Gladstone Capital Corporation

Greetings. Welcome to Gladstone Capital Corporation fourth quarter and year-end earnings 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. Please note this conference is being recorded. I will now turn the conference over to David Gladstone, Chief Executive Officer. Thank you. You may begin.

Well, thank you, Sherry. That was a nice introduction, and good morning, everybody. This is David Gladstone, Chairman of the Earnings and Conference Call for Gladstone Capital for the quarter and fiscal year ending September 30, 2022. Again, thank you all for calling in. We're always happy to talk to our shareholders and the analysts that follow us, and we welcome the opportunity to provide an update on our company. And now we'll hear from General Counsel Michael Lacalce, who will make a statement regarding certain forward-looking statements. Michael?

Thanks, David. Good morning, everybody. Today's report will include forward-looking statements on the Securities Act of 1933 and the Securities Exchange Act of 1934, including those regarding our future performance. These forward-looking statements involve certain risks and uncertainties that are based on our current plans, which we believe to be reasonable. The many factors may cause our actual results to be materially different from any future results expressed or implied by these forward-looking statements, including all risk factors. Find in our forms 10Q, 10K, and the other documents that we've filed with the SEC, and you can find them in the investor relations page of our website, gladstonecapital.com. You can also sign up for our email notification service there, and you can also find them on the SEC's website, which is www.sec.gov. and we undertake no obligation to publicly update or revise any of these forward-looking statements, whether as a result of new information, future events, or otherwise, except as required by law. Today's call is an overview of our results, so we ask that you review our press release and Form 10-K issued yesterday for more detailed information. Again, you can find them on the Investors page of our website. Now I'll turn the call over to Gladstone Capital's President, Bob Marcotte. Bob? Thank you, Michael.

Good morning, all, and thank you all for dialing in this morning. I'll cover the highlights for last quarter and the fiscal year ended September 30 and conclude with some market commentary as we look forward into fiscal 23 before turning the call over to Nicole Schultenbrand, our CFO, to review the financial results for the period and our capital and liquidity position. So beginning with last quarter's results, originations for the quarter totaled $86 million, which included three new platform investments, and included $26 million of add-on investments to existing portfolio companies. Amortization and repayments were $22 million, so net originations were strong at $64 million for the quarter. Interest income for the quarter rose 24% to $15.6 million, as the average investment balance was up approximately $47 million, or 9.3%, and the weighted average loan yield for the quarter rose 120 basis points to 11.2%. In the absence of material exits, prepayment fees and fee income declined to $400,000. However, total investment income still rose by 16 percent to $15.9 million for the quarter. Borrowing costs rose $700,000, or 20 percent, with increased bank borrowings and higher LIBOR rates, as well as fees associated with the $50 million increase to our credit facility commitments. However, our net interest margin jumped by $2.3 million, or 25%, to a record $11.5 million for the quarter. Administrative costs were largely unchanged. However, net management fees rose by $900,000 to $3.4 million with the increase in assets, higher incentive fees associated with the increase in investment yields, and the absence of incentive fee credits compared to the prior quarter. Net investment income rose $500,000 to $7.5 million, or 22 cents per share. The net realized and unrealized losses on the portfolio for the period came in at $2.4 million, as loan depreciation on a couple of credits and the markdown of legacy equity valuation anticipation of a subsequent exit outpaced the generally favorable operating performance of the portfolio. As a result, NAV declined 4 cents per share to 9.08 as of September 30. While we've only begun to realize the benefit of higher interest rates, we're pleased to report our cumulative net interest income generated a 10.1 percent return on our net assets over the past year. With respect to the portfolio, our portfolio continues to perform well with generally modest leverage metrics and favorable liquidity And as such, we did not experience any prepayments false last quarter. Depreciation for the quarter totaled a $2.3 million as the rise in the number of our equity positions was more than offset by yield-driven discounts on several recently closed debt investments. A reduction in the cumulative appreciation of our legacy common stock position in Targus in anticipation of an exit. and loan depreciation associated with soft operating performance at edge adhesives. Since the end of the quarter, notable portfolio events include the sale of the common equity investment in Targus and the liquidating distributions from our LP investment in Leeds Novomark Capital. In reflecting on our fiscal 22 performance and outlook for what is now our fiscal 23, there are a couple of comments I'd like to leave you with. During fiscal 22, our originations increased by 50 percent to almost 280 million, which lifted our net originations to 115 million for the year, while still maintaining our focus on investing in growth-oriented lower middle market companies. Today, our portfolio is over 50 companies, and we've broadened our private equity network in the process. We've maintained our underwriting rigor, and are fortunate to have our portfolio heavily weighted towards senior secured loans, which have risen over the past year to 71.4% of our investments. Secured debt investments have increased to 89.2% of total investments, and the core portfolio continues to be modestly leveraged at under 3.5 times EBITDA. Based on the cumulative asset growth of the past year, We've elevated our balance sheet leverage to the target range of 90 to 110 percent of NAV, as we've previously referenced. And we'll look to maintain our leverage in that range as we grow our assets going forward. While our asset growth may moderate with our leverage profile, we do expect our net interest income to rise with the full quarter impact of the current interest rates, as well as the increased spreads and more conservative leverage metrics of the currently tighter credit environment. With our floating rate investments exceeding our floating rate liabilities by approximately 400 million and the current floating rates on pace to be up about 125 basis points for the quarter, we would expect our net interest margin to be up in the range of 1.25 million this quarter. Based on the portfolio performance and as the net interest income is realized, we expect to be in a position to consider increasing the shareholder distributions in the coming quarters. And now I'll turn the call over to Nicole Sheldon-Brad, the CFO for Gladstone Capital, to provide some more details on the fund's financial performance for the quarter. Nicole?

Thanks, Bob. Good morning, all. During the September quarter, total interest income rose 23.6% to $15.6 million, based on an increase in both earning assets as well as prevailing rates. The investment portfolio weighted average balance increased to $553 million, which was up $47 million or 9.3% compared to the June 30th quarter. The weighted average yield under interest-bearing portfolio rose 120 basis points to 11.2% with the increase in floating rates on the 89% of the investment portfolio that is carried at floating rates. Other income declined by $800,000 to $400,000. However, total investment income still rose by $2.2 million or 15.6% to $15.9 million for the quarter. Total expenses rose by $1.6 million quarter over quarter as interest expenses increased $600,000 and we had a $900,000 increase in net management fees driven by higher average assets, increased yields, and reduced incentive fee credits. Net investment income for the quarter ended September 30th with $7.5 million, which was an increase of $500,000 compared to the prior quarter, or $0.22 per share, and covered more than 100% of our shareholder distribution. The net increase in net assets resulting from operations was 5.1 million or 15 cents per share for the quarter ended September 30th, as impacted by the realized and unrealized valuation depreciation covered by Bob earlier. Moving over to the balance sheet. As of September 30th, total assets rose to 660 million, consisting of 649 million in investments at fair value and 11 million in cash and other assets. Viability has increased to 345 million, and consisted primarily of 150 million of five and an eighth senior notes due January 2026, 50 million of three and three quarter senior notes due May of 2027, and as of the end of the quarter, advances under our line of credit were 142 million. As of September 30th, net assets rose by 2.6 million from the prior quarter end with the realized and unrealized valuation depreciation, which was offset by common share issuance under our ATM program of 4.5 million. NAV declined slightly from $9.12 per share as of June 30th to $9.08 per share as of September 30th. Our leverage as of the end of the year rose with the increase in total assets to 110% of net assets. During the quarter, we amended our line of credit to increase the facility commitments to $225 million, and at quarter end, we had an excess of $60 million of current borrowing availability under our lines. Following the end of the quarter, we added another bank to our facility, bringing the total commitment to $245 million. With respect to distributions, our monthly distributions to common stockholders increased to $0.07 per share, effective for the months of October, November, and December, which is an annual rate of $0.84 per share. The Board will meet in January to determine the monthly distribution to common stockholders for the following quarter. At the distribution rate for our common stock and with the common stock price At about $10.04 per share yesterday, the distribution run rate is now producing a yield of about 8.4%. And now I'll turn it back to David to conclude.

Thank you, Bob and Nicole. You did a good job of letting our shareholders know what's going on at the company. And Michael, I appreciate your comments as well. In summary, just another solid quarter for Gladstone Capital, which capped a stellar year for the company as well. Company closed $86 million of new and add-on investments of an existing portfolio company, which lifted the total investments to $649 million, which represents an increase of $92 million or 17% over the last year. Interest income, that is for the quarter, was up 25% based on the higher interest rates in the company's favorable capital structure. We expect the current rates to sustain this momentum and support potential increases in our common distributions in the coming quarters. In summary, the company continues to stick to a strategy of investing in growth-oriented, lower-middle-market businesses with good management. Many of these investments are supported by mid-sized private equity funds, and they're looking for an experienced partner to support the acquisition and growth of the business over the time that they are invested. This gives us an opportunity to make an attractive interest paying loans and support our ongoing commitment to pay cash distributions to shareholders. I'm going to stop now and ask the operator to come on and we'll get some questions from the analyst and other people that are on the line. Sherry.

Thank you. If you would like to ask a question, please press star 1 on your telephone keypad. A confirmation tone will indicate your line is in the question queue. You may press star two if you would like to remove your question from the queue. And for participants using speaker equipment, it may be necessary to pick up your handset before pressing the star keys. Our first question is from Mickey Schleen with Lattenburg-Thoutman. Please proceed.

Yes, good morning, everyone. Excuse me. Bob, you mentioned the portfolio's average leverage, which is an attractive figure. Could you discuss the trends in revenues and margins at the portfolio and where the cash interest coverage ratio lies and your sense of your borrower's abilities to service their debt as LIBOR and so forth climb?

As you point out, the average leverage is less than three and a half turns. There are certainly, you know, some above that. But the focus really is making sure the leverage profile and the line of credit and liquidity of the businesses are solid. The interest coverage obviously is in flux. I would say right now the folks that we're focused on most closely are anything related to consumer-oriented businesses. where pullback or in-market demand might be impacted. We are also seeing areas where some of the business services are being impacted, things that might be marketing-oriented or have discretionary spend on the part of those businesses. But for the most part, those are the only areas that we're seeing any issue. Most of our investments are business-to-business, and we are definitely seeing nice, sustaining growth in many segments where domestic manufacturing is a priority that is a continuation of the trend of bringing back production to domestic manufacturers and managing the logistics associated with domestic. So with respect to overall leverage, Obviously, we always have maintenance covenants in all of our deals, which require interest coverage. That's typically 1.1 to 1.2 turns of coverage. At this stage, I don't think we have any particular covenant defaults or covenant issues in that regard, so we feel the portfolio has plenty of coverage, even at the leverage level that they are. And we've also had very few draws against any of our associated lines of credit. So much like when we saw the PPP situation and the onset of COVID, we've seen very little draws against the liquidity of the businesses. They're managing their liquidity profile appropriately. So at this stage, interest coverage, we're not concerned. Obviously, we're going to monitor it closely. The The increase in interest rates in the last quarter obviously has to play through a few more quarters before we start to see significant change in those, but we're watching it closely. I don't anticipate that we have any material issues in the short term. And as I've said in the past, about 70% of our deals are sponsored deals. So we have equity investors and funds below us that obviously are in the process of managing those capital structures and in many cases support the underlying businesses. Did I leave anything out on that, Mickey?

No, no, that was great. Thank you. Just one follow-up, Bob. You just mentioned some comments about the market dynamics. I'm curious how you view supply and demand of private capital the debt markets where you operate uh you know clearly everyone wants to you know invest in software companies with recurring revenues and those deals are still highly sought after but overall when you think about the pipeline has has the deceleration the economy the rising rates um you know some concern about how the election would turn out has that slowed demand for your capital And where do you see the most interesting risk-reward in terms of industries and securities, you know, whether first lien, second lien, or other?

There's a lot in there, but the simple framework is I think there are a lot less folks coming down market. There's certainly plenty of opportunities up market given the discounts in the broader syndicated marketplace. So there's not a lot of big guys coming down. The commercial banks have paused, whether it's for regulatory or their own portfolio matters. And you have folks that aren't in a position to raise additional capital or somewhat balance sheet constraints. So where it might have been a broad competitive process, there's definitely fewer players on the field at the moment to take up those opportunities. The second is we are seeing sponsors leaning into growth-oriented businesses where they see an outlook for continued expansion. It might be capital equipment where automation and technologies are improving performance or reducing labor requirements, those kind of things. And as a result, there's only a few folks on the field. What we're tending to see is people are more interested in getting their deals closed than shopping around knowing full well there aren't a lot of places to go. And so from our perspective, what that's enabled us to do is be more selective in terms of the businesses that we go after. Leverage is probably down. And in select instances, I think pricing is up, but we are closing deals in what I would say are probably more defensive sectors. contract manufacturing of food products, certain healthcare related segments that are certainly more defensive. Those kind of situations we're getting our attractive rates and in attractive sectors. With respect to how we're playing and where we're playing, You know, it is a trade-off. Today, you know, balance sheet leverage and the framework unit tranches chew up a lot of capacity for fundings. So we will selectively look at unit tranches, or we may team up with other folks to pursue unit tranche-type opportunities. We did close a fairly large second lean asset in the quarter at a very attractive pricing. So I think in certain instances where leverage is down and it's the right kind of sector, we are going to pursue second lien, and we may see that grow a bit in our portfolio. But that is highly dependent upon what's going on in the senior market, because we obviously don't want to be taking undue risk that the senior lenders might inflict on the underlying business. So I would say right now we're probably being more defensive, getting the pricing that makes sense for us. and seeing a fair bit of growth in some nice sectors to diversify the portfolio.

Thank you, Bob. That's really helpful. Those are all my questions. I appreciate your time. Thanks for dialing in, Mickey.

So next question.

As a reminder, just star 1 on your telephone keypad if you would like to ask a question. We will just pause for a brief moment to pull for any final questions. There are no more questions at this time, so I will hand the conference back over to management for closing comments.

Thank you very much, and thank you all for calling in. I hope you're having a good day today, and we'll see you next quarter. That's the end of this call.

Thank you. That will conclude today's conference. You may disconnect your lines at this time, and thank you for your participation.