Earnings Call Transcript - HRZN Q4 2022

Operator, Operator

Ladies and gentlemen, greetings and welcome to the Horizon Technology Finance Corporation Fourth Quarter 2022 Earnings Conference Call. As a reminder, this conference is being recorded. It is now my pleasure to introduce you to Megan Bacon, Director, IR and Marketing. Please go ahead.

Megan Bacon, Director, IR and Marketing

Thank you, and welcome to Horizon Technology Finance Corporation's fourth quarter 2022 conference call. Representing the company today are Rob Pomeroy, Chairman and Chief Executive Officer; Jerry Michaud, President; and Dan Trolio, Chief Financial Officer. I would like to point out that the Q4 earnings press release and Form 10-K are available on the company's website at horizontechfinance.com. Before we begin our formal remarks, I need to remind everyone that during this conference call, the company will make certain forward-looking statements, including statements with regard to the future performance of the company. Words such as believes, expects, anticipates, intends, or similar expressions are used to identify forward-looking statements. These forward-looking statements are subject to the inherent uncertainties in predicting future results and conditions. Certain factors could cause actual results to differ on a material basis from those projected in these forward-looking statements, and some of these factors are detailed in the risk factor discussion in the company's filings with the Securities and Exchange Commission, including the company's Form 10-K for the year ended December 31, 2022. The company undertakes no obligation to update or revise any forward-looking statements, whether as a result of new information, future events, or otherwise. At this time, I would like to turn the call over to Rob Pomeroy.

Rob Pomeroy, Chairman and CEO

Welcome, everyone, and thank you for your interest in Horizon. As we always do on our quarterly calls, I will update you on our performance and our current overall operating environment. Today, I will also provide an update on our advisors' exciting new strategic development. Jerry will then discuss our business development efforts, our portfolio events in our markets, and Dan will detail our operating performance and financial condition. We will then take some questions. Horizon and our advisor, Horizon Technology Finance Management, performed well in the fourth quarter, capping off a strong 2022 in the face of a challenging macroeconomic environment. Our earnings exceeded our distributions for the quarter and year. We grew the size of our portfolio to over $700 million. We bolstered our balance sheet, and we maintained solid credit quality. We are very pleased with how we successfully navigated through 2022, and I'm proud of our advisors and their team's efforts throughout the year as they further validated the earnings power of our portfolio, our predictive pricing strategy, and our disciplined investment approach. Turning to our accomplishments in 2022. Our portfolio at year-end stood at $720 million, an increase of 57% from the end of 2021. Our significant growth resulted from both our advisers' ability to originate high-quality venture debt investments and the increasing power of the Horizon brand in the venture debt community. We finished the year with a committed and approved backlog of $220 million, which provides us with a solid base of opportunities to grow our portfolio in 2023. We generated net investment income of $1.46 per share, well in excess of our distribution level for the year, due largely to higher interest rates on our floating rate investment portfolio and the growth in our portfolio. I would note that last quarter, based on our strong performance and the confidence in our outlook, we increased our declared monthly distributions by 10% to $0.11 per share as well as paid a $0.05 per share special distribution for our third consecutive year. This quarter, based on our outlook and our undistributed spillover income of $0.68 per share as of year-end, we declared monthly distributions of $0.11 per share through June of 2023. We achieved a portfolio yield on our debt investments for the quarter of 14.5% and a full year debt portfolio yield of 14.4%, at or near the top of the BDC industry. We maintained a stable credit profile throughout the year in the face of the challenging macro environment, with 95% of our debt portfolio rated 3 or higher at the end of the year. As always, we are consistently and actively managing our portfolio of investments to maintain its credit quality. We ended the year with a net asset value of $11.47 per share. Finally, we continue to fortify our balance sheet during the year, raising approximately $50 million of equity in 2022 from our at-the-market program, all at a premium to NAV. Additionally, we raised nearly $90 million from our overnight equity offering in March and our notes offering in June. While we have adequate liquidity and capacity to fund our current backlog, we will opportunistically and strategically seek new debt and equity capital as our portfolio and backlog continue to grow. Entering 2023 with concerns about higher interest rates, inflation, and a possible global recession, we continue to closely manage our portfolio and will remain selective in originating new investments. We believe our portfolio and backlog is positioned to generate strong NII in 2023, which may exceed our distributions. On the strategic front, last week, we were excited to announce that our advisor has agreed to be acquired by an affiliate of Monroe Capital, one of the premier boutique asset managers in the country, with over $16 billion in assets under management. Please note that the transaction is subject to certain closing conditions, including shareholder approval of a new investment management agreement due to the change of control in the advisor. The new investment management agreement is substantially similar to the existing agreement between our advisor and HRZN. The Board of Directors is unanimously recommending approval of the new agreement, including all of our independent directors. We believe that Monroe's platform, culture, and values are well aligned with those of the adviser, making this a natural fit for the advisor. Most importantly, the entire team that currently staffs our advisor is expected to remain and continue to manage Horizon. To be clear, Monroe has agreed to acquire the advisor, not Horizon, the public company. We also believe that Monroe's purchase of the advisor will create more value over time for Horizon shareholders because the adviser's ability to access Monroe Capital's platform and infrastructure will lead to increased investment opportunities and greater portfolio diversity for Horizon while potentially reducing expenses through economies of scale and access to more efficient capital. The advisor and its existing management have strong incentives to grow and strengthen Horizon over time. We are confident that the advisor, Monroe, Horizon, and Horizon's shareholders will all benefit from this transaction and are excited to be partnering with Monroe. In summary, the Horizon team continues to rely on its collective expertise and experience in all economic cycles to smartly execute its strategy and remains well positioned to navigate through the current credit cycle while taking advantage of new opportunities to originate high-quality investments. With that, I will now turn the call over to Jerry and Dan to give you more details and color on our performance.

Jerry Michaud, President

Thanks, Rob, and good morning to everyone. Despite continued macroeconomic headwinds in Q4, we grew our portfolio by $85 million in the quarter and $262 million for the year, ending 2022 with a record high portfolio of $720 million. In the fourth quarter, we funded 10 transactions totaling $104 million, including $73 million in debt investments to four new portfolio companies consisting of investments in two new tech companies and two new life science companies, providing further diversification to our portfolio. Our onboarding yield of 13.3% during the quarter was above Q3 yield and continues to reflect our discipline in structuring and pricing transactions, which will produce strong net investment income. We experienced one loan prepayment and one partial paydown during the quarter totaling $8 million. We expect prepayments to continue to be lower in the first half of 2023 compared to our historic levels as the IPO and M&A markets remain muted. Our debt portfolio yield of 14.5% for the quarter was a testament to the value of our floating interest rate structures in a rising rate environment, which helped us generate one of the highest portfolio yields in the BDC industry. As of December 31, we held warrant and equity positions in 98 portfolio companies with a fair value of $32 million. As we've consistently noted, structuring investments with warrants and equity rights is a key aspect of our venture debt strategy and an additional value generator. In the fourth quarter, we closed $133 million in new loan commitments and approvals while we maintained our selective approach to new opportunities and ended the year with a committed and approved backlog of $220 million compared to $252 million at the end of the third quarter. We're pleased with the size of our committed backlog as it positions us to grow our portfolio in the current challenging macro environment. As we noted on our prior call, most of our funding commitments are subject to our portfolio companies meeting certain key milestones. Our portfolio's credit quality remains solid as shown by the fact that the fair value of 95% of our debt portfolio consisted of 3 and 4 rated debt investments as of December 31. We had three one-rated debt investments at the end of Q4, representing 1.2% of our total debt portfolio, and we had two 2-rated debt investments. We continue to closely follow and regularly communicate with all of our portfolio companies as well as monitor the overall macro environment. Subsequent to the end of Q4, Horizon funded two new transactions totaling $25 million, received two prepayments totaling $10 million, and received one partial prepayment totaling $3.2 million. In addition, upon the closing of Cadrenal Therapeutics' initial public offering on January 24, 2023, Horizon received 600,000 shares of stock of Cadrenal stock which closed at $2.06 on Monday. We have recorded no investment for Cadrenal at the end of Q4. Turning now to the venture capital environment. According to PitchBook, approximately $238 billion was invested in VC-backed companies in 2022. While not the record-shattering year of 2021, it was still the second highest year of VC investment on record. With that said, VC investment activity continued to soften in the fourth quarter. Given the current market environment with lower M&A activity in a virtually closed IPO market, VC investors will likely continue to reduce the pace of investment in the first half of this year. We note, however, that despite the lower level of investment of 2022, the VC community did continue to invest in high-quality, growth-oriented companies in the healthcare tech, sustainability, and space technology markets. In terms of VC fundraising, $163 billion was raised during 2022, a record. However, only $12 billion was raised in the fourth quarter, which could signal considerably lighter VC fundraising for 2023. At the same time, VC's dry powder of just under $300 billion remains at record levels. Meanwhile, VC-backed exit activity remains modest given the current environment and the closed IPO window total exit value for the quarter was just $5 billion and the $71 billion exit value for the year was the lowest since 2016. Given the uncertainty environment, we would expect VC-backed exit activity to remain muted for the first half of 2023. Demand for venture debt remains relatively solid as venture-backed companies continue to seek alternative financing options while they wait for the M&A and IPO markets to emerge from their slumber. Further, we have seen tech-oriented banks begin to tighten their activity in the venture debt market. This lack of alternative financing sources creates additional opportunity for our advisor to source and originate high-quality venture debt loans. Given our advisor's strong and active lending platform and solid investment capacity of Horizon, we believe Horizon remains well situated to compete for and win high quality and well-priced investments, which will continue to grow the Horizon portfolio. Our committed, approved, and awarded backlog as of today stands at $225 million, while our Advisor's pipeline of new opportunities today remains at $900 million, still near historic highs. Looking ahead in 2023, we remain focused on credit quality to ensure optimal outcomes for our portfolio. We believe the challenging environment may persist for at least the first half of 2023, but there will continue to be attractive, quality companies looking for venture debt solutions, which will enable us to selectively grow our portfolio, our committed backlog, and our advisor's pipeline. Thus, we believe we remain well positioned to continue delivering additional long-term shareholder value.

Dan Trolio, Chief Financial Officer

Thanks, Jerry, and good morning, everyone. As Rob and Jerry mentioned, the fourth quarter capped off a very solid year for Horizon. We significantly grew our portfolio and once again generated NII that more than covered our distributions while further strengthening our balance sheet and maintaining stable credit quality. To recap 2022, we grew our portfolio by 57% to $720 million. In February, we expanded the capacity of our New York Life credit facility by $100 million to $200 million and extended its maturity date to June 2028. In March, we successfully raised over $34 million in net proceeds from our common stock offering. We further strengthened our balance sheet in June by completing our 6.25% notes offering, which raised over $50 million in net proceeds. In November, we closed a $100 million loan securitization with a 7.56% coupon rate, which freed up capacity in our KeyBank credit facility and increased our capacity to make new debt investments. Finally, we successfully and accretively sold nearly 4 million shares through our ATM program during the year, raising over $50 million. This includes receiving net proceeds of approximately $17 million from the program in the fourth quarter, demonstrating our continued ability to opportunistically access the equity markets. We believe our thoughtful and proactive balance sheet management keeps us well positioned for additional growth and shareholder value creation in 2023. As of December 31, we had $91 million in available liquidity, consisting of $28 million in cash and $63 million in funds available to be drawn under our existing credit facility. In addition, there was only $5 million outstanding under our $125 million KeyBank credit facility and $177 million outstanding on our $200 million New York Life credit facility, leaving us with ample capacity to grow the portfolio. Our debt-to-equity ratio stood at 1.38:1 as of December 31, which was above our target leverage of 1.2:1. Netting out cash on our balance sheet, our net leverage was 1.28:1. Based on our cash position and our borrowing capacity on our credit facility, our potential new investment capacity at December 31 was $171 million. For the fourth quarter, we earned total investment income of $23 million, an increase of 37% compared to the prior year period. Interest income on investments increased primarily as a result of the higher average size of our earnings debt investment portfolio for the quarter and increases in the variable interest rates on our debt investment. Our debt investment portfolio on a net cost basis stood at $701 million as of December 31, a 14% increase from September 30, 2022. For the fourth quarter of '22, we achieved onboarding yields of 13.3% compared to 12.9% achieved in the third quarter. Our loan portfolio yield was 14.5% for the fourth quarter compared to 16.2% for last year's fourth quarter. Total expenses for the quarter were $12 million compared to $8.7 million in the fourth quarter of '21. Our interest expense increased to $6.2 million from $3.3 million in last year's fourth quarter due to an increase in average borrowings and higher interest rates on our borrowings. Our base management fee was $3 million, up from $2 million in last year's fourth quarter due to an increase in the average size of our portfolio. Our performance-based incentive fee declined to $1.4 million from $2 million for last year's fourth quarter. Net investment income for the fourth quarter of '22 was $0.40 per share compared to $0.43 per share in the third quarter of '22 and $0.39 per share for the fourth quarter of '21. For the full year 2022, we generated NII of $1.46 per share, more than covering our total distributions during 2022 of $1.25 per share. The company's undistributed spillover income as of December 31 was $0.68 per share. We anticipate that our larger portfolio, along with our predictive pricing strategy will enable us over time to generate NII that covers our increased distribution. To summarize our portfolio activities for the fourth quarter, new originations totaled $104 million, which were partially offset by $4 million in scheduled principal payments and $8 million in principal prepayments and partial pay downs. We ended 2022 with a total investment portfolio of $720 million. Given the macro environment and recent prepayments, we would expect to see lighter portfolio growth in the first quarter than we saw in the fourth quarter. At December 31, the portfolio consisted of debt investments in 60 companies with an average fair value of $686 million, and a new portfolio of warrants, equity, and other investments in 100 companies with an average fair value of $34 million. Based upon our outlook for 2023, our Board declared monthly distributions of $0.11 per share for April, May, and June 2023. We remain committed to providing our shareholders with distributions that are covered by our net investment income over time. Our NAV as of December 31 was $11.47 per share compared to $11.66 as of September 30, 2022, and $11.56 as of December 31, 2021. The $0.19 reduction in NAV on a quarterly basis was primarily due to our paid distributions, including a $0.05 per share special distribution and adjustments to fair value, partially offset by net investment income. As we've consistently noted, 100% of our outstanding principal amount of our debt investments has interest at floating rates with coupons that are structured to increase as interest rates rise with interest rate floors. As of December 31, 97% of our debt investments will benefit from additional increases in their applicable base rates. This concludes our opening remarks. We'll be happy to take questions you may have at this time.

Operator, Operator

Our first question comes from Ryan Lynch from KBW.

Ryan Lynch, Analyst

The first one I had was regarding the transaction of the Advisor. So in my experience in the BDC sector, the external manager has typically been majority owned by the founders and executives. And in this case, that would be you and Jerry. I'm not asking you to reveal any personal financial information, but can you confirm that if you and Jerry are the majority shareholders of the private manager? Can you give shareholders comfort that the liquidity event in the private manager doesn't signal a potential change in Horizon's management in the mid near or immediate term?

Rob Pomeroy, Chairman and CEO

Thanks, Ryan. This is Rob. As we've said in the press releases, and we said in our script, we're all staying and we have long-term strong incentives to continue to grow Horizon, the public company as we also grow the Horizon platform, we're not going anywhere.

Ryan Lynch, Analyst

Okay. The other question I had was, was this deal shop around? Or was this an exclusive talk with Monroe?

Rob Pomeroy, Chairman and CEO

We're not going to comment on the process. This was a mutually beneficial opportunity for them to enter a business they've been interested in for a long time. We identified a sizable platform to advance our franchise, equipped with strong capabilities to support our growth and raise capital for both the public company and our overall platform.

Ryan Lynch, Analyst

Okay. Moving on to the fourth quarter results, I have a couple of questions regarding that. It seems that you made a significant investment in Evelo Biosciences during the fourth quarter, amounting to approximately $45 million, which is reflected at par. However, there appear to be some notable misses in their trials, and they've substantially reduced their workforce, leading to a significant decline in their stock price to $0.62. Was the trial data they released in the first quarter taken into account when you made this investment? Also, has the new data published in the first quarter of 2023 been incorporated into the fair value of your investment in the fourth quarter?

Jerry Michaud, President

Ryan, this is Jerry. Evelo released details about their company, and I can provide some insights. They encountered disappointing results in a Phase II trial for dermatitis, failing to meet the clinical trial endpoints, which was disappointing for all involved, including us. Regarding your specific question, we did consider this potential outcome during our underwriting. Evelo has a platform technology, and they recently provided another update on their ongoing clinical trials. They have several trials in progress, including a Phase II trial for psoriasis, which is significant as there currently isn't a pill for psoriasis. Additionally, they are working on a Phase III trial for psoriasis. The company is active with multiple clinical trials and is focused on inflammatory conditions, an area with substantial unmet needs. I also want to mention that Flagship Ventures is a majority shareholder in the company and has been very supportive. They developed the technology and are recognized as one of the largest life science investors in the U.S., backing successful companies like Moderna. Our underwriting considered much more than just the potential outcomes of one clinical trial.

Ryan Lynch, Analyst

Okay, understood. My final question is more about the overall venture capital lending landscape, not just your portfolio. With the notable decline in exit activity and lower valuations in the VC markets, how do you expect the level of new venture investments to change? This includes investments in new companies and, more importantly, the support for existing companies through additional funding rounds. Although a lot of capital has been raised in venture capital, do you believe they will actively invest when they are receiving very little back from exits?

Jerry Michaud, President

Yes, that's the right question. There's a dynamic at play here. On one hand, there is a significant amount of capital committed to venture capital funds, and eventually, these funds will need to invest that capital. This could lead to increased pressure to invest, particularly in the second half of this year, even if it's not as pronounced in the first half. An interesting article recently discussed how a firm raised two large funds and mentioned that they plan to actively invest in the current market, believing valuations are favorable. However, on the flip side, the IPO market is still quite distracted by broader economic issues, leading to very few IPOs. The M&A landscape is also not much better, although there has been some activity. Notably, high-quality companies continue to secure funding, with several in our portfolio raising over $75 million last year. For many others, while fundraising is ongoing, the focus has shifted from ambitious growth plans to achieving cash flow positivity. Companies are opting for smaller funding rounds instead of large raises aimed at scaling rapidly. Today, we see many firms raising capital for six, nine, or twelve months, with the hope of navigating toward improved market conditions. Overall, investors are still willing to support companies, although there are unique situations influenced by macroeconomic factors. For the first half of this year, we anticipate continued investment as firms strive to keep their portfolio companies funded, albeit not necessarily aiming for rapid growth but rather preparing for better market conditions, valuations, and a healthier IPO and M&A landscape. This is the current environment we are navigating, and we're mindful of both macroeconomic trends and the profiles of the investors involved.

Operator, Operator

Our next question comes from Bryce Rowe from B. Riley.

Bryce Rowe, Analyst

Wanted to ask about balance sheet leverage. Obviously, you all finished the year over the high end of your target. You're now at 1.28x from a net debt perspective. Just any thoughts on continuing to, I guess, operate at above the target? Do you feel comfortable doing that? Or should we expect you all to try to move back down into that target range over the course of '23?

Daniel Trolio, Chief Financial Officer

Yes. Bryce, we do watch that very closely and just want to point out that's just a snapshot at a point in time at the end of the quarter. And that will fluctuate up and down throughout the quarter. But being at 1.28x net of cash is a place that, yes, it's slightly above what we say our target is 1.2. But we're very comfortable at that level with the cushion between 1.28 and the regulatory cap of 2x. So I would say you could expect to be around that level throughout 2023.

Bryce Rowe, Analyst

Okay, that's helpful. And then maybe just a bit of a question around portfolio yield and pricing. When you get a change in the prime rate, can you remind us when that change in rate goes into effect for your various loans? I would assume that it might vary loan by loan, but just curious if there is a general practice there.

Daniel Trolio, Chief Financial Officer

You are correct. It does vary loan by loan. But generally, it will be either at the time that the rate changes in effect or the first of the month following the rate change.

Bryce Rowe, Analyst

Okay. And then maybe the last one for me. From a yield perspective, do you have a good sense of what the weighted average pricing for your loans is?

Daniel Trolio, Chief Financial Officer

Yes, we do. With a significant amount of our portfolio funded at 3.25% prime rate, and the longer period with lower prepayments, we're looking at the floor rate, which will continue to grow as the portfolio changes as we put new loans on at the higher prime. It's around 3.75% on average.

Operator, Operator

Our next question comes from the line of Vilas Abraham from UBS.

Vilas Abraham, Analyst

Can you guys comment a little bit on the negative migration in the quarter, particularly the couple of one-rated credits that picked up there?

Jerry Michaud, President

Yes. Basically, we had two transactions that had kind of idiosyncratic events specific to the companies, one related to a strategic deal that was about to get done and then didn't. So we downgraded that, and it's still very early in the process. So we felt it would be appropriate to mark it down, and we'll see how that goes. We'll be working on both of those transactions over the coming quarters. Hopefully, we can get something resolved by the third quarter in both of them. So really, it was nothing more than that. And we have to work them. We took a conservative approach relative to the valuation given the macroeconomic circumstances; a better market that may have been better or more opportunities for the companies to do to get something else more positive done, but that didn't happen yet. So that's where we are today with them.

Vilas Abraham, Analyst

Okay. And then maybe just more broadly, as you look across the industries in your portfolio, are you seeing any particular industries more stressed than others? Or are kind of all dealing in a similar fashion with the broader pressures?

Jerry Michaud, President

Yes. Yes, that's a good question. I think the reality is that it's not one specific industry, which at times in our business it has, because there can be some cycles in life science as an example that is very specific to that market versus more broader macro issues. What we're seeing is that the dislocation in the broader markets is causing kind of a slowdown, take your time take a step back kind of environment where it's not so much that anyone is concerned about a specific market or even a specific company. But they're taking a very slow approach to when the market is going to change. So I think that in this case, just as macro environments have kind of lowered the tide for all boats, I think when the market turns around, you'll see it will raise most boats because there really hasn't been any specific event in any of the markets that we serve that would suggest that something is going on in those markets that are outside of macro dislocation events.

Vilas Abraham, Analyst

Okay. And one of the things that founders and venture-backed companies started doing early last year was kind of trying to control their cash burn, right? And as you kind of think about how that's progressed to this point? What inning do you think we're in, in these companies getting to where they need to be to adapt to the new environment here?

Jerry Michaud, President

Yes, that's a great question. Historically, by the time you're asking these types of questions, most of the necessary cuts and reductions in spending have already occurred. This trend is evident in our market as we observed a slowdown in the venture ecosystem during the fourth quarter, with companies focusing on cost-cutting and expense reduction. A significant amount of that has already taken place. Even in the new opportunities we are encountering, companies have undergone a process of cost reduction and are now concentrating on achieving cash flow breakeven rather than aggressive growth. Therefore, in the first half of this year, many transactions will involve companies that have already made those adjustments. Venture capitalists and investors in these firms are now looking at the next steps for returning to a growth trajectory, though this may not occur in the first half of this year but will happen over time. We have certainly seen a lot of that already take place.

Vilas Abraham, Analyst

Okay, that's helpful. And if I could squeeze one more in here on the synergies with the advisor. I think you mentioned that there are some expense saves that could be realized here. Can you quantify that at all or give any timing around that?

Rob Pomeroy, Chairman and CEO

Yes. The answer really is, not yet. But the transaction just announced spent a lot of time working on it, but we don't have any definitive answers for that at this time.

Operator, Operator

Ladies and gentlemen, there are no further questions in the queue. I would like to turn the conference over to Robert Pomeroy, Chairman and CEO, for closing comments.

Rob Pomeroy, Chairman and CEO

Thank you all for joining us this morning. We appreciate your continued interest and support in Horizon, and we look forward to speaking with you again soon. This will conclude our call. Thank you.

Operator, Operator

Thank you. The conference of Horizon Technology Finance Corporation has now concluded. Thank you for your participation. You may now disconnect your lines.