First Eagle Alternative Capital BDC, Inc.
Q4 2021 Earnings Call Transcript

Published: 4 Mar 2022

[Operator:]

Good morning, and welcome to First Eagle Alternative Capital BDC Inc. Earnings Conference Call for its Fourth Fiscal Quarter ended December 31, 2021. It is my pleasure to turn the call over to Sabrina Rusnak-Carlson, our First Eagle Alternative Capital BDC Inc. Ms. Rusnak-Carlson you may begin.

[Sabrina Rusnak-Carlson:]

Thank you, operator. Good morning, and thank you for joining us. Joining me on today’s call are Chris Flynn, President of First Eagle Alternative Credit; Michelle Handy, Head of Portfolio & Underwriting for Direct Lending; and Jen Wilson, our Chief Accounting Officer and Treasurer. Before we begin, please note that statements made on this call may constitute forward-looking statements within the meaning of the Securities Act of 1933 as amended. Such statements reflect various assumptions by First Eagle Alternative Capital BDC concerning anticipated results that are not guarantees of future performance and are subject to known and unknown 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 and include the factors included in the section entitled Risk Factors in our most recent Annual Report on Form 10-K as updated by our Quarterly Report on Form 10-Q and our periodic and other filings with the Securities and Exchange Commission. Although we believe that the assumptions on which any forward-looking statements are based on are reasonable, any of those assumptions could prove to be inaccurate. And as a result, the forward-looking statements based on those assumptions also could be incorrect. You should not place undue reliance on these forward-looking statements. First Eagle Alternative Capital BDC undertakes no duty to update any forward-looking statements made herein unless required by law. All forward-looking statements speak only as of the date of this call. Our earnings announcement and 10-K were released yesterday afternoon, copies of which can be found on our website, along with our Q4 earnings presentation, that we may refer to during this call. A webcast replay of this call will be available until March 14, 2022 starting approximately two hours after we conclude this morning. To access the replay, please visit our website at www.feacbdc.com. With that, I’ll turn the call over to Chris.

[Christopher Flynn:]

Thanks, Sabrina. Good morning, and thank you for joining us on our earnings call. On today’s call, I’ll provide an overview of our fourth quarter results, some portfolio highlights and Michelle will share some market perspectives, and then Jen will discuss the portfolio and financial results in more detail. Let’s begin with our quarter results first. It was a productive quarter for the BDC and we feel good about the balance sheet and are proactively taking actions to increase net investment income now. Current key initiatives include the following

[Michelle Handy:]

Thanks, Chris, and good morning. In light of the recent public market volatility stemming from the Russia/Ukraine conflict wanted to proactively share our perspective on its impact on the BDC and private credit market. First, in short, the impact of the BDC should be limited. As you know, we invest primarily in U.S. businesses that have no direct exposure to Eastern European markets. However, geopolitical events such as these do cause market volatility, resulting in fluctuations in the cost of capital. Additionally, inflation and ongoing supply chain disruption could be exacerbated. At BDC, we typically invest in high free cash flow, low CapEx business models in certain industries such as healthcare, technology, business services and financial services. These industries tend to be less susceptible to certain inflationary factors, such as increases in raw material prices and supply chain disruptions. Further, our borrowers are modestly levered, and as a result, increases in interest rates are likely to be less impactful. The biggest risk to our portfolio is potential wage increases, which we are closely monitoring. We feel our portfolio is well positioned with a primarily first lien investment mix and conservative leverage. Despite geopolitical environment, we have a positive outlook for the overall middle market lending environment. Origination activity remains robust and deal quality remains high. Rising interest rate environments can be good for floating rate credit. There’s price discovery in the market, and we anticipate spreads could widen. We will continue to closely monitor the economic environment and will remain disciplined in our investment approach. In summary, we believe that the investment environment remains favorable from a fundamental credit standpoint, and that a conservative portfolio of floating rate senior secured loans is a good stable asset class during periods of public market volatility, especially when the volatility is not directly impacting the fundamentals of the underlying business.

[Christopher Flynn:]

Thank you, Michelle, for sharing those perspectives. Having a pulse on the current market environment to help us better understand opportunities in risk today is imperative. Ultimately, our goal is to continue to diversify our investment approach as we grow the BDC portfolio in 2022 and beyond. With that, I’ll turn the call over to Jen.

[Jen Wilson:]

Great. Thanks, Chris, and good morning, everyone. First, I’d like to start off with some investment and portfolio highlights. As Chris mentioned, we had an active quarter with 14 new and several follow-on investments totaling $53.3 million at a blended yield of 7%. Additionally, we have six notable realizations through the repayments of our first lien positions in Igloo, Urology Management Associates, Alpine SG, Xcel Brands and Trace3 and our subordinated debt position in C&K Market, which generated $50.8 million in cash proceeds. Additionally, we sold our Series A preferred equity in Sciens Building Solutions and our common equity in Urology Management Associates, generating an additional $4.3 million of cash proceeds. As of December 31, our portfolio was valued at $392.1 million, down slightly from $402 million at the end of Q3. It was invested 76% in first lien senior secured debt and 19% in the Logan JV. As a reminder, the Logan JV is 99% invested in first lien assets. The remaining 5% of the BDC’s portfolio was held in second lien debt and other non-income-producing an equity holdings, including our restructured equity like second lien investment in OEM. The weighted average yield on the debt and income-producing portfolio based on cost and including Logan was 6.5% in Q4. This was down slightly from the prior quarter, primarily driven by the repayment of our investment in Igloo, which paid interest at 11.5% at a subsequent redeployment into lower-yielding assets. As Chris noted, we placed two additional investments, Aurotech and the second lien PIK position of smarTours on non-accrual during Q4. Total non-accruals as a percentage of our portfolio at fair value and at costs, were 2.3% and 4.4%, respectively. Now I’d like to address the financials for the fourth quarter. During Q4, we recognize $8.1 million of investment income, primarily from interest and dividends. Interest income decreased approximately $249,000 from Q3 to $6 million for Q4. The decrease was primarily driven by the repayment of Igloo, which I previously discussed, and the redeployment of the proceeds into lower-yielding assets. Included in the $6 million is $367,000 related to accelerated amortization of OID. Dividend income from the Logan JV was relatively flat quarter-over-quarter at $1.7 million, and other income of 355,000 was relatively flat as well. Total expenses for the quarter were $5.3 million, up slightly from Q3. The biggest driver of the increase was $152,000 increase in interest and fees on borrowing during the quarter. This was primarily due to carrying the additional add-on of our 2026 notes that we held for 30-day period before we were able to redeem our 2023 notes. With respect to other items below the net investment income line, the company had a net realized gain for Q4 of $3.1 million. This included gains on the disposition of our Series A preferred stock in Sciens Building Solutions and common stock of Urology Management assets, as well as a loss on the extinguishment of debt in connection with the redemption of our 2023 notes. From a leverage perspective, we ended Q4 with a debt to equity ratio of 1.18 times. We had ample borrowing capacity on our credit facility to continue to grow and increase leverage for our target of 1.2 to 1.3 times. In November, we closed on a $42.6 million public debt offering add-on to our 5% notes due 2026. The new bonds were issued at a price of 101% of the aggregate principal amount of the notes issued, resulting in a yield to maturity of approximately 4.75%. Proceeds from the issuance, in addition to funds from our revolving credit facility, were used to redeem our 6.125% 2023 bonds at par. The refinancing resulted in a loss on the extinguishment of debt equal to the difference between the amount we paid to redeem the bond, which is par and the carrying value of the bonds, which includes the impact of the unamortized deferred financing cost of the bond. With the redemption of the 2023 bonds, we were able to reduce our weighted average cost of debt to 4.19% as of December 31. This is a 39 basis points decrease from September 30 and 126 basis points decrease from December 31, 2020. We continue to evaluate opportunities to further reduce our cost of financing. With that, I’d like to turn the call back over to Chris.

[Christopher Flynn:]

Thanks, Jen. Overall, this is another productive quarter for the BDC. We further reduced our cost of debt liabilities. We are thinking to work with our joint venture partner and the Logan joint venture to restructure the existing financing. We’d like to increase our portfolio allocation to higher-yielding ABL transactions and further increase portfolio diversification and reduce exposure to legacy concentrated investments. I’d now like to turn the call back to the operator to open it up for questions. Operator?

[Operator:]

Thank you. Our first question is from Lee Cooperman with Omega Family Office. Your line is open.

[Leon Cooperman:]

Thank you, ma’am. I appreciate it. Let me say what I’ve said before, very few managers have stood behind the product and the way that you guys have. And honestly, very few managements have done the poor job you or your predecessors have done and I realize you have to fix it up mode. We went public in 2010. At 2013, we had an underwriting offering in 2012 at $14.09. In 2013, we sold more stock at $14.62. And basically, we know we are today $4.45, and I would say the market, I think is quadrupled in that same period of time. Stock is selling at 6 – 71% of book value, which is a result of a poultry 6% return on equity. So now for the questions as per the statement. Given the way you want to run the business, what is a realistic return on equity expectation? And when can it likely be achieved? And I give you all my questions at one shot, number one. Number two, is a manager for Segal willing to do the right thing for shareholders emerged a company and forego the magic consent payment. We are simply an irrelevancy with a market cap of $335 million. Nobody’s interested in this, except me and a few other people. When are we likely see a dividend increase, which is what will lead me necessary to get the stock to get closer to book value? And you’ve addressed loan quality, and I guess what we’ve had a couple of non-accrues is less than 1% of the portfolio. So I shouldn’t be comfortable with your loan quality. I answered the fourth question myself. That’s it, Chris.

[Christopher Flynn:]

Perfect. Thanks. Lee, thanks. I appreciate the question. Let me walk you through my observations and maybe give you a sense of why I’m actually optimistic. First, as it relates to the $0.09 versus the $0.10, this is basically a rounding this. If we had another $80,000 of income, we would have heard at $0.10 on the earnings release. I can assure you I would have not personally bought shares in December, if I was worried that we weren’t going to cover the $0.10. Second, as it relates to the NAV decrease, the majority of that was related to two securities that were already non-earning. So it’s not affecting my earnings potential because we currently earn zero on them already. I know we talked on OEM a bit in the script, but I’ll provide a bit more color. This is our partnership with – this is our first year of our partnership with Plasma Therm. The first year has some growing pains and now those have been resolved and we feel good about our prospects in 2022. With that said, we can’t ignore the fact that 2021 was behind expectations since the markdown on the balance sheet. Now, next, if you look at the two non-accruals, the first is smarTours. As a reminder, this is the investment restructured as part of COVID. The management team has done an excellent job navigating a very difficult travel market and we’ll look into rebounding nicely there. There was a setback with Omicron and now we have the Russian invasion of Ukraine. We’re still very optimistic about this investment in the long run, but the rebound given the above will be delayed for a period of time. As for Aurotech, this is an investment that struggled since close and we’re looking to exit as soon as possible. The reason I highlight this now is with our new portfolio guidelines, this investment capital at risk for FCRD is $3.3 million and putting on a non-accrual is not a material hit to our earnings. Under the past strategy, this could have been a $25 million or $30 million investment, which is likely resulted in significant pressure on our dividend. My point is now that we have an asset side of the balance sheet properly set and we can manage a diversified portfolio much easier given the risk and the portfolio was much lower, highly diversified 95% first lien, which brings me back to the first comments I made in the earnings call. We’re finally in a position to go on the offense and work to increase in AI. We’ve already done our bond deal that a substantial savings, we’re actively moving to reduce costs debt in both the FCRD balance sheet and the Logan joint venture. Prior to the Russian invasion, my expectation is that the debt reductions that I just referenced would have increased NII between 20% and 30%. My hope was to have this done prior to the call today, but market factors have delayed that. To the extent we’re able to execute, we will be back in front of our investors with updated guidance. We recognize the status quo is not an option. And I’ve said at the start, I’m optimistic we can actually start to see growth in our portfolio and growth in NII.

[Leon Cooperman:]

I guess the question is what is the realistic return on equity for the shareholders? Basically, how you want to run the company?

[Christopher Flynn:]

Yeah, if I can get the balance sheet done, Lee, I just said I can – I think I can increase NII by 20% to 30%. So I’m at $0.10 today and it would move it to $0.12 to $0.13.

[Leon Cooperman:]

And what’s the timetable for that?

[Christopher Flynn:]

I would say the markets to stabilize. I wish I could tell you the day as soon as I know, we will tell you. We will 8-K and we’ll come back and provide new guidance.

[Leon Cooperman:]

I think you’re running out of time basically.

[Christopher Flynn:]

Lee, I don’t disagree with your statement. We’re running as best as we can. The good news is for once I said upfront, we’re on the offense now. The balance sheet is set. We can reduce our cost of liabilities and we can now start focusing on growing the NII, which should move the stock price closer to the book value.

[Leon Cooperman:]

Gotcha. Well, I’m rooting for, you know that.

[Christopher Flynn:]

I’m rooting for you, too. We’re the two largest shareholders, Lee, so we’re 100% aligned.

[Leon Cooperman:]

All right. Good luck. Thank you.

[Christopher Flynn:]

Thank you, sir.

[Operator:]

Thank you. Our next question comes from Paul Johnson with KBW. Your line is open.

[Paul Johnson:]

Yeah. Good morning, guys. Thanks for taking my questions. On the ABL segment that you talked about this morning, I’m just curious where is that being sourced from in the foreseeable platform? Is it going to have any sort of particular focus? It sounds like first deals you did were more retail focused? Is that going to be what we can kind of expect from this deals? And also, what sort of yields do you – could we expect to see from that?

[Christopher Flynn:]

Yeah, thanks. No, I appreciate the question. We did a team lift out in July of 2020, Larry Klaff and Lisa Galeota, both of them have been in the industry for a number of years, I’ve known both personally and professionally. I’ve attempted to have them as part of the platform for a few times, it’s never going to get a transaction done. But we’re super happy to have them here on board. So it’s just a – it’s an added team as part of the direct lending platform. The first proof of transactions we put it in our retail that they have the ability to do non-retail deals as well. So expect necessarily to be concentrated there. Regardless of the sector that they invest in, it is a collateral-based loan, meaning that we’re only going in on a balance sheet where we can carve out specific collateral. So while there might be a slight higher probability of default, your loss given default on any of these investments should be de minimis. Average spreads range on these investments from anywhere as low as LIBOR plus 600 to 650 to as wide as 800 to 850. We’re just now starting to leg it. Like I said, we have about 5% of the book in ABL right now. Our goal is somewhere 15 over time.

[Paul Johnson:]

Great. And I appreciate. That’s really good color. Kind of segue from there, the pipeline that you guys are looking at today, I mean, I think the portfolio yield today is 6.5%, you’ve just done a few investments quarter-to-date this quarter around the same yield. I mean, you have a general idea of what sort of your pipeline is and in sense of the yield on those assets?

[Christopher Flynn:]

Yeah, I think the pipeline yield is, I’d say, right now it’s flat. I think there’s a little price discovery going on. And just given the volatility in the market, too early to tell what the new level will be. I can assure you, it’s not going to be lower. If anything, it will be higher. The last couple of term sheet we’ve put out, we’ve tried to move pricing now maybe 50 basis points, we’ll see if that lands. But I described the pricing environment is stable, consistent what we’ve done in the past with potentially some upside to the except its continued volatility in the market.

[Paul Johnson:]

Okay. Thanks for that. And then on the JV, Logan JV, I believe the cost of funding within that JV is plus 2.5, correct me if I’m wrong there. I mean, I know you said you’re working on potentially refinancing the debt within there. I mean, where do you think – could that realistically be brought down incrementally? And then also, with the JV itself, I think the believer leverages around 1.5 or 1.6 times. I mean, can that be increased? What’s happening with the capital there? Are you guys reinvesting within the JV? Do you intend to grow the JV anymore? Just any pillar there would be great?

[Christopher Flynn:]

Yeah. Now, it’s a good question. I appreciate it. I’m probably not in a position right now, given that we’re pursuing a few different activities to the point and the exact direction that we’re going all to say that we have the ability to both lower costs and increase leverage to this extent, we think it’s prudent. And that’ll be a key driver into the reference I made to the lease question. We’re able to execute what how well, we think we want to execute, you can see that nice pop in NII, like I said, performance in that 20% to 30% increase range.

[Paul Johnson:]

Okay. And one or two more. On OEM group, the write-down there, was that – there – it sound like that was the main driver of depreciation, or correct me if I’m wrong, and then just an update on that company? I know that’s been a company that’s been marked down every other quarter. So that being impacted by the semiconductor supply chain issues that globally we’re facing at the moment?

[Christopher Flynn:]

Yeah, so just as a reminder, OEM has been an investment in our portfolio since 2010. We’ve owned the entire capital structure, the debt and the equity for a significant period of time. We finally positioned the business in such a way where we could develop the technology and some, excuse me, engineering capabilities that we think are marketable. Just given the size of the investment, we were not comfortable making the investment to develop a sales force ourselves. So we obviously partner with Plasma Therm, which specializes in distribution. These are two private companies. I’m probably not going to go into too much detail on what the issues were. I think as I said in my comments, we just – we categorized it simply just growing pains as we’re working with two businesses together for the first year. We do believe those pains have been resolved and we’re optimistic for 2022. But reflected in the markdown and you’re right, it was the largest markdown on the book. Again, if not income or earnings, it’s not going to hurt my NII with related to reflecting the 2021 with softer than we originally underwrote. But again, we think those issues are behind us, and we look forward to a good 2022 on that name.

[Paul Johnson:]

Okay, appreciate that last question. And previously, you already mentioned this on a call. I just didn’t catch it. But for your current share repurchase program, I think you bought back some shares this quarter. What sort of capacity do you guys have remaining under that program?

[Christopher Flynn:]

Yeah, we do have a program in place. I’ll let – sorry, Jen?

[Jen Wilson:]

Yeah. No, that’s fine. So we were authorized for $10 million through December 31 and we had just implemented our 10b-5. So we repurchased approximately 152,000. So I would say that we have about $9.5 million. We’ve been out in the market since then. We will continue with our 10b5-1 plans, but we’ve got plenty of capacity authorized repurchase plan right now.

[Paul Johnson:]

Okay, appreciate that. That’s all the questions for me today. Thanks.

[Christopher Flynn:]

Thank you, sir.

[Operator:]

Thank you. Our next question is Matt Jaden with Raymond James. Please go ahead.

[Matt Jaden:]

Hey, good morning, and appreciate you taking my questions. Chris, I think you said you expect to exit the non-accrual in 1Q. Should we expect any modest markdown versus the 12/31 mark?

[Christopher Flynn:]

I’d be referencing, yeah. yeah, there could be a further markdown on that position. Yes.

[Matt Jaden:]

Got it. Maybe following up on…

[Christopher Flynn:]

Just to be clear, I just want to clarify, I mean, it’s a very small position. So even if there is a further markdown, it’s not going to have a material move to our book value.

[Matt Jaden:]

Fair enough. Maybe following up on Paul’s question on the ABL opportunity, do you have a longer-term target of what you think the ABL opportunity could represent as a percent of the total portfolio?

[Christopher Flynn:]

Our target right now is 15%. We may move that to 20%, depending how the portfolio performs and where we sit with our lenders and our ability to grow the borrowing base.

[Matt Jaden:]

Got it. Last one for me on leverage. So I think as we sat in 3Q, Chris, you said you expected to hit that 1Q low end of the target range by 4Q. So a little short this quarter, was that just a function of unexpected re-phase flowing through? And then at the secondary question that, were in 2022, would you expect kind of to get into that low end of the target range?

[Christopher Flynn:]

Yeah, Igloo was a very sizable position that came in late in the quarter, I think it was what 30 with 5.5% of the book. So that came in – that came back late. So we would have missed our guidance by small amount. Our pipeline is robust. Like I said last year, we did over $2.4 billion in origination. So I have a pressure point. It’s not on the pipeline, it’s more distant and getting the balance sheet right for us to leg into that leverage. So I like to push through that 1.2, 1.3 as soon as we can. He was going a bit slow, obviously, right now with some uncertainty in the market. There’s some lot of price discovery. So I’d say there’s a pause on new business. But we anticipate that to stabilize and we anticipate to be writing new loans here and in the near-term. And well, I guess that will be in that 1.2 to 1.3 in short order.

[Matt Jaden:]

Got it. That’s it for me. I appreciate the time this morning.

[Christopher Flynn:]

Thank you, sir.

[Operator:]

Thank you. And I’m not showing any further questions in the queue.

[Christopher Flynn:]

All right. Well, thank you, operator. We appreciate the support of our shareholders and look forward to providing you an update in the spring for our Q1 2022 results. Feel free to reach out to Jen or myself if you have any additional questions before then.

[Operator:]

Thank you. Ladies and gentlemen, with that, we conclude today’s program. Thank you for your participation, and you may now disconnect.