Stellus Capital Investment Corporation
Q3 2021 Earnings Call Transcript

Published: 29 Oct 2021

[Operator:]

Good morning, ladies and gentlemen, and thank you for standing by. At this time, I would like to welcome everyone to the Stellus Capital Investment Corporation Third Quarter 2021 Results Conference Call. At this time, all participants have been placed on a listen-only mode. The call will be open for question-and-answer session following the speakers’ remarks. This conference is being recorded today, Friday, October 29, 2021. It is now my pleasure to turn the call over to Mr. Robert Ladd, Chief Executive Officer of Stellus Capital Investment Corporation. Mr. Ladd, you may begin your conference.

[Robert Ladd:]

Yes. Thank you, Katie, very much. Good morning, everyone, and thank you for joining the call. Welcome to our conference call covering the quarter ended September 30, 2021. Joining me this morning is Todd Huskinson, our Chief Financial Officer, who will cover important information about forward-looking statements as well as an overview of our financial information.

[Todd Huskinson:]

Thank you, Rob. I'd like to remind everyone that today's call is being recorded. Please note that this call is the property of Stellus Capital Investment Corporation and podcast of this is strictly prohibited. Audio replay of the call will be available by using the telephone number and PIN provided in our press release announcing this call. I'd also like to call to the customary safe harbor disclosure in our press release regarding forward-looking information. Today's conference call may also include forward-looking statements and projections, and we ask that you refer to our most recent filing with the SEC for important factors that could cause actual results to differ materially from these projections. We will not update our forward-looking statements unless required by law. To obtain copies of our latest SEC filings, please visit our website at www.stelluscapital.com, under the Public Investors link or call us at [phone]. At this time, I'd like to turn the call back over to our Chief Executive Officer, Rob Ladd.

[Robert Ladd:]

Thank you, Todd. I'm pleased to report another solid quarter in which we covered our dividend, increased net asset value, received realized $7.9 million and maintained stable asset quality. In addition, as a result of our continued dividend coverage, our Board increased our regulator dividend to an aggregate of $0.28 per share beginning in the fourth quarter. We have continued to see many interesting opportunities and as a result, funded $60 million on a cost basis during the third quarter. Since year end, we have originated of new investments and our portfolio has increased by $128 million, net of payoffs of $787 million on a cost basis. We'll begin by discussing our operating results followed by a review of the portfolio, including asset quality and then our dividend strategy and outlook. And Todd will now cover our operating results.

[Todd Huskinson:]

Thank you, Rob. For the quarter ended September 30, 2021, we covered our dividend of $0.27 per share with core net investment income of $0.31 per share. GAAP net investment income was $0.21 per share, which includes capital gains incentive fees of $1.7 million related to our realized and unrealized gains during the quarter and income tax expense related to our spillover income. We generated realized gains of $7.9 million related to the realization of an equity investment and unrealized gains of $2.1 million related primarily to the appreciation of our equity co-investment portfolio. During the third quarter, our Board declared a regular dividend of an aggregate of $0.27 per share, an aggregate $0.03 per share of supplemental dividends and the fourth quarter dividend of an aggregate of $0.28 per share. The early declaration of the fourth quarter dividend was required in order to complete the distribution of spillover income from 2020 in a timely manner, consistent with maintaining our qualification for taxation as a regulated investment company, and to eliminate our liability for corporate level U.S. Federal income tax. Despite this additional accrual in the third quarter, net asset value increased during the quarter to $14.15 per share. I'd like to note that these distributions constitute all remaining distributions for the year, so our fourth quarter net asset value will not be further reduced by distributions paid in the fourth quarter. We continue to recycle capital in our first SBIC license and deploy the low-cost debentures in our second license. Of the $100 million of debentures in our second license that are pooled so far, the all-in cost is approximately 2.5%. To date, we've committed the full $87.5 million of equity to SBIC II, our second license, and have funded $70 million of that commitment. We have drawn $100 million of the $175 million of debentures that will be available when equity is fully funded. And with that, I'll turn it back over to Rob.

[Robert Ladd:]

Okay. Thank you, Todd. I'd like to now cover the following areas

[Operator:]

. Our first question comes from Ryan Lynch with KBW.

[Ryan Lynch:]

The first one I had, I mean, there was a pretty substantial increase in total revenues this quarter. $17 million versus the $15.1 million in the previous quarter, and portfolio was actually ahead of net repayments. What I wanted to get a sense of is what sort of level -- and now I know you had big -- very strong net originations in Q2, so maybe some of that's finally flowing through gaining full impact in the third quarter. But what I'm trying to get a sense of is, what is -- what was the level of accelerated or one-time fees or OID that you recognized in the third quarter? And how does that compare based on what you guys are, kind of an average of what you guys have historically received?

[Robert Ladd:]

Yes. Good question, Ryan. So in the quarter, the fee acceleration was approximately $700,000. And in previous quarters, it would have been a fraction of that because there were relatively few repayments.

[Ryan Lynch:]

Okay. So there was only a...

[Robert Ladd:]

I was going to say the quarter was a benefited from just what you said, a full quarter where we were operating at a higher portfolio level as compared to the first 2 quarters; and then 2, from early repayments, meaningful fee reclassification. Not very little of it in fact. I don't think there was any actual call premium, just given the duration of how long we've held along. So it's just the early OID, if you will, was coming back upon the repayment.

[Ryan Lynch:]

Okay. Okay. So $700,000 of kind of acceleration versus very little in the past. So that kind of brings to my next question. This quarter, you guys broke above the upper end of your incentive fee hurdle range and actually broke out of that range. Would you anticipate that you guys would fall back within your incentive fee hurdle range going forward and that will be kind of what you guys will operate within on a consistent basis besides sort of one-off quarters of popping out like we saw in the third quarter? Or do you guys expect to get above that hurdle range on a consistent basis going forward?

[Robert Ladd:]

Yes. And this came up last quarter. So I'd say that we'll likely operate in the range and then quarters where we have these early repayments. You may remember that we had nominal repayments during COVID and then coming into this first part of the year, we did expect the second half of the year, those repayments would pick up. And as I said earlier, we're expecting a number in the fourth quarter that we're now in. So it's possible we'll operate above the range in the fourth quarter. But I think on a normalized basis, we'll probably be in the range on the catch-up.

[Ryan Lynch:]

Okay. Understood. And then just one last one for me and then I'll hop back in the queue. You mentioned $7.5 million of potential realized gains could be recognized in the fourth quarter. I'm just curious, is all of that already previously been recognized as an unrealized gain in your portfolio? Or could there actually be further gains when you guys actually -- if you guys actually do recognize those?

[Robert Ladd:]

Yes. Yes, Ryan. So if they came in, the delta between expected proceeds and now valuations, about $2.8 million. So if they all came in, you'd see all things being equal, an increase in NAV by $2.8 million.

[Operator:]

Our next question comes from Christopher Nolan with Ladenburg Thalmann.

[Christopher Nolan:]

Rob, the $0.06 supplemental dividend, if I understood correctly, starts in the first quarter of 2022 and should be a regular quarterly event going forward?

[Robert Ladd:]

Yes. That's the plan.

[Christopher Nolan:]

Okay. And then the tax -- excuse me, the $0.2 million in excise taxes in this quarter, why didn't you guys just do a distribution just to -- getting into the REIT distribution so you can avoid that? I mean.

[Robert Ladd:]

Yes. So this is approximately our run rate and that’s based on the 20-plus million of spillover that will continue to spill over for the time being. So we got to pay all of it out to eliminate .

[Christopher Nolan:]

Got you. And Todd, do you have an exact number for the spillover income at September 30?

[Todd Huskinson:]

I'd say, well, spillover from last year was about $21 million. So -- and that may move around just depending on kind of how things are ultimately classified and so forth. But I would, Chris, assume it's about $21 million in total spillover.

[Operator:]

Thank you. Our next question comes from Robert Dodd with Raymond James.

[Robert Dodd:]

First, on the -- you gave some color on you expect repayments. I mean, it's a really active market out there. But you expect to at least equal them in deployments. On the deployment side right now with that competitive market, are you seeing any shifts in dynamics? I mean, is it -- is the SBIC sized type assets are rather -- are those -- that's where you've got capital, but are those just more attractive as well? Or any dynamics about different parts of the market that you play in, that you can give us color on?

[Robert Ladd:]

Sure. So we're continuing to see a number of interesting SBIC qualifying opportunities. And now we're seeing some that are larger companies that would not qualify. So I think we're seeing good activity on both fronts. We just went through the pipeline with our teams this morning and very robust activity, some are closer to being finalized than others. But I think you'll see a nice mix going forward at both. And it's helpful too that -- although it is a competitive market as always, we continue to see proper capital structures where the equity checks are 40% to 50% of the capital, leverage is typically -- for us from 4x to 4.5x, and it could be less depending on the company, appropriate pricing and structures and the continued ability to earn equity co-invest. So the market is quite good, competitive, but lots of opportunities for us, both on the SBIC and non-SBIC side.

[Robert Dodd:]

And then just one more sort of on spillover. I mean if you generate the $7.5 million in realized gains in the fourth quarter along with obviously almost 8 that you generated this quarter, I mean, is any of that shielded either in blockers against previous losses or anything like that? Because obviously, if not, that accrues to quite a lot of spillover going into next year, above the 20.

[Robert Ladd:]

Sure, Robert. So very good question. The bulk of the equity gains that we've seen in the third and likely in the fourth are actually in blockers, and so that would not increase the spillover income.

[Operator:]

Our next question comes from Bryce Rowe with Hovde Group.

[Bryce Rowe:]

I wanted to, I guess, start maybe along the same lines of Robert's questioning there in terms of what you're seeing in the market. Could you guys kind of describe what you're seeing from a pricing perspective on newer deals relative to some of the activity that might be coming out of the portfolio right now?

[Robert Ladd:]

Yes. So I'd say, as you can see from the scheduled investments, the all-in yields that were new investments are ranging at about an 8% when you include the fee accretion as well, typically LIBOR plus 6% with a LIBOR floor of 1%, sometimes a little bit higher. And so repayments and new loans are about the same yield. And you could see this -- or 8.3% yield come down just a little bit, but we think we'll be able to maintain it at, at least the 8% level. So -- and that pricing has roughly been true now for over a year or so.

[Bryce Rowe:]

Okay. That's good news. And then maybe you all could see, we've certainly heard you all talk about kind of the leverage profile of Stellus' balance sheet in quarters past. But any thoughts on how you think about balance sheet leverage, now you've got to some more SBA debentures through your second license. So just trying to gauge how quickly you might go through that. And then how you think about kind of your strategy to fund new investments once you get beyond the available debenture capacity?

[Robert Ladd:]

Sure. So I think as a general matter on the leverage profile, we like to maintain our regulatory leverage at 1

[Bryce Rowe:]

That's good commentary, Rob. And then maybe just some more questions around the realized gains or the companies that are being exited, the equity investments that are seeing some exits. Can you speak to kind of what's driving those decisions? Is it more tax planning, tax driven? Or is there the potential for a lot of this activity that we've seen especially in the back half of this year to persist into next year?

[Robert Ladd:]

Yes. So I'd say that it's mostly what appear to be almost pent-up demand on the sell side that during COVID, M&A activity slowed down materially and now it's picked back up. So we would just see it as something that some companies might have sold a year ago, but for COVID, and now they're coming to market. It's interesting on the tax side, our tax advisors have indicated new tax law relative to capital gains would be effective in September. So any sales now would be covered by the new tax regime, but we'll see whether that's the case. So we think this is less tax driven, given that the rates seem to going to be moved up retroactively. So it's more just, we think, pent-up demand on the sell side. And I'd say, yes, we would look out to the next year and expect that continue to see companies be sold, assuming that the market and the individual company performance was good. It's also, Bryce, good to raise this, too, is this is part of our -- as you know, from the very start of the company back in 2012 that we've always had this strategy, not everyone does that in addition to the lending, we like to always buy a smaller piece of equity in the companies we lend money to. And we've thought over time that this would be helpful to our shareholders and of course it has been. So this -- we're glad to see that these gains have continued. And this is, of course, why we feel comfortable now having additional dividends be paid into next year. We've, of course, declared the first quarter as these have been coming in.

[Operator:]

Our next question comes from Christopher Nolan with Ladenburg Thalmann.

[Christopher Nolan:]

Rob, given all the moving pieces with the macroeconomic picture, what are you hearing from your portfolio companies? I mean, are they hunkering down to be more defensive or what? I mean, can you just give some sort of a little color on that?

[Robert Ladd:]

Sure. I'd say as a general matter, our company -- portfolio of companies, which are over 70 today, are performing well. And I think there's a lot of optimism and around those businesses and around the economy generally. I know we're all concerned about potential inflation, but all are operating well. We have some portfolio companies that have experienced labor shortages or wage increases that they're having to work with and others are dealing as you know with supply chain logistics issues, but these are well-managed businesses with very professional owners and private equity firms and managing through it. So we would very positive about what our portfolio companies are seeing and continuing to grow and effectively end up delevering as a result. So, positive. But we're always cautious for what’s next and we continue to be very selective in our investing, new investing. And just because we can't predict the future, but we're quite optimistic at this point.

[Operator:]

I'm showing no further questions at this time. I would now like to turn the call back over to Mr. Ladd for closing remarks.

[Robert Ladd:]

Okay. Thank you, Katie, and thank you, everyone, for your support over this last 9 years. And we look forward to speaking with you in the spring when we'll have the results from the fourth quarter and for our 10-K.

[Operator:]

Thank you. This concludes today's call. Thank you for your participation. You may now disconnect.