Saratoga Investment Corp.
Q2 2009 Earnings Call Transcript

Published: 15 Oct 2008

[Operator:]

Welcome to the GSC Investments second quarter fiscal 2009 financial results conference call. (Operator Instructions) Now for opening remarks, I would like to turn the call over to the Chief Financial Officer, Mr. Rick Allorto.

[Richard Allorto:]

I would like to welcome everyone to GSC Investment Corp's second quarter 2009 earnings call. Before we begin, I would like to read a brief statement. This conference call contains statements that to the extent they are not recitations of historical fact constitute forward-looking statements within the meaning of the Private Securities Litigation Reform of 1995. Actual outcomes and results could differ materially from those forecast due to the impact of many factors. We do not undertake to update our forward-looking statements unless required by law. A replay of this conference call will be available from 1

[Richard Hayden:]

Welcome to all our shareholders. Needless to say, the last quarter has been a period of tumultuous volatility and disruption in the global markets. We've seen de-leveraging. We've seen de-risking. We've seen de-rating of almost every asset class. We have not been immune, but on balance I think we have done well as Seth will detail later. Before proceeding, I want to spend a few moments on stock ownership and emphasis the fact that GSC and the management team as a group are the largest shareholders in GNV. I assure you, we are very, very focused on preserving our capital currently and maximizing our value in the future. As you know, the Board of Directors recently promoted Seth Katzenstein as the CEO and President of our company. He succeeds [Tom Englestein] who is going back to his roots in the distressed investment area, but he will continue to be an advisor to the BDC and indeed, he maintains an office two doors down from Seth so we will look forward to his continued support and advice. Seth is the head of our credit and portfolio management for the U.S. COO group, and he has been the portfolio manager for the BDC since the IPO in March of '07. He was worked at GSC and its predecessor for over 10 years and before that, at Solomon Brothers. I've worked with Seth during my eight years at GSC and I have the highest confidence in his judgment, his credit skills and I think he is extremely qualified to lead us during these challenging markets. The Board of Directors and I certainly look forward to working with him and his team in the months and years ahead. I also want to mention that Alex Wright who heads the U.S. COO group has assumed the primary responsibility for origination of deals for the BDC and will continue to work closely with Seth as he has for several years. I will now turn the call over to Seth for an update on the company's performance in the last quarter.

[Seth Katzenstein:]

I would also like to welcome you onto our second quarter conference call this morning. I will briefly comment on the current market volatility and then I will review our investment portfolio and strategy. Afterwards, I'll turn the call over to our Chief Financial Officer, Rick Allorto who will review our second quarter financial results. Over the past month, a number of historic events have unfolded which have resulted in unprecedented volatility in the financial markets. Although we could not have predicted this unprecedented economic upheaval, we believe that our investment strategy is staying high in the capital structure of our portfolio companies, positioned us best under the circumstances. Almost 70% of our portfolio is invested in senior secured obligation and almost 17% of our portfolio is invested in a CLO that is collateralized by more than 90% senior secured first lien term loan. We believe that this investment strategy sets us apart from other business development companies. Our business strategy has been and remains to employ a modest amount of leverage to make portfolio investments that pay an attractive risk adjusted return, and to distribute our net investment income as an attractive dividend to our shareholders. Our strategy is designed to withstand normal capital market volatility because short term changes in the fair value of our investment portfolio do no directly affect our ability to generate net investment income. While we are obviously concerned about the continuing deterioration in the financial markets and the economy in general, the financial impact on our portfolio companies and our credit facility, we are pleased that we have been able to maintain our dividend despite the decline in the fair value of our investment portfolio caused by an unprecedented dislocation in the corporate debt market. Our net investment income per share was $0.42 for the second quarter versus $0.38 in the first quarter. We declared and paid a dividend for the second quarter of $0.39, equal to our first quarter dividend. For the second quarter, our net asset value per share was $11.05 compared to $11.75 as of May 31. At the end of the quarter, 21% of our corporate debt investments were first lien term loans, 39% were in second lien term loans and 24% were in senior secured notes which means that more than 80% of our corporate debt investment portfolio was invested in secured obligations. We believe that being senior and high in the capital structure increases the probability of significant recoveries from troubled investments. Our corporate debt portfolio is diversified with investments in a variety of industries and issuers. As of August 31, we have 44 corporate debt investments in 23 industries and our average portfolio company investment was $3.5 million. We have increased diversification of our portfolio. Since May 31, 2007, the concentration of our top ten corporate debt investments has declined from 59% to 51%, and the concentration of our top five investments has declined from 41% to 31%. Our stated goal is to limit any single corporate debt investment to no more than 5% of our investment portfolio, and in fact, our average corporate debt investment is less than 2.5% of our investment portfolio. Jason Incorporated is the only portfolio company that exceeds our 5% limitation. During the quarter, in response to market conditions, we modified the criteria for watch list investments in order to provide an earlier warning of potentially problematic assets. As a result, we added two portfolio companies to our internal watch list, increasing the total to six. However, following the end of the quarter, we exited our investment in EuroFresh, reducing our internal watch list to five investments. As anticipated, during the quarter another watch list credit, Atlantis Plastics became our first investment to be carried on a non-accrual basis. Atlantis filed for a Chapter 11 bankruptcy protection on August 10. We expect to realize a recovery of 55% to 60% of par by the end of our third fiscal quarter. Our single largest investment is the equity tranche of our internally managed CLO. This fund is invested in 124 issuers across 31 industries which helps protect the CLO from performance problems associated with any individual company or industry. 90% of the collateral is invested in first lien senior secured term loans with the balance of its portfolio invested in a combination of second lien term loans, high yield bonds and mezzanine CLO securities. The CLO's portfolio continues to perform well with only two watch list investments and no non-performing investments. And as a reminder, the CLO has no mortgage related investments. The next payment date for the CLO is October 20, and we expect the annualized cash on cash distribution to be in excess of 20%. Also, we recently posted on our website, gscinvestmentcorp.com, a primer on a CLO which we believe you might find useful. I'd now like to turn the call over to Rick to review our second quarter financial results.

[Richard Allorto:]

In my review of our financial performance, I will compare our performance to the fiscal quarter of 2009 instead of the second quarter fiscal 2008. We feel that our sequential quarterly performance provides a more meaningful comparison because we were still ramping our portfolio at that time last year and did not have the CLO investment. Please refer to our 10-Q which we will file later today for additional information regarding our year over year performance. GSC Investment Corp's net loss for the second quarter ended August 31, was $2.6 million or $0.31 per share. Our net investment income was $3.5 million or $0.42 per share and our net loss on investment was $6 million or $0.73 per share. For the six months ended August 31, our net income was $244,000 or $0.03 per share. Our net investment income was $6.7 million or $0.80 per share and our net loss on investments was $6.4 million or $0.77 per share. As of August 31, our net asset value per share was $11.05, a decrease of $0.70 per share from the prior quarter. For the second quarter ended August 31, our total investment income was $5.8 million, and increase of $120,000 versus the prior quarter. Our investment income was comprised of $5.3 million of interest income, $489,000 of management fee income associated with the CLO investment, and $90,000 of miscellaneous bank interest and fees. The increase versus prior quarter is mainly attributable to a higher effective interest rate earned on the CLO equity investment. For the second quarter ended August 31, our total operating expenses before manager reimbursement were $2.6 million, a decrease of $177,000 versus the prior quarter and consisted of $624,000 in interest and credit facility expenses, $706,000 of base management fees, $407,000 of incentive management fees, $261,000 in administrator expenses and $643,000 in general and administrative expenses. The decrease versus the prior quarter is attributable to a decrease in interest and credit facility expense due to a lower average borrowing during the quarter, partially offset by an increase in incentive management fees. We recorded $261,000 in manager expense waiver and reimbursement for the quarter ended August 31, resulting in total operating expenses after manager reimbursement of $2.4 million, a decrease of $140,000 versus the prior quarter. The largest write down in the quarter was $3.3 million and our investment in the CLO equity. We valued this investment based on a discounted cash flow model that utilizes pre-payment, reinvestment, and loss assumptions that are based on both historical experience and projected performance. The unrealized loss is primarily a result of changes we made in these assumptions in response to the current credit environment. Additional details on the unrealized losses in our portfolio are available in our shareholder presentation which can be found on our web site. As of August 31, 29% of our investments were liquid and fair valued based upon market quotes. 31% were fair valued by an independent third party valuation firm, and 40% were fair valued internally. Approximately 60% of our investments fair value are based primarily on market input, or valued by an independent third party valuation firm. The quarter ended August 31, we did not have any significant asset realizations and recorded a net realized gain on investments of $174,000. As of August 31, we had borrowed $66.3 million under our credit facility and had $33.7 million of undrawn commitments. The actual amount that we can borrow is based upon a dynamic calculation that includes such factors as market values, asset ratings and recovery rates and portfolio diversification. Over the past three quarters, the market values of our assets has declined by approximately 11% and several investments have received ratings downgrades. Accordingly, the total collateral balance for our bond base has declined and limited our access to draw down on the remaining commitments. As of August 31, the availability was $1.5 million. That concludes my financial review. I will now turn the call back over to Seth.

[Seth Katzenstein:]

I just have a couple of follow up comments. Over the past several weeks, the leverage loan market has experienced significant selling pressure caused by a technical imbalance of buyers and sellers. Buyers continue to remain extremely cautious as rebounds have been followed by even deeper losses. This cycle will continue until a sufficient amount of leverage has been removed from the financial system and confidence has returned. Although we can't control the effects of market volatility on our investment portfolio, or predict the severity or duration of the anticipated recession, we think our increased diversification and strategy of remaining high on the capital structure will serve us well. I would like to thank all of our shareholders for their support during this especially difficult time. I look forward to working with each of you. I would now like to turn the call over to the operator to start the question and answer session.

[Operator:]

(Operator Instructions) Your first call comes from Greg Mason – Stifel Nicolaus.

[Greg Mason:]

First I wanted to talk about your Deutsche Bank credit facility. If we're remembering right that has an $88 million minimum net worth covenant. You guys are at $91 million right now and Seth, you just said that the levered loan markets since August has significantly deteriorated, so is it reasonable to expect that you will violate that covenant next quarter and are you having discussions with Deutsche about that?

[Seth Katzenstein:]

You're correct. Minimum net worth is $88 million and at the end of the quarter we had about a $3.6 million in our cushion on that covenant. We won't test that covenant again until January when we have to report our January borrowing base, so we have a little bit of time on that to see how the markets perform. As respect to discussions with Deutsche Bank, it's a little premature to comment on that, but that is certainly one item under consideration.

[Greg Mason:]

What are your thoughts in discussions with Deutsche, the concerns about the line just being pulled because of the credit environment versus being re-priced.

[Seth Katzenstein:]

We have a good relationship with Deutsche Bank. They've been supportive of us since we put the facility in place shortly after going public, and we look forward to continuing to work with them. But it's premature to comment on anything specific about the facility at this time.

[Greg Mason:]

Moving on the CLO, you said the decline in equity was due to some changes in your assumptions. Can you tell us what you're assuming, for example [queue mode] of loss assumptions for the CLO and how are those trending today relative to your expectations?

[Richard Allorto:]

There are two primary modeling assumptions. You calculate the fall rate assumption in looking and modeling out the future cash flows. Historically, we have generally looked at as a firm, the 2% default case and again, there's some current estimates in the market and these are forecasted estimates of a much higher expected default rate. So we did increase that assumption. The next major assumption is the discount rate in your net present value calculation, and that's one more derived at the current environment we're seeing in conjunction with the fair value accounting and trying to determine what we think we could exit this for and large of a discount we think a potential buyer would require. Actual performance to date, we've had no defaults in the facility so the increase in the default rate is currently just based upon the modeled assumption.

[Greg Mason:]

Can you tell us what the new constant rate default rate is?

[Richard Allorto:]

We ran various models ranging from 2% up to 6%, and we looked at discount rates, not present value discount rates in the range of 25% to 35%.

[Greg Mason:]

Can you tell us of the $5.3 million in interest income, what was the CLO equity contribution to that $5.3 million?

[Richard Allorto:]

$1.1 million.

[Greg Mason:]

You kind of touched on it, but in the past you said you expected about half of the benefit from that CLO equity to come in the August quarter and the full impact in the November quarter. What do you expect that $1.1 million to go up to assuming that the current collateral remains unchanged?

[Richard Allorto:]

Round numbers would be the $30 million times 20% effective interest rate, so $1.5 million.

[Operator:]

Your next question comes from James Ballan – J.P. Morgan

[James Ballan:]

I wanted to ask a little bit about the net investment activity. It looks like the number for the exits and repayments on the quarter slowed pretty significantly. Is this something you think was a result of just your portfolio specifically or do you think this is more of the market impact and has that slow down persisted since the end of the quarter?

[Richard Allorto:]

Right now, we're very cautious and conservative in how we're going to invest our portfolio. There's a significant slow down in the new issue activity which is one area that we focused on a lot since we went public, and for all intents and purposes, originators are not underwriting new transactions and the forward calendar is basically empty. But there are a significant number of opportunities in the secondary market, and we are continuing to evaluate those. But you have to take into account that a lot of the seasoned deals have weakened structures and you really do need to be cautious as you're kind of picking through them in this current credit environment. So that certainly has been a factor in our investment pace. In addition, we focused a lot last quarter as strategies industries were rolling off and partially putting that money to work ahead of time in anticipation of the pay down so we have front loaded activity a little bit in the prior quarter. The combination of those in conjunction with just focusing on liquidity in general on our portfolio accounts for the more limited investment activity relative to our historical pace when we were ramping.

[Operator:]

Your next question comes from [Jasper Bundt – Fox Knit Kelton]

[[Jasper Bundt:]

Can you give us any color on the portfolio migration in terms of your internal rating system? Where did you see movement? Could you give us any updates in terms of some of your larger holdings like [Kemper Sports] and McMillan? Are there any action with those companies that would be worth noting?

[Richard Allorto:]

I think the big thing to note is the fact that we added two names to our watch list during the quarter really as a result of expanding the criteria so we could have an earlier warning system in place to focus on their performing credit. The two credits that were added were IDI, also known as Interdent and McMillan were added during the quarter. So that brings the total to six for the quarter, but you have to exclude EuroFresh which we have divested and Atlantis Plastics which ultimately will go away later this month, if not this month, certainly by the end of the quarter. That's really what we're focused on. If you look at the rest of the portfolio and critically, we don't anticipate any additional payment defaults or non-performing assets between now and the end of the fiscal year. Beyond that, it's a little difficult to forecast given the fact that if we're not in a recession, we will be.

[[Jasper Bundt:]

In terms of your credit facility, if you had a borrowing base of $1.5 million and then you had about $66.5 million total facility effectively which would give our $68 million. When and how often does that get re-priced in terms of your assets and when do the calculations get done? Is it safe to assume that you'll have a facility of effectively $68 million through third quarter, or does it last longer? When will that change?

[Richard Allorto:]

We report our bond base to Deutsche Bank on a monthly basis. There are a handful of assets in the calculation that do get currently priced, but the majority of the portfolio, the pricing we'll use our August 31 values. Beginning in October, for then the next three or four months, but there are a number of limited assets that are priced at the current price.

[Seth Katzenstein:]

I just want to emphasize something. The markets are extremely volatile but we as a practical matter because we get to use the fair values on our books and records, only have to mark our portfolio for the borrowing base on a quarterly basis, other than the exceptions that Rick mentioned that are valued monthly. So it does smooth out availability and the fluctuations in our portfolio with respect to our credit facility.

[[Jasper Bundt:]

I also noticed in your shareholder presentation, it looks like the EBITDA underlying your portfolio went up a bit. Is that concentrated in a few companies that have flowing cash flows or is that across your portfolio?

[Richard Allorto:]

It's definitely a trend we're seeing across our portfolio as companies are reporting weaker year over year results. For people on the call it's Page 7 of the shareholder presentation, when you compare that to the slides of the previous quarter, it's depending on the asset category, but over all it's about a quarter of a turn increase across the whole portfolio. And that just really a decline in overall performance of companies, and we're on top of it, and we think ultimately the fact that we focus on investments that are high on the capital structure and senior secured will ultimately protect us and serve us well.

[Operator:]

Your next question comes from Bob Martin.

[Bob Martin:]

Can you give me the non-accruing loans at fair value as a percent of total loans?

[Richard Allorto:]

The only non-accrual is Atlantis Plastics which at August 31 fair value was $3.5 million. As a percentage of the total portfolio, that equals 2.2%.

[Bob Martin:]

Are the non-accrual loans the same as securities over 90 days delinquent?

[Richard Allorto:]

No, Atlantis became a non-accrual because of the bankruptcy filing.

[Bob Martin:]

Do you track 90 day delinquent loans?

[Richard Allorto:]

Yes and no. We have no other loans that are payment default. Our policy would be to continue to accrue, however potentially establishing a reserve against that accrual up until a point where a company does file bankruptcy.

[Bob Martin:]

Other BDC's report securities over 90 days delinquent and it's good to have a yardstick to have the figure from you to compare with other companies.

[Richard Allorto:]

Our 90 day delinquency would be zero. And to the extent that we have any delinquent loans we would report that in our Q.

[Bob Martin:]

Some BDC's report portfolio company weighted average net debt to EBITDA ratio. Do you do that?

[Richard Allorto:]

We don't report it that way in our Q, but if you look at Page 7 in our shareholder presentation, we break out by each asset category the credit stats, and we focus on leverage ahead of our investments and leverage through our investments. Page 7 does a pretty good job of breaking that out.

[Bob Martin:]

You mentioned your asset coverage ratio was 238%. This is the first time for me to notice that spec. Can you give me some information as to how that compares with other companies? How does that compare with you coverage ratio in the past?

[Richard Allorto:]

Starting with the second part, how it compares with our performance in the past, over the past three or four quarters, I would say that's roughly in line. Last quarter was a little tricky. We have a very large asset redemption in strategic industries and made a pay down on our credit facility on the last day of the quarter. I think last quarter was 256%. Historically, I want to say we're right around the range we're at for the quarter end at 238%.

[Seth Katzenstein:]

Our strategy is different than some of the other credit oriented BDC's. We focus on loans and securities that are high in the capital structure, that are senior secured and probably have a little bit lower of a rate, interest rate or coupon, and we offset that by employing leverage. So when you compare our asset coverage ratio to other BDC's, we might have a little less coverage because we have always employed a strategy of utilizing leverage to generate net investment income and pay out an attractive dividend to our shareholders.

[Operator:]

You have a follow up question from Greg Mason – Stifel Nicolaus.

[Greg Mason:]

One thing I'd like you to comment on about portfolio exit opportunities. Some other BDC's have talked about their ability to as an investment violates a debt covenant to pro-actively modify those investments. Since you tend to buy more into club deals where you're one of several senior debt sponsors, what are your opportunities to work with your portfolio companies and potentially modify investment rates or covenants?

[Richard Allorto:]

The situation is pretty similar for us as well. The extent of the issuers that we invest in run into covenant problems and violate either financial covenant or in the extreme case, can't pay their interest and principal. They're going to have to work with us and the other lenders in the bank group or the other bond holders to come up with a solution. And those solutions entail a number of things including equity contributions from the financial sponsors that own the company to provide liquidity or to reduce debt which is what we would focus on, and then also increases in rate and fees to compensate the lenders for the risk associated with the credit. But our focus is on protecting the investment not necessarily increasing our returns. We want to make sure we get our money back. Our strategy has always been predicated on that and so we're going to use those situations as opportunities to increase the company's liquidity position and to get paid down if possible.

[Greg Mason:]

Can you talk a little bit more about how many lenders are at the table? You guys have talked in the past that you do club deals and not broadly syndicated deals. How many senior lenders are at the table typically in the investments that you're in?

[Richard Allorto:]

It's going to vary per investment. It's definitely issuer specific depending on the size of the company and who ultimately originated the loan and structured it. But for the traditional, more club like deals it could be anywhere from five to ten, maybe a dozen. But it's going to vary.

[Operator:]

We have no further questions. Mr. Katzenstein, I'll turn the conference back over to you for any closing remarks.

[Seth Katzenstein:]

We would like to thank everyone today for their participation and please do not hesitate to contact either Rick Allorto, Michael Yip or myself if you have any additional questions. Have a good day.