Bilal Rashid - Chairman & CEO Jeff Cerny - CFO & Treasurer Steve Altebrando - VP of IR.

Mickey Schleien - Ladenburg Thalmann & Co. Christopher Testa - National Securities Casey Alexander - Compass Point Research.

Welcome to the OFS Capital Corporation Third Quarter 2016 Earnings Conference Call. [Operator Instructions]. I would now like to turn the conference over to Steve Altebrando. Please go ahead..

Thank you. Good morning, everyone and thank you for joining us. With me today is Bilal Rashid, our Chairman and Chief Executive Officer; and Jeff Cerny, our Chief Financial Officer and Treasurer. Please note that we issued a press release this morning announcing our third quarter results.

This press release was subsequently filed on Form 8-K with the SEC. Both documents can be obtained under the Investor Relations section of our website at ofscapital.com. 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 risks, 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 SEC.

Although we believe these assumptions are reasonable, any of those assumptions could prove inaccurate and, as a result, the forward-looking statements based on those assumptions also could be inaccurate. You should not place undue reliance on these forward-looking statements.

OFS Capital undertakes no duty to update any forward-looking statements made herein. All forward-looking statements speak only as of the date of this call. Our comments may reference adjusted net investment income, a non-GAAP measure. For reconciliation, please refer to our investor presentation on the Investor Relations section of our website.

With that, I will turn the call over to our Chairman and Chief Executive Officer, Bilal Rashid..

Thank you, Steve. Good morning and welcome. We're pleased that in the third quarter our net asset value remained stable and our net investment income was $0.34 per share which covered our distribution.

This is the sixth consecutive quarter our net investment income has exceeded our distribution and over this period our adjusted net investment income per share was 110% of our distribution. We believe that this 110% coverage is more indicative of our earnings power than our distribution coverage for this quarter.

In a quarter where we generated historically-low fee income and when most of our investments closed in September, we were still able to generate net investment income that exceeded our distribution. Our fourth quarter is off to a strong start with the closing of transactions totaling approximately $23 million.

Given our ample dry powder, we believe that we have significant room to continue to grow our net investment income as we go through the fourth quarter and into 2017. The overall credit quality of our portfolio remains solid.

As we have mentioned on prior calls, OFS Capital does not have any investments in the oil and gas sector and we have focused on sectors that are less cyclical and have a track record of performing throughout an economic cycle. Approximately two-thirds of our loan portfolio is senior secured.

We had just one loan on non-accrual at the end of the quarter. The other non-accrual from last quarter was resolved with a full recovery of principal plus accrued interest. Since the beginning of 2011, we have invested $652 million and had a cumulative net realized loss of just $600,000 which is less than 0.1%.

As always, we remain focused on capital preservation. We have been able to achieve these strong results by adhering to our time-tested underwriting standards and our hands-on portfolio management approach. We will continue focusing on the lower middle market, particularly the non-sponsored segment of that market.

This is an area that remains underserved and we have longstanding relationships and deep experience there, giving us significant competitive advantages. We continue to believe that our best opportunity to generate strong risk-adjusted returns is in this part of the middle market.

OFS Capital also benefits from the broad expertise of its experienced external manager which has an approximately $1.5 billion credit platform and has successfully navigated multiple credit cycles since its inception in 1994.

Our team has the size, relationships and breadth of expertise across all parts of the leveraged loan market to provide us with considerable capital markets intelligence as well as industry expertise. The OFS platform allows us to see a broad array of potential transactions and to be highly-selective in making investments.

We have been able to finance our origination activities with very attractive long term financing. As you know, we have a $150 million in fixed-rate SBA debentures through the SBIC program with a weighted average coupon of 3.18% and no maturities until 2022.

This continues to have a meaningful positive impact on our return on equity especially given the size of our portfolio. In addition, our portfolio is positioned to benefit from a meaningful increase in interest rates if and when that may happen. Nearly two-thirds of our loans are floating-rate while our debt is 100% fixed-rate.

Overall, adhering to our investment discipline and diligently executing on our business plan, has led to strong total return for our shareholders. As measured by distributions plus the change in our net asset value over the last two years, our total return has been 22%.

Our long term performance is enhanced by the alignment of interests between our shareholders and our external manager which owns more than 30% of the Company. Looking ahead, we have significant capital resources on hand as well as several additional sources to raise new capital to grow net investment income and our distribution.

As of the end of third quarter, we had $28 million in cash; $18 million invested in the senior club loan portfolio that can be redeployed in higher-yielding investments; an untapped $25 million revolving credit facility which was just recently upsized from $15 million; the capacity to incur leverage through the bank loan or the bond market which we actively monitor; and, finally, our application for a second SBIC license was submitted last year and if approved would provide access to additional capital through SBA debentures.

As a reminder, our existing SBIC debt does not count towards the BDC leverage test so we have not tapped any of our available statutory leverage. We expect to continue to finance the Company in a thoughtful manner and anticipate raising additional capital when accretive.

Our focus remains on what has benefitted our shareholders over the past several quarters. One, maintaining our strict underwriting standards and avoiding highly-cyclical sectors such as the oil and gas sector. Two, being responsive to our borrowers' needs by providing flexible capital solutions.

This has led to repeat business, a reputation as a reliable partner and, ultimately, good-quality deal flow. Three, remaining focused on the best risk-adjusted returns for the long term. At this point, I'll turn the call over to Jeff Cerny, our Chief Financial Officer..

Thank you. We're pleased with our third quarter results. As Bilal just mentioned, we continued to focus on the credit quality and stability of our portfolio which has resulted in a stable net asset value over time. We have 20% of our net asset value in cash and the potential to borrow additional capital.

As you also just heard, our only debt at quarter end is long term fixed-rate SBA debentures with a weighted-average coupon of 3.18%. This debt does not count towards our asset coverage ratio and, coupled with our cash position, gives us room to grow our net investment income.

We believe that access to additional growth capital and no regulatory leverage puts us at a competitive advantage relative to some of our peers. Turning to our portfolio, at the end of the quarter we had investments in 38 companies totaling $259.2 million on a fair value basis which is above our cost.

At September 30, 2016, the debt portfolio is at 99.1% and the equity portfolio is at 110.1% of cost. As a percentage of fair value, our investments were approximately 67% senior secured loans, 20% subordinated debt and 13% equity. As a percentage of cost investments were just under 12%.

It is important to note that approximately two-thirds of these equity investments produce investment income due to their contractual coupons. Our portfolio remains diverse with an average investment in each portfolio company of $6.8 million or 2.6% of the total portfolio.

The overall weighted average yield to fair value on our debt investments remained strong at 11.88%. At the end of the quarter, two-thirds of our loan portfolio had floating-rate coupons. There is only one loan on non-accrual, Community Intervention Services, with a total principal balance of $6.7 million and total fair value of $5.4 million.

We placed Community Intervention Services on non-accrual in the second quarter after the company experienced covenant defaults and our payments were blocked by the company's senior lender. We're involved in ongoing negotiations with the senior lender, equity sponsor and the company to reach a resolution that will allow interest payments to resume.

However, at this point, we cannot predict the timing of a resolution. Total investment income was consistent with that of last quarter. We derived approximately $7.4 million in total investment income in the third quarter compared with $7.7 million in the second quarter.

This slight decline was primarily driven by a decline in non-recurring investment income which was at its lowest point in the past five quarters. And it is notable that, despite lower non-recurring investment income, we still had net investment income, core earnings power sufficient to achieve our distribution target of $0.34 per share.

As we deploy available cash, of which $23 million has already been deployed so far this quarter, our core earnings power will continue to grow. Total expenses of $4.1 million were essentially unchanged quarter over quarter.

Net investment income for the third quarter was approximately $3.3 million or $0.34 per share, again covering our distribution of $0.34.

As Bilal previously mentioned, we have more than covered our distribution for six consecutive quarters on an adjusted NII basis and over this time period our adjusted net investment income was at 110% of our distribution. As to deal activity, during the third quarter we closed transactions with an aggregate invested amount of $16.7 million.

We continue to maintain a consistent risk tolerance in our sourcing and underwriting and have access to meaningful deal flow that allows us to be selective. At quarter's end, we had approximately $28 million of cash, $18 million remaining in lower-yielding assets and the potential to borrow significant additional growth capital.

We believe that we have the flexibility to execute on our investment strategy and increase our earnings per share. We recently upsized our line of credit by $10 million to $25 million which allows for additional flexibility in our business going forward. We remain selective on credits, structure and pricing.

We intend to continue to prudently deploy capital and generate liquidity on a timeline that allows us to maximize our earnings for our shareholders. As we have mentioned in the past, we expect to sell lower-yielding assets or otherwise raise capital when we believe it is accretive and can be deployed in a timely manner.

With that, I will turn the call back over to Bilal..

Thank you, Jeff. Summarizing our thoughts on the quarter, we're pleased that our net asset value was stable and our net investment income covered our distribution despite historically low fee income.

Given the amount of investments we closed at the end of third quarter and the beginning of the fourth quarter, we believe that we're well-positioned to finish the year on a strong note.

Our results over the past several quarters highlight the strength of our underwriting capabilities and the long term alignment of interest between our shareholders and our external manager which owns more than 30% of our company.

Our focus has been to deliver capital to the lower middle market, especially to the non-sponsored community which is where we continue to find attractive risk-adjusted returns. This is demonstrated by the attractive yield on our loan portfolio of 11.88% while maintaining a stable long term net asset value.

In terms of our liabilities, we have attractive long term fixed-rate financing through the SBIC program with a weighted-average coupon of 3.18%. With this fixed-rate financing and approximately two-thirds of our portfolio being floating-rate, we're well-positioned for an eventual increase in interest rates.

In addition, we have significant capital resources available to continue to grow our earnings. OFS Capital remains committed to providing long term value to all its stakeholders including both shareholders and borrowers. As a lender, we remain focused on being responsive to the needs of our borrowers by providing them flexible capital solutions.

With that, operator, please open up the call for questions..

[Operator Instructions]. The first question comes from Mickey Schleien of Ladenburg. Please go ahead..

Bilal, my first question relates to the tone of the market. We've seen some very severe compression in spreads in the more liquid end of the middle market. And I'm curious whether that's starting to trickle down into the lower middle market where your company generally operates..

As you know, we focus on the lower part of the middle market, especially on the non-sponsored part of the middle market, because we feel that it is a much more inefficient part of the market and more underserved. We're not seeing that spread compression yet in our part of the market. And that's the reason why we really like being there.

So, I would say we're not seeing that compression yet on our side..

Bilal, can you remind us what sort of the average EBITDA is of the portfolio companies in which you're investing?.

Yes. The average EBITDA is between $7 million and $8 million..

Okay. My next question, we're almost halfway through the quarter and I appreciate your comments about originations so far.

But what sort of visibility do have on repayments this quarter, at least to this point?.

Yes. Actually, we haven't seen a lot of repayment activity recently. And so, I would say that repayments are on the low side..

Okay. And just a couple more questions. One is housekeeping. Could you break down how much of your cash is in the SBIC? And any update you can provide on the second SBIC license. And that's it for me. Thank you..

Yes. So, as far as the SBIC, Mickey, we had about, at quarter's end, about $20 million of the $28 million in the SBIC..

Okay.

And any progress on the second license or any feedback from the SBA?.

Yes. So, as we mentioned in the remarks, we don't have any update on that front. And if we receive any meaningful update there we will inform you guys..

The next question is from Christopher Testa of National Securities. Please go ahead..

Just kind of commenting on one of Mickey's questions with repayments, are you seeing repayments being muted? I know lower middle market LBO multiples are extremely high.

Is it from just a lack of M&A or is this simply a niche part of the lower middle market where there's nobody to refi these guys out despite spreads coming in?.

Yes, when it comes to repayments, actually the third quarter was historically low. We resolved one of our non-accrual loans that had been on for a while. It started as a $4 million obligation. It was paid down to about $1 million. And that repaid in full in the third quarter; all principal, all interest. And that was really our only repayment.

As we look into the fourth quarter, we're not seeing repayments as we look forward and I think it is largely attributable to more M&A activity being down..

And just on Community Intervention, how much debt is senior to you in that structure?.

You know what? I actually don't have that number handy. It is a national bank that holds that position. I could certainly get back to you on that..

And with $18 million remaining in club loans which you're able to sell out of now -- I understand they're not extremely liquid, but you can negotiate a sale.

Given that the loan prices have rebounded so strongly, are you seeing this as an opportune time to sort of shop these around and exit these in order to reinvest in your direct originations?.

I guess what I would say is that market has been relatively stable as well. They're slightly larger than what we're investing in, but it is kind of a club loan market. So, I don't know that it's necessarily an opportune time to sell those. We haven't seen a major uptick in the valuation of those loans.

So, I think we're monitoring it regularly and we would look to liquidate out of those loans if and when we feel we can put the capital to work properly..

Okay, great.

And could you provide us an update on your attachment point through the last dollar of risk?.

Yes. We remain under 4 times; on average, probably closer into the mid-3s. And that's through, obviously, senior secured, second lien, as well as mezzanine subordinated investments. So, we still feel good about the portfolio and kind of where we're at from a last dollar of leverage..

[Operator Instructions]. The next question is from Casey Alexander of Compass Research. Please go ahead..

As it regards to second SBA, I'm working a little from behind, do you have a green light letter for the second SBA?.

No, we don't have a green light letter yet. We're working on that..

Okay, I just wanted to check. And, secondly, you have such an enviable track record of lack of credit losses.

Can you kind of fill me on -- do you have specific verticals that you've focused on or a specific structure that you rely on that has allowed you to build such an enviable track record?.

To answer your first question, if you look at our portfolio it's fairly well-diversified across industries. The only industry exposure that we don't have, luckily, is in the oil and gas sector. So, I think getting these good results is a combination of several factors.

One, our underwriting expertise; OFS platform has been in business since 1994 and our investment process has been developed over many years. So, I think it goes to the underwriting expertise. The second point is portfolio management. We're very hands-on with respect to portfolio management. I think that has allowed us to also mitigate the losses.

Even if there is a non-accrual or a company goes into default we've been able to navigate through that and mitigated our losses that way.

I would say the part of the middle market that we've been playing in, the lower part of the middle market and especially the non-sponsored part of the middle market, I think we're able to get some certainly attractive returns, but we're also able to get very attractive structures.

We're able to actually attach at a lower leverage point, as Jeff was saying earlier on. So, we're able to generate about 11.88% yield on a portfolio that is less than 4-times debt-to-EBITDA multiple. And, also, if you look at our portfolio, about two-thirds of it is senior secured.

So, I think that has certainly been helpful, as well, in terms of mitigating the losses. So, it's a combination of several different factors, but we've very happy with the track record so far..

On the floating-rate portion of your portfolio, what's the benchmark that your loans float off of? And, in general, is there a floor? And, if so, what is, in general, the floor? I know it might be for everyone.

But, in general, what's kind of the structure you use?.

Yes. Generally speaking, it's a 3-month LIBOR and, generally speaking, the floor is 1%..

There are no additional questions at this time. This concludes our question and answer session. I would like to turn the conference back over to Bilal Rashid for closing remarks..

Thank you all for joining our call today and we look forward to speaking with everyone again next quarter. Operator, you may now end the call. Thank you..

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