend; and third, investment expectations for the balance of 2014. .

As we've described over time, the process of completing the acquisition of our drop-down SBIC fund took longer than we would've liked. This delay hampered our ability to fully implement our business plan, mainly in terms of being able to leverage the potential of the SBIC fund.

This vehicle is a critical driver of profitability for OFS Capital, both through the capacity to fund investments, which are expected to generate double-digit returns on average, as well as access to favorable financing. .

After assessing the impact of this protracted delay on our shareholders, the Investment Advisor unilaterally decided to reduce the base management fee by 2/3 for the remainder of 2014. The net result of this reduction is a halving of the base management fee for all of 2014 from 1.75% back to 0.875%. .

At the time we went public, the Investment Advisor agreed to lower the base management fee by 50% for approximately 1 year. Its purpose was to ease the burden of management fees on the earnings of the company while we work toward adding higher-yielding investments to the portfolio.

A guiding principle of our Investment Advisor is that a manager should never profit from its investors. The manager should always profit alongside of its investors. .

As you may also be aware, the Advisor is controlled by the largest shareholder of OFS Capital, which owns more than 30% of our outstanding shares.

This unilateral action to cut the base management fee is being taken to reaffirm the alignment of interest among all stakeholders and demonstrates confidence in our ability to deliver superior returns over the long term by providing capital to middle-market companies across the United States. .

All of the pieces are in place to put our capital to work in direct investment opportunities. On our last earnings call, we mentioned our target run rate of about $10 million per month in SBIC investments. And so far this quarter, we're on pace and remain confident that we will continue to do so over the long term. .

As we announced this morning in our earnings release, OFS Capital's Board of Directors approved a $0.34 distribution for the second quarter, payable on June 30 to shareholders of record as of June 16. Last year, our second distribution was paid on April 30, 2013. I am calling this out, as it is a change from the schedule we filed last year.

It is our expectation to continue to make future distributions at the end of each calendar quarter consistent with other BDCs. .

Now before providing some color about our backlog, I'll turn the presentation over to our Chief Financial Officer, Bob Palmer. .

Thanks, Glenn. Our investment portfolio totaled $228 million on a fair value basis as of March 31, equating to 97.9% of cost. The portfolio was comprised of 56 companies, 47 in the senior loan fund and 9 in the SBIC fund. .

senior secured debt investments and 54 borrowers with an aggregate fair value of $210.9 million; subordinated debt investments in 2 borrowers with an aggregate fair value of $9 million; and equity interest in 8 of the SBIC funds, 9 portfolio companies, which had an aggregate fair value of $8.1 million. .

At March 31, the 56 companies in our portfolio were diversified across 18 industries. Our largest portfolio company investment accounted for 6.5% of the aggregate fair value of our investment portfolio at March 31 and investments in our 5 largest names accounted for just under 19% of the portfolio's total fair value. .

Our average portfolio company loan size was approximately $4.1 million at March 31, and the weighted average yield to fair value on our debt investments was 8.35%, including 6.89% on debt investments in our senior loan fund and 13.23% on debt investments in the SBIC fund. The 8.35% overall figure compares with 8.53% as of December 31, 2013.

A number of our portfolio companies completed credit agreement amendments in the first quarter of this year that involved reductions in pricing. We're seeing that trend continue thus far in the second quarter. .

The leverage loan market remains competitive, including in the middle and lower middle market segments in which we participate. Floating rate loans comprised 84% of our loan portfolio at the end of the first quarter of 2014, as all of the loans in the senior loan fund are at floating rates, while 7 of the 9 loans in the SBIC fund carried fixed rates.

All of our floating rate loans contained LIBOR floors. We had 1 nonaccrual at March 31, our debt investment in Strata Pathology, which had a fair value of $1 million and which has been on nonaccrual since the first quarter of 2013. .

In the quarter, we closed a senior secured debt investment in 1 new portfolio company with a face amount of $3 million, and we made $0.8 million add-on loan in an existing portfolio company. We made both of those investments through our SBIC fund.

Thus far, in the second quarter we have closed 2 debt investments, both through the SBIC fund, with an aggregate principal balance of $13 million. .

We derived approximately $5 million in total investment income from our portfolio in the first quarter of this year compared with $4.5 million in the fourth quarter of 2013. Approximately $3.3 million of this quarter's total was derived from our senior loan fund while $1.7 million came from our SBIC fund. .

Expenses totaled $3.6 million for the 3 months ended March 31 compared with $3.1 million for the prior quarter.

Included in the $3.6 million in first quarter expenses were approximately $1.3 million in management fees, which included $0.2 million to MCF Capital Management for its role with respect to the senior loan fund and $1 million in base management fees to our Investment Advisor. .

As Glenn discussed a few minutes ago, earlier this week, our Investment Advisor reduced the effective base management fee from 1.75% to 0.875% for fiscal year 2014. The $1 million in base management fees in the first quarter were calculated on an annual rate of 1.75%.

In order to achieve the reduced effective base management fee rate of 0.7 -- 0.875% for the entire fiscal year 2014, the base management fee for the remaining 3 quarters will be approximately 15 basis points per quarter. .

Net investment income for the first quarter was approximately $1.4 million, or $0.15 per share, compared with just under $1.4 million, or $0.14 per share, in the fourth quarter of 2013. .

$0.9 million of unrealized gain on non-control, non-affiliate investments; $0.5 million in unrealized gain on affiliate investments; and $0.8 million of unrealized loss on our control investment in Tangible Software, Inc. .

For the 3 months ended March 31, we had net increase in net assets of $2.1 million, or $0.21 per share, compared with $1.2 million, or $0.12 per share, in the 3 months ended December 31, 2013. .

With respect to liquidity, we had $37 million in cash and cash equivalents, as well as $14.7 million in borrowing availability on the senior loan funds credit facility at March 31. As of May 7, we had $21.7 million in cash, including $18.9 million in the SBIC fund and $15.4 million in borrowing availability on the senior loan funds credit facility.

At this time, the SBIC fund has leveraged commitments of $61.4 million from the SBA and $26 million of outstanding SBA-guaranteed debentures, leaving incremental borrowing capacity of $35.4 million under SBIC regulations.

Between its $18.9 million in cash and the $35.4 million in borrowing capacity, the SBIC fund currently has approximately $54.3 million with which to make investments. .

With that, I'll turn the call back over to Glenn. .

Thanks, Bob. Our investment pipeline is beginning to show real results, and we are encouraged by our present backlog that includes 9 potential investments totaling $87 million. The definition of backlog is investment opportunities where, in my opinion, there is a greater than 50% % chance of closing.

The backlog includes add-on investments, balance sheet refinancings, change of control transactions and dividend recapitalizations. We are working with private equity firms, independent sponsors and management owners. I'm very pleased with the investment opportunities being generated by our expanded team and the diverse sourcing of these transactions.

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Looking ahead, our plan is to complete the necessary steps to fully capitalize the SBIC fund, which should provide us with access to the full $150 million in SBA-guaranteed debentures. We believe we are well positioned going forward and have a strong investment team that is delivering attractive underwriting opportunities. .

With that, operator, you can now open the phone lines for questions. .

[Operator Instructions] We have a question from J.T. Rogers from Janney Capital Markets. .

First question, just on the Operating Expense line, I saw that went up by 200, or the -- specifically, the Administrative Expense line. That went up by $200,000 associated with an increase in salaries and bonus accrual.

So wondering if that is a onetime or a seasonal event or if $475,000 is a new run rate for administrative expenses?.

J.T., thanks. That is seasonal onetime a year. And what it reflects, J.T., is the bonus payments that happened in the spring of the year for employees whose time is allocated under the services agreement. .

Okay. And then I think last quarter, you talked about there being -- there -- in the fourth quarter, there's $200,000 of legal and accounting expense related to the SBIC drop-down, and some of that would be going away in the first quarter. It didn't look like there was a significant drop in the professional fees.

Just wondering if -- what's the run rate on professional fees, if there was another sort of onetime issue in that line item. .

There were some onetime line items. They were carryover expenses relating to the drop-down that was completed in January. We consummated and paid the money in December. And there were legal and accounting expenses related to that, that carried through into the first quarter.

We do expect to be discussing meaningful reductions in the professional fees going forward. .

Can you quantify that? Is that $50,000, $500,000? Just trying to get a range of the magnitude. .

My expectation is that it should approach $100,000. .

In savings?.

In savings. .

Okay, great. And then there looked like there was a big decline in the fair value of Tangible.

Just wondering what is -- what's going on there and what's your all's view as to the forward outlook for that company?.

Sure. J.T., it's a government contractor. And as you may be aware, a number of the government contractors have experienced headwinds of late. And we're in active discussions with the company and its backers. We're not in a position at this point to give you more color on that, but we hope to be able to do so in the relatively near-term future. .

And just -- obviously, in discussions but just looking at sub, if I do my math right, sort of a mark at about a 30% discount to par.

Would that indicate the potential for this company moving to nonaccrual?.

There's always that potential. All payments are current with that name, and there wasn't meaningful excess cash flow payment made during the first quarter. .

Okay, great. And then just looking in to 10 years -- a little bit -- I think you all said that you were closest receiving, like final capital certificate from the SBA.

I assume you all received that?.

Still going through it with them, J.T. .

Okay, all right. It looks like the backlog is good. I think you mentioned there's some pressure on margins. But in terms of that, Glenn, I think you said it was an $87 billion backlog.

Is -- what sort of the yield on that piece of the -- on that backlog, and maybe what are the IRRs expected from that, from those investments?.

I won't address IRRs because it's a blend of -- on average. I mean, there -- because there's a blend of equity investments and whatnot in there. So it's hard to really to make a public statement on that.

But if you look at the investments, the actual coupons on those investments, we're probably close to 11% in cash yields on those, probably closer to 3% in PIK, on average, out of that $87 million for all of that interest-bearing securities we're looking at. So it kind of bring this to a 13%, 14% yield on those types of investments.

There are $5 million-ish of potential equity investments that we're looking at, an add-on and new transaction. So it would -- a nice blend of deals, certainly a good mix of senior and second-lien transactions, unit tranche-type deals.

But I think the coupon, as I mentioned, is looking like it's a 10.8% cash yield, 3.1% on the PIK side, on the interest-bearing securities that we have term sheet data. The only other statement I'd make on that is all these term sheets are evolving, which is -- makes me confident that we're continuing to negotiate through them.

But that's with -- how the group seems to be building. .

And our next question is from Terry Ma from Barclays. .

Can you maybe just talk at a high level about how you go and source deals for your investment pipeline for the SBIC fund?.

We have a direct marketing group. We've built that out over time. The SBIC team, the principals that came onboard had an existing program. We've augmented that with incremental hires, and we've been expanding that. We're basically a broad direct marketing process, but we also work through intermediaries.

We're not -- and we also try to diversify that with working with partners in the BDC space, in the SBIC funds. So we have some material relationships with other parties in the markets. We're trying to get a blend of transactions out of the market, both direct and working with other people.

Some of our direct transactions we try to share with our partners, the BDCs and the SBIC funds. So we try to hit as many places as possible in order to generate as big a volume of looks as possible in order that we can make good quality decisions on investment opportunities.

The one thing I do -- would mention is that we do meet weekly, Mondays, and review our pipeline report, which is much larger than this backlog I spoke about. And I've been quite pleased about the number of looks we have and how large that report is at this current time.

Our meetings used to take, let's say, a year ago, maybe 30 minutes to get through everything. It's taking us 1.5 hours to look at these deals, start to work through that and determine which ones we want to put resources against. .

Sounds good. That's great. Obviously, it's going to be lumpy from quarter-to-quarter. I think you guys said you closed one investment so far.

But how confident are you that you can maintain this $10 million a month run rate?.

That's why I took the time to come break this down and give you that $87 million number, because I said I'll take a really good look at what we had out there in the market. Now when those $87 million closes, I just couldn't tell you. But it looks like that's within a 3-month time horizon. A couple could be done in the next several weeks.

So it's -- but a lot of these transactions are direct investments working with management teams that don't close these types of deals. It's just not what they do. They actually manage companies. So those take a little bit longer.

And a couple of transactions in my backlog are actually deals that are fairly well baked, that we're working with other SBIC funds and BDC funds. And accordingly, those may come in a little bit quicker. So -- as I tried to illustrate in the earnings call and in our scripted remarks, I feel good about the blend there.

I think this portfolio, hopefully, will be coming in on a fairly consistent basis over the coming months. .

And just to clarify, Terry, we had one new investment, one add-on in the first quarter, and 2 so far this quarter. .

And our next question is from Christoph Kotowski from Oppenheimer. .

Obviously, we'll readjust our model for the fee waivers and all that, but even with that, it just doesn't seem likely that the net investment income would cover the dividend anytime soon.

And I wonder what is the philosophy, or thought about maintaining a dividend that's so far above the base level of earnings? Do you have a thought on how long that continues or whether that's a desirable state? Or -- I guess just what's the philosophy of having such a gap between the dividend and the actual investment income?.

$87 million of transactions along the parameters that I described to you, it could easily double our run rate in earnings, I mean, if you just simply do the math. So we took a good look at the end -- at the beginning of this year, where we are, what happened and why it happened.

And it led us to the conclusion that, at this point, we shouldn't be burdening the shareholders with a cut in the dividend, that the managers should be bearing that expense and -- in order to create enough room for us to build this dividend.

It really -- with the team we have in place, we really don't need a lot of transactions to create the level of income and create a level of run rate to bring the dividend -- to bring the earnings up to support the dividends substantially. So right now, our job is just to work and get these investments done and producing some real income.

There are no excuses at this point any time. Everything is -- everything's in place, and I feel really confident that we're going to be able to pick up that pace of earnings.

But the one thing I would tell you is our absolute priority is to make sure we fully fund the SBIC equity portion of the capital structure, in order that we get access the full leverage right now.

So everything we will do will probably be driven to a large extent by whether or not that comes -- that becomes at risk by following the continuing dividend policy. .

Okay.

And funding the SBIC, I mean, do you use liquidity from the senior portfolio, or do you draw down the credit facilities you have? How do you do that?.

Well, we physically have cash in the SBIC fund right now, which we talked about in the course of dividend. And then the balance of that would always be used either a mixture of cash out of earnings, hopefully will be, but to a large extent, we'd be relying on availability under our line of credit with Wells Fargo. .

This will conclude our question-and-answer session. I would like to turn the conference back over to Mr. Glenn Pittson for any closing remarks. .

I appreciate everyone taking the time to sit in on the call. Look forward to talking at length about what occurs with this backlog in the next earnings call. .

Thanks for all your time, and we'll be talking to you in a month. .

The conference have now concluded. Thank you for attending today's presentation. You may now disconnect..