ArrowMark Financial Corp.
Q3 2020 Earnings Call Transcript
Published:
- Operator:
- Welcome to the StoneCastle Financial Corp. Q3 2020 Investor Conference Call. At this time, all participants are in a listen-only mode. A question-and-answer session will follow the formal presentation. As a reminder, this conference is being recorded. Now, I would like to turn the call over to Rachel Schatten, General Counsel of StoneCastle Financial. Please go ahead.
- Rachel Schatten:
- Good afternoon. Before we begin this conference call, I'd like to remind everyone that certain statements made during the call may be considered forward-looking statements based on current management expectations that involve substantial risks and uncertainties. Actual results may differ materially from the results stated in or implied by these forward-looking statements. This would depend on numerous factors, such as changes in securities or financial markets or general economic conditions; the volume of sales and purchases of shares of common stock; the continuation of investment advisory, administrative and service contracts, and other risks discussed from time to time in the company's filings with the SEC, including annual and semiannual reports of the company.
- Sanjai Bhonsle:
- Thank you, Rachel. Good afternoon and welcome to StoneCastle Financial's third quarter investor call for 2020. Here with me today is Pat Farrell, our CFO; and Julie Muraco, Investor Relations. During todayβs presentation, I will briefly comment on the banking industry and credit markets before commenting on the company. Then I'll provide StoneCastle Financial's quarterly results and portfolio review, and Pat will provide you with greater detail on our financial results before we open the call for questions. During the past two weeks, we saw several banks reporting better than expected earnings for the third quarter and many banks are signaling that they are well-positioned to withstand a prolonged economy recovery. Furthermore, banks are well-capitalized and for the most part have adequate reserves in anticipation of an increase in corporate defaults. The government stimulus issued in Q2 helped many businesses weather the third quarter, and we believe that any additional stimulus going into 2021 will have the potential impact of keeping corporate default rates lower than expected. Going into Q4 and first-half 2021, our outlook for the banking industry remains cautiously optimistic. As of this call and some exceptions, StoneCastle's underlying banks have reported third quarter results. Banks in our portfolio reported median net income, up 8.4% versus the second quarter. In addition, our portfolio banks reported average Tier 1 capital ratios of 12.4%, flat from Q2. Finally, StoneCastle's underlying banks reported change in median reserves, up 5 basis points to 1.27% and loan book growth was up 7.8%. I want to take a moment to mention some interesting statistics on community banks regarding the PPP stimulus program. The Independent Community Bankers Association reported that community banks exponentially serve their local and rural communities by providing PPP loans to 98% of the economically distressed or low-income counties and to approximately 97% of the rural counties receiving such loans. Overall, community banks were the dominant PPP lenders serving approximately 58% of our PPP participants and 48% of all U.S. small businesses.
- Pat Farrell:
- Thank you, Sanjay. As I do each quarter, I will present the financial results by going through the components of the company's quarterly results in detail. The net asset value at September 30th was $20.89, up $0.62 or 5% from the prior quarter, including reinvestment of dividends. Before I review the components of NAV, I want to note that in mid-October, the company reported the estimated month end September NAV to be $20.93, which was $0.04 higher than our quarter end NAV of $20.89. This difference was due to a minor adjustment related to preparing the consolidated financials. As you know, we are publishing monthly estimated NAVs to provide clarity and transparency for our shareholders. Therefore, the NAV as of September 30th and quarter end is $20.89. Now on to the breakdown of the NAV components. The NAV is comprised of four components
- Sanjai Bhonsle:
- Thank you, Pat. Now operator, I would like to open up the call for questions.
- Operator:
- Thank you. A this time, we will be conducting a question-and-answer session. Your first question comes from the line of Chris O'connell with KBW. Please proceed with your question.
- Chris O'connell:
- Good evening, gentlemen.
- Sanjai Bhonsle:
- Good evening, Chris.
- Chris O'connell:
- So I guess, I just wanted to start out with the CLO sale. I know that, you guys have maybe seen that as an opportunity to refinance. And maybe if you could just walk through as well the aspect of -- I thought that you had said in the prepared comments that the rates were going to go up. And that was part of the decision for exiting that investment. I mean, I guess, by rates, wouldn't that be a higher yield for you receiving?
- Sanjai Bhonsle:
- Yes. Hi, Chris, it's Sanjai. I'll take the first part here. Pat, just feel free to add something later, if I've forgotten. So just as a way of background, that $45 million position was as an equity position in our CLO 2015. And in the way, it was structured is it had notes ahead of it, essentially about $200 million. That had a cost of capital somewhere in the 500s. The way it was structured initially was that five years post its issuance, those liabilities that are ahead of that $45 million equity tranche were going to step up by about 70 basis points. So β but the underlying assets there β the earning assets were community banks. And so if you think about it, what you're earning on those community banks, now is going to be net earnings on those community banks is going to be less than what you're making before, because the liability costs in the CLO is going to go up by 70 basis points. And so that was going to lead to lower earnings. That was one. Number two is, and if you think about it, for a funded size with a fairly concentrated position, being $45 million. And we took this as an opportunity to diversify our holdings. And then number three is, it did need to get refinanced, the CLO liabilities had to get to be financed. And we also didn't want to take a capital markets risk, especially what we saw how spreads kind of blew out on liabilities back in mid of March, April, May. And so that coupled with also the banks, generally speaking, that were held of assets in the CLO were about half the size of the rest of our portfolio. We also took this opportunity to improve the overall risk profile. So that was kind of a few reasons as to why we decided to exit this position at a gain from essentially what was marked at. And so β and hopefully, that helps.
- Pat Farrell:
- I can just add in that with regard to that, we did see a nice markup from where it was marked at June 30. So we picked up an extra almost $470,000 in value from β it was marked in June versus the sale price. So other than that, Sanjai kind of nailed it there.
- Chris O'Connell:
- Great. That's helpful. And then looking at the alternative capital investment demand and yields going forward, it seems like the yields have come down a bit. I mean, I know it was β generally, you were saying the market was that plus 900 to 1,000 basis points prior above LIBOR. I guess, where are you seeing those new yields or those base spreads coming on up?
- Sanjai Bhonsle:
- Sure. So the yields that you're seeing on our new alternative capital security investments is kind of reflective of the risk profile that we are willing to take this year, especially after again, what happened with COVID, et cetera. And so the reason you're seeing lower yields than something that we had initially discussed is because it reflects those structures reflect a much more conservative portfolio, that's β the underlying assets are backing those securities and also the structure. So from that perspective, these are more conservative investments. That again, is a sign β a reflection of the kind of the risk that we're seeing out there. So we're just being very prudent in kind of what we're buying.
- Chris O'connell:
- Got it. So in terms of the pool, then, I guess, of alternative investments that you are looking at to put on balance sheet versus the overall market, I guess, where are you seeing those spreads that are now?
- Sanjai Bhonsle:
- Sure. So the spreads that we're seeing today are kind of ranging between the L plus 9s and L plus 10s to the high single-digit type of yields that we are showing to you for the investments in 3Q. And just based on our analysis of the underlying investments, it just so happens that so far we have kind of more gravitated from a risk-adjusted basis towards the high single digits, but we are seeing yields that are ranging in the low double digits to the high single digits. One thing I'd bring the attention to you is that from a yield to call basis, these -- some of these investments are yielding in the double digits versus when you're kind of looking at it from a yield to maturity basis.
- Chris O'connell:
- Got it. So I mean, is it fair to say that over the next two to three quarters of the investment yield, pending any changes in the overall macro rate environment, remain kind of in this high to low-9s range compared to what was kind of high-9s to low-10s previously?
- Sanjai Bhonsle:
- Yes. I mean, based on what our pipeline is today, and assuming all things constant, we expect the yield to be in the 9-ish type of range going forward, again, with all things constant.
- Chris O'connell:
- Great. Helpful. And then on the expense side, I noticed that there's like a few upticks in overall kind of other expenses, more notably, I guess, in professional fees in a few other minor line items. Are those expected to kind of revert back to what had been kind of the low 400s range going forward?
- Patrick Farrell:
- Yes, yes. We had a few adjustments we needed to make for on professional fees and valuation fees, et cetera. But yes, I think -- and the combination of that, along with kind of true enough and making sure that going into Q4 we're accrued appropriately. So I think you are going to see those come down a bit in the fourth quarter to some more what you've seen in previous quarters.
- Chris O'connell:
- Great. That's helpful. And then I appreciate all your comments around credit quality and the overall bank market or community bank market right now and some of that reserve info surrounding, the banks that are underlying your portfolio. Is there any pockets of risk that you're ultra focused on coming out of the 3Q updates or where deferrals kind of to the extent they're disclosed by the banks, are remaining higher than you would like to see?
- Sanjai Bhonsle:
- Yes. So as it relates to deferrals, let me take that last part of the question first, is in discussion with our banks, and also kind of what we are seeing out there is there, they've come down meaningfully. And then as you might recall, at the peak, some of these banks have seen like 20-plus type percent deferral rate. And now you're kind of looking at the low single-digits. And so from that perspective, that's improved materially for the banks. And just looking at our portfolio of banks, net income was up versus 1Q and 2Q. And it's almost going to reach the levels of kind of what we saw in the fourth quarter of last year. From a risk basis, actually, kind of what I β and we see is more of a loan growth possible issue. And in a lot of businesses out there are being very prudent from what we are seeing in talking to our management teams, where they're not overloading themselves with debt. I can give you an example of this bank that we spoke recently with in our portfolio had a $10 million revolver line. And pre-COVID, this company was asking for like a $12 million line, because they were going to utilize it. And today, that all reline almost at the unused capacity, because the company is doing a better job of managing working capital, et cetera. And so β but having said that, that, obviously β or that coupled with NIM, they are a little worried about their income going forward. But overall, we have seen a growth in the loan book, at least as it pertains to our portfolio of banks that we own. And so that's kind of how I see more of a risk to the company's P&L, our bank's P&L being NIM, contraction NIM and not a meaningful growth in the loan book.
- Chris O'connell:
- Great. That's all I have. Thank you.
- Operator:
- Your next question comes from the line of Bryce Rowe with National Securities. Please proceed with your question.
- Bryce Rowe:
- Thanks a lot. Good evening.
- Pat Farrell:
- Good morning.
- Sanjai Bhonsle:
- How are you Bryce?
- Bryce Rowe:
- Hi. Hey, Sanjai, I wanted to ask about the unrealized depreciation on some of the alternative securities, and obviously, good to see. But curious, what's driving that? Is that a rate thing? Is it a credit β or is that purely just credit spreads coming in? Was there something specific to some of the specific securities that would drive some of the appreciation?
- Sanjai Bhonsle:
- Sure. Pat, do you want to take that first part or do you want me to β
- Pat Farrell:
- Yes. Yes. I'll take a little bit of that. I'd say on the β just on the kind of the mathematical side. We did buy a number of these in Q2 at very good, very attractive pricing. So I can β that I can speak to right away. And interestingly, enough, we mentioned that there were a couple of paydowns this quarter and one of them being with NASA and Sonata. Both of those, we have purchased one of them at 87 and change and 93, and they both they both had β we had paydowns on those at par. So, definitely got some great deals there. So I'd say on the one side, on the math side, certainly, we've got some really great deals. And most of the others we also bought at discounts some at very nice discounts in the 80s. So I'd say number one, was just opportunistic purchasing. And then I'll throw back to Sanjai to give some thoughts on where the pricing is going today.
- Sanjai Bhonsle:
- Sure. So, Bryce, just to add a little bit more color to what Pat said. Back in doing the dislocation back in March, April has as repo lines came due for some people for some managers out there. To get on side with those repo lines, they had to delever. And what you do at that point is you take your best asset that's got the highest mark and you sell it. And that's exactly what happened. And just like some community banking securities that were -- then we kind of bought at a pretty attractive price. We kind of saw the same thing in alternative capital securities. And we were all over those in terms of looking at TAM analysis and then deciding to buy them. And so that's kind of what you -- that's kind of how that opportunity came about. And obviously, with the market normalizing a little bit more, you've kind of seen appreciation there. And in certain instances actually have realized a gain because those securities got partially repaid. In terms of what we're seeing in the new issue market, kind of the same. And -- but again, I want to make a distinction that we are seeing LIBOR plus 9, LIBOR plus 10 type of transactions. And yes, we have bought some high single-digit type of transactions. But again, based on our analysis, based on our outlook, we are investing in more of the conservatively structured alternative capital securities. And that actually worked really well for the fund, and they are very accretive.
- Bryce Rowe:
- That's helpful, Sanjai. And just maybe for the benefit of me and others that aren't as familiar with the alternative capital securities, what makes one more conservatively structured than one that's not?
- Sanjai Bhonsle:
- Sure. So we can start with just the asset base, looking like we usually tell you that the underlying assets, generally speaking, are investment-grade. And so what we move from, for example, is, let's just say, a portfolio of assets that initially was coming in at like a BBB- average rating, we'll move up in rating category to make it more like a BBB, BBB+ type of security. So obviously, moving up in the rating category, which is a proxy for risk, the securities generally carry a little bit of a lower return, right?
- Bryce Rowe:
- Yes.
- Sanjai Bhonsle:
- And so that's one of the primary ways of how we go about getting a more conservative security.
- Bryce Rowe:
- Okay. That's good commentary. And then I appreciate your comments about the current fourth quarter pipeline across the alternative capital securities universe being in the -- I think I heard this correctly, $3.5 billion to $4 billion for new issuances. And you made the commentary or the comment about the issuer base expanding. So I was wondering what the pipeline might have looked like, I don't know, a year ago, just for comparative purposes. And then when you talk about issuers, the number of issuers expanding, what's driving that. Is that just familiarity with the structure and the capital treatment? I mean, just wondering what you think there.
- Sanjai Bhonsle:
- Sure. So, before I can answer the fourth quarter purchases that we did year-to-date, it's a mix between alternative capital securities and community banks, right, but focusing more on the alternative capital side of it, the $3.5 billion to $4 billion. Worth noting there, that's kind of what you're seeing the issuance to be in the fourth quarter of this year. Obviously, just like anything else our product selection process, we participate in some, and we don't participate in some. In terms of the issuer base growing, it's a reflection of particular bank's balance sheet and kind of what they did during in 2019 in terms of adding on risk to their balance sheet. Coupled with where the equity markets are for issuing additional Tier 1 capital. Like we have said before in my previous comments, the most efficient way to address Banks balance sheet, one of the most efficient ways to do that is to issue more alternative capital securities. So there are some newcomers that have come to us -- to the market during this quarter, and we have participated in some of their deals, is -- they are -- given market conditions, they're kind of finding the most efficient way to rightsize their risk profile is to issue additional alternative capital securities.
- Bryce Rowe:
- Okay. That's helpful. And maybe one more question for me. Just considering the repayment -- or the sale of the larger asset here, this core CLO. I'm wondering how you think about kind of repayment risk within the portfolio now relative to the -- to your -- to the individual securities within your portfolio.
- Sanjai Bhonsle:
- Sure. So in terms of repayment risk, we're not seeing anything -- we didn't see anything out of the ordinary during 3Q or in 4Q to believe that there's an acceleration in repayment. And so this is something that's fairly average, I would say. And just kind of give you a little bit more background. I think we ended Q1 with $133 million of invested assets. It was up to about $165 million in Q2 and then Q3 was $147 million, and that was really more related to that sale of that CLO position. And we -- for the balance of Q4, we are looking at a decent amount of deals. And we -- all things constant, we do expect to see a net growth from here. And so from an income perspective, et cetera kind of more additive than Q3. Again, all things constant.
- Bryce Rowe:
- Got it. All right. Well, thank you for answering all the questions, and good to see the continued progress in terms of the originations.
- Sanjai Bhonsle:
- Yes. Well, thank you very much, and thank you for your support.
- Bryce Rowe:
- Welcome.
- Operator:
- Your next question comes from the line of Devin Ryan with JMP Securities. Please proceed with your question.
- Devin Ryan:
- Great. Hi, Sanjai. Hi, Pat. How are you?
- Sanjai Bhonsle:
- Good. How you are doing?
- Pat Farrell:
- Hi, there.
- Devin Ryan:
- Most questions have been asked, but I just want to spend a moment on credit. I think, Sanjai, you could talk about this a bit. But if we think about an area where there is a second shutdown and if that creates more stress in the system, how are you thinking about the portfolio in that scenario just bridging the gap between now and the vaccine. And could that also create opportunities from a pricing perspective and some of the things you're looking at, just given that it is kind of topical at the moment here.
- Sanjai Bhonsle:
- Sure. So the last part of your question, the short answer to that is yes, but I'll add a little more color to that. From a credit perspective, I think we all are pleasantly surprised how well actually, relatively speaking, the credit space has done as it relates to defaults. I think back in March and April, a lot of estimates were fairly high. And I think generally speaking, we're going to be under like 10%. And if you're to look at, say, the high yield market combined with the leveraged loan market, right? And so from that perspective, the stimulus came in to benefit everybody, a main street primarily. So, from that perspective, we -- again, we see, going forward -- we are cautiously optimistic about the default rates going forward. Then again, if we were to see a prolonged recovery or added shutdowns, because of COVID, what we expect there, again is we expect another stimulus build to come through. And we've seen that story play out before, where I think they will support the consumer and the small businesses. So -- and again, talking to all our banks, kind of that's kind of where the head is. And a lot of the banks have made have increased reserves for -- all pointing to 2021. And so again, they're cautiously optimistic about it. We -- and so are we. I hope I answered your question.
- Devin Ryan:
- Yes, that's terrific. Thanks, Sanjai. And then, maybe just a follow-up, because this is coming up in a lot of my client conversations. Just the numerous scenarios of the election outcome and how that could impact financials, and I think to the extent, it is a Biden administration and a red senate or close to that, the progressive agenda doesn't feel very likely. It's probably not going to have a lot of legislative change. But, one area that could see some changes on the regulatory front, just given that, that maybe easier to push through in Democratic administration. I'm curious, if there's any focused on at the moment that you feel like could be -- an issue or maybe even create opportunities? Or is it just too early say, at this moment?
- Sanjai Bhonsle:
- Yes. I would say, it's a little too early, but it seems like it's pointing towards, say, split Congress, which obviously would dampen some kind of other things as it relates to the progressive agenda, right? But also, having said that, I think from what we are hearing, our discussions are monitoring the markets, et cetera. The focus probably initially is going to be more on the economy. And then, in the next, maybe taxes then, say, bank regulations at this point.
- Devin Ryan:
- Yes. Okay, terrific to be determined. Well, thank you guys taking the question and congrats on a good quarter.
- Sanjai Bhonsle:
- Thank you.
- Pat Farrell:
- Thank you.
- Operator:
- Ladies and gentlemen, we have reached the end of the question-and-answer session. And I would like to turn the call back to Mr. Sanjai Bhonsle for closing remarks.
- Sanjai Bhonsle:
- Thank you, operator. Thank you all for listening. And we obviously appreciate all your interest in StoneCastle. I look forward to speaking with you all during next quarter's conference call. And in event, we did not touch base prior to year-end I just want to wish everyone a healthy and happy holiday season. Thank you, and good night.
- Pat Farrell:
- Goodnight.
- Operator:
- This concludes today's conference. You may now disconnect. Thank you for your participation.
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