ArrowMark Financial Corp.

Welcome to Stone Castle's Financial Corp Q4 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. If anyone should require operator assistance during the conference, please press star zero on your telephone keypad. As a reminder, this conference is being recorded. Now, I would like to turn this call over to Ms. Julie Morocco, Investor Relations of Stone Castle Financial. Thank you. You may begin.

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 volumes 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. Stone Castle Financial has based the forward-looking statements included in this presentation on information available to us as of December 31, 2020. The company undertakes no duty to update any forward-looking statement made therein. All forward-looking statements speak only as of today, March 1st, 2021. Now, I will turn the call over to Sanjay Bosley.

Thank you, Julie. Good afternoon, and welcome to Stone Castle Financial's fourth quarter investor call for 2020. Along with Julie, here with me today is Pat Farrell, our CFO. During today's presentation, I will briefly comment on the banking industry and credit markets before commenting on the company. Then I will provide Stone Castle Financial's quarterly results and portfolio review, and Pat will provide you with greater details on our financial results before we open the call for questions. In general, the fourth quarter of 2020 continued the trend of large money-centered banks and community banks reporting better than expected earnings. Furthermore, we believe banks will continue to be well capitalized. For the most part, banks have adequate reserves in anticipation of any corporate defaults from continued economic uncertainty. The most obvious concerns continue to be the industry sectors most affected by the pandemic in hospitality, retail, transportation, and some parts of energy. I want to remind our shareholders that the bank investments in Stone Castle Financial's portfolio have underlying loans diversified by industry sectors. Also, community banks within the portfolio primarily service their local markets in real estate, such as multifamily, owner-occupied residential, C&I, and other small businesses that have held up well during the past year. During the fourth quarter, we saw relatively strong performance with most of the company's community banks reporting sequential growth in net income with fairly stable to upward trending Tier 1 capital ratios. The issuance of new PPP loans helped community banks partially mitigate increases in loan loss reserves, with some banks partially reversing these increases during the fourth quarter. A majority of the company's underlying community banks had reported their fourth quarter results with median net income up 16.8% versus the third quarter. In addition, these banks reported average tier one capital ratios of 12.3% flat from Q3. Finally, our underlying community banks reported a fourth quarter change in reserves, which were up 15 basis points to 1.37%. In general, loan books were flat from the prior quarter. We also saw strong performance in the regulatory capital sector during the fourth quarter. In this sector, the company's regulatory capital investments performed extremely well, with several investments either paying down at par or continuing to amortize ahead of schedule. For the most part, the amortizing assets were purchased at attractive discounts during the market dislocation in Q2. As expected, the regulatory capital investments proved to be resilient during 2020. For the first half of 2021, our outlook for the banking industry remains cautiously optimistic. We are encouraged by the efforts towards additional government stimulus and other agency programs designed to help the consumer and small business. It is likely that these programs will be distributed through the banks, similar to the first round of PPP. Now, let me comment on the credit markets. In the fourth quarter, the Federal Reserve signaled that US interest rates will remain low for the foreseeable future. Recent policy considerations and some reported economic indicators began fueling talks of inflation in the credit markets. Post the U.S. election through today, we have seen the yield curve steepen for the 10-year treasury. We believe this is due to the factors already mentioned, along with the perception that COVID vaccinations and the stimulus package may result in better economic conditions in the second half of the year. Regarding impending inflationary pressures, We believe during an upward trend in rates, banks should benefit from higher net interest margin, or NIM, which would positively impact earnings. Next, I will cover our origination pipeline during the quarter. In Q4, the primary markets continue to be active in both regulatory capital and community banking securities. In regulatory capital securities, primary issuance during the fourth quarter was approximately 3.5 billion, which is consistent with a seasonal spike in activity during prior years. The full year issuance was approximately 9 billion, and our expectation for 2021 remains optimistic. We also believe the secondary markets will continue to be a source for regulatory capital investments. Community banking originations in the primary market continue to be relatively strong. In Q4, community banks raised approximately $2.6 billion, down from $3.1 billion in Q3. Banks were generally able to issue sub-debt in the 4% to 6% range, similar to the third quarter. The continuation of attractive interest rates should allow these banks to issue sub-debt at historically low rates into the foreseeable future. Now on to Stone Castle Financial's results for the quarter. We are pleased to report that net investment income for the fourth quarter was approximately $3.1 million, or 46 cents per share, an increase of 4 cents per share from the prior quarter, or up 11%. The fourth quarter net investment income had a positive impact from other income of approximately 3 cents per share, which Pat will discuss further in his comments. At the end of the fourth quarter, The value of the investor portfolio was 178.4 million versus 147 million at the end of the third quarter, an increase of 21%, primarily due to the new investments made during the quarter. The net asset value at the end of the fourth quarter was $21.44 per share, up 55 cents or nearly 5% from the prior quarter, including the reinvestment of dividends. Now let me turn to the portfolio review. During the fourth quarter, the company invested a total of $42.5 million in seven investments, including $37.5 million in six regulatory capital transactions and $5 million in one community bank preferred stock. The seven new investments contributed a weighted average coupon of 10% and a weighted average yield to maturity of approximately 10.4% to the portfolio. and majority of the securities were purchased in the primary market at par. Yields of these new assets remain accretive to our earnings. Since the transition over to Stone Castle Aramark as a new advisor, the company has made $99.3 million of investments, which exceeded the last two years combined in terms of gross investment activity. During the fourth quarter of 2020, the company received proceeds of $12.2 million from full calls on two investments, proceeds of $7 million from the sale of one investment, and received partial paydowns of $3.7 million from four investments for a total of $22.9 million in proceeds. In the first quarter of 2021, we continued to make new investments and will share more details when we report on our first quarter results. At quarter end, The estimated annualized effective yield generated by the investor portfolio, excluding cash and cash equivalents, was approximately 9.65%. This portfolio yield has held stable, above 9% for 16 consecutive quarters, or four years running. Our investment team is positioning the portfolio for the most advantageous risk-adjusted returns available to us in banking-related assets, with a long-term view on creating shareholder value. A full schedule of investments can be found on our website. Before I turn the call over to Pat, let me close my remarks by reflecting on my first year as chairman and CEO of Stone Castle Financial. It was just about this time last year that shareholders approved Stone Castle Aramark as an investment advisor, and the current investment team began advising on the assets of Stone Castle Financial. As always, they have continually emphasized managing risk, growing assets, enhancing the dividend, and increasing the value of the company. As mentioned previously, in aggregate, Stone Castle Aramark reported total new investments of $99.3 million in assets, despite the volatility of the credit markets and the competition for yield-oriented assets. The Board of Directors declared a $0.05 special dividend, which enhanced the regular cash dividend and offered investors a year-end 2020 dividend yield of just over 8%. The net asset value of the company grew from reported March 31st Q1 pandemic-related low of $19 to $21.44 per share reported at year-end. FAB will report on the annual performance of NAV But I particularly want to point out this metric as it speaks to the team's ability to navigate volatile markets and produce solid performance during a challenging year. I also want to point out to our investors that the breadth and the scope of the personnel who work with management on Stonecastle Financial's investment portfolio and in operations has been significantly expanded with the transition to Stonecastle Aramark and the Aramark platform. The depth of expertise in banking-related assets across Aramark's platform offers a significant and intangible advantage to the company and to our shareholders. I want to acknowledge my colleagues for their hard work, and I want to thank you, our shareholders, for the steadfast support you have shown the company over the last year. It is much appreciated. I'm excited for what the future holds for Stone Castle Financial and the opportunity to grow the portfolio. Now I want to turn the call over to Pat.

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 December 31st was $21.44 per share, up 55 cents, or 4.8% from the prior quarter, including reinvestment of dividends. Now, on to the breakdown of the NAV components. The NAV is comprised of four components, net investment income, realized capital gains and losses, the change in value of the portfolio's investments, and lastly, distributions paid during the period. Let's review these components. Gross income for the quarter was 4.7 million, or 71 cents per share. Net operating expenses for the quarter were 1.6 million, or 25 cents per share, resulting in net investment income for the quarter of $3.1 million, or $0.46 per share. This compares to $2.8 million reported in the prior quarter, up $0.04 per share. I would like to note in the fourth quarter, $0.03 per share of net investment income represents non-recurring income related to the reimbursement of certain expenses in connection with the transition to Stonecastle Aramark. Realized capital gains and losses in the quarter is the second component affecting the change in NAV. The net realized capital gains from investments were approximately 312,000 or approximately 5 cents per share. Realized losses due to foreign currency transactions were approximately 1.6 million or 25 cents per share. The third component changes an unrealized appreciation or depreciation of the portfolio relates to how the value of the entire investment portfolio has changed from the previous quarter end to the current quarter end. For the fourth quarter, the change in net unrealized appreciation on investments and foreign currency transactions was $5.4 million or $0.81 per share, an unrealized depreciation on options written of $620,000 or $0.09 per share. I want to point out that gains and losses from foreign currency hedging activities did not impact our net income. The fourth component affecting the change in net asset value is distributions. The regular cash distribution for the quarter was $0.38 per share, along with a special cash dividend of $0.05 per share for a total distribution of $0.43 per share, which was paid on January 5th to shareholders of record on December 21st. In summary, we began the quarter with a net asset value of $20.89 per share. During the quarter, we generated net income of 3.1 million, net realized capital losses of approximately 1.3 million, and the unrealized value of the portfolio increased by 4.8 million. The sum of these components, offset by a distribution of 43 cents per share, resulted in a net asset value of $21.44 per share at December 31st, which was up 55 cents, or 4.8% from the prior quarter, including the reinvestment of dividends. The 2020 annual performance of net asset value was down 39 cents per share, from $21.83 to $21.44. As Sanjay mentioned, the recovery of NAV throughout 2020 From the March 31st low of $19 to $21.44 at year-end, we believe speaks to the quality of the underlying credits in the portfolio. Turning to the valuations for our portfolio holdings, it is worth noting that the vast majority of the portfolio continues to be independently marked from broker-dealer quotes. For the quarter, approximately 85% of the portfolio prices or marks reflect a minimum of two quotations or actual closing exchange prices. These quotations represent an independent third-party assessment of the current value of the portfolio. This should provide a greater degree of confidence in the company's underlying value versus other publicly-traded closed-end funds and BDCs whose portfolios are comprised of assets that do not have readily available market quotations and therefore self-mark many of the assets in their portfolios. At quarter end, the company had total assets of $188.4 million, consisting of total investments of $178.4 million, and cash, interest, and dividends receivable and prepaid assets totaling approximately $10 million. Our dividend yield at the end of the quarter was approximately 8.2%. Now let me update you on the balance of our credit facility. On December 31st, the company had $43 million drawn from the facility or 23% of total assets, leaving 19 million available to draw. Based on regulated investment company rules, we may only borrow up to 33.3% of our total assets. Now I want to turn the call back over to Sanjay for closing remarks.

Thank you, Pat. Now, operator, I'd like to open up the call for questions.

At this time, we will be conducting a question and answer session If you would like to ask a question, please press star 1 on your telephone keypad. A confirmation form will indicate your line is in the question queue. You may press star 2 if you would like to remove your question from the queue. For participants using speaker equipment, it may be necessary for you to pick up your handset before pressing the star key. One moment while we poll for questions. Our first question comes from the line of Chris O'Connell with KVW. You may proceed with your question.

Good evening. Good evening. So I just wanted to start off with the portfolio yield. I know you guys mentioned at the end of the quarter coming in around 9.65. I was just wondering if you had what the average yield was for the fourth quarter.

Do you want to take that?

Sure.

I believe we noted that in the press release. 9.65 was the number for the quarter.

Okay, great. And then it sounds like the investments you made during the quarter were coming on around, you know, 10.4% yield. Was there any change in that in terms of what the investments were coming on, you know, following the quarter end?

You mean for Q1?

Yeah, you guys had mentioned that, you know, following the end of the quarter, you had made, you know, some additional investments, I think around 13.5 million or so. I'm just wondering if there's any change in that yield versus, you know, what was oncoming during the fourth quarter?

Those are also strong. Also in the nines, and I believe we may have a couple of tens in there as well.

Okay, great. And then, so I'm assuming it's safe to say that, you know, all new investments are coming on kind of consistent to that level and kind of consistent to, you know, what you guys were gearing toward last quarter in the high nines range. And as far, you know, the demand and the growth and, you know, the back half of the year, especially in the fourth quarter, was really strong. You know, congratulations there. But I was wondering going forward, you know, demand obviously, you know, following quarter end also seems strong. Is it safe to say that given where the sub debt issues that you guys mentioned in the four to six range, you know, for community bank yields and in general, you know, community banks, you know, are kind of flush with liquidity right now, you know, following some of the Fed actions in 2020? Is it safe to say that the alternative investments will be kind of leading the first half 21 demand, at least as far as you see now?

Yeah. So, Chris, that's, you know, that should be fairly accurate. You know, you're right. The community bank's top debt is in 4% to 6% range, and, you know, we are seeing a slowdown of issuance there. to begin with here in the new year. And, you know, if there is any portfolio churn, you should expect, you know, a disproportionate amount of that liquidity being deployed in regulatory capital investments, you know, Q1, Q2 at least.

Great. And then as far as the demand for overall, you know, alternative capital investments, Has that kind of remained strong so far in 2021?

What do you mean by demand for community?

Are you guys continuing to see strong growth in the first half of the year?

Oh, okay, got it. Yeah, so just to – we talked about this in our previous calls. Regulatory capital issuance is a bit seasonal. And usually, you know, Q4 is the strongest quarter. And then, you know, Q1 kind of lags that, right? What we have seen during Q1 is the, you know, the seasonal adjustment to that. However, you know, the secondary markets and regulatory capital have been fairly active. And so from that perspective, we are seeing, you know, sufficient amount of investments that we need to take a look at. And so between the primary market and the secondary market in Q1, you know, it's a healthy amount of investments, again, like I said, to analyze and, you know, make a decision on.

Got it. And just given, you know, where we are in the quarter, a little bit further than we typically are, you know, for this call in update, you know, is it safe to say also with, you know, your comments around the red cap, investments, you know, being seasonally a little bit lower in the first quarter, that the first quarter kind of net investment portfolio growth, you know, isn't going to be too much stronger than what was already indicated in the press release? Or do you guys have kind of a late pipeline that's coming through, you know, in the back half of this story?

Yeah, so, you know, obviously I can't give you specific details as to what's going on in Q1. But as mentioned in my previous comments, you know, we did make additional purchases during the first quarter. And like I said, it has been a fairly active quarter, both in the primary and secondary markets. But having said that, you obviously see some investments repay, and timing of that is not always a known quantity. But I'll just kind of mention that we have been active buying new investments here during the first quarter.

Got it. Thanks. I'll step out of the queue. Thank you.

Ladies and gentlemen, we have reached the end of today's question and answer session. I would like to turn this call back over to our CEO for closing remarks.

Well, thank you, operator. Again, thank you for your support through a challenging 2020. Please do stay safe and healthy, and I'm looking forward to the time when we can all meet in person again. So thank you, good night, and I'll speak with you all soon.

This concludes today's conference. You may disconnect your lines at this time. Thank you for your participation and enjoy the rest of your day.