Earnings Call Transcript - HRZN Q3 2021

Operator, Operator

Greetings. Welcome to Horizon Technology Finance Corporation Third Quarter 2021 Earnings Call. At this time, all participants are in a listen-only mode. A question-and-answer session will follow the formal presentation. Please note, this conference is being recorded. I will now turn the conference over to Megan Bacon to begin. Thank you.

Megan Bacon, Presenter

Thank you and welcome to the Horizon Technology Finance Corporation third quarter 2021 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 Q3 earnings press release and Form 10-Q 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 regards 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, 2020. 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, CEO

Good morning. Thank you for joining us and for your continued interest in Horizon. Today, I will update you on our performance and our current overall operating environment. Jerry will then discuss our business development efforts, our portfolio events and our markets. Dan will detail our operating performance and financial condition and then we will take some questions. Our third quarter was a testament to the power of the Horizon brand and the lending platform of our advisor, Horizon Technology Finance Management, as well as our continuing efforts to grow our portfolio. We executed in all aspects of our operations and we are proud of the results. During the quarter, our portfolio grew to more than $450 million, a 12% increase from the end of the second quarter and up 28% from the end of 2020. These numbers are even more impressive when you consider that the portfolio experienced $50 million in prepayments during the third quarter. We finished the third quarter with a committed backlog of $101 million, providing us with momentum to continue our portfolio growth. We generated net investment income of $0.40 per share, well in excess of our distribution level for the quarter, thanks to the continued success of our predictive pricing strategy. Based on our outlook and our undistributed spillover income of $0.44 per share as of September 30, we declared monthly distributions through March of 2022, which marks 63 consecutive months at $0.10 per share. In addition, we declared a special distribution of $0.05 per share payable in December. We achieved a portfolio yield on our debt investments of 16.2%, at or near the top of the BDC industry. We maintained a stable portfolio credit profile with 97% of our portfolio rated three or higher. We are consistently and actively managing our portfolio of investments to maintain its credit quality. We ended the quarter with NAV of $11.63 per share, a $0.43 per share increase from June 30 resulting from a combination of outearning our distributions, accretive share issuances and increases in fair value of some of our investments. Finally, our balance sheet remains strong with ample capacity to fund more growth in our portfolio and move closer to our target leverage of 1.2:1. We achieved these excellent results due to our advisor's incredible team, focused predictive pricing strategy, discipline in selecting quality investments and expanded lending platform. For the quarter, the advisor's platform funded a record $141 million in new business in what is typically a lighter quarter for originations. Our advisor is competing for and winning larger, high-quality venture debt investments, while at the same time, continuing to diversify our portfolio and further reducing concentration risk. Given the momentum generated in the third quarter, we believe we remain well positioned to continue growing our portfolio of investments and to continue producing strong net investment income. Our belief is supported by the following: our advisor continues to strengthen the Horizon platform with new hires; demand for venture debt within our target industries remains robust; our committed backlog and pipeline of investments are still strong; our advisor's expanded lending platform and the increasing recognition of the Horizon brand are enabling us to access a considerably larger number of investment opportunities and we continue to maintain ample capacity to execute on our backlog of commitments as well as our advisor's pipeline of new opportunities. While we are excited and optimistic for Horizon's future, we remain aware of possible headwinds from macroeconomic issues, including the supply chain, global inflation, labor issues and the pandemic. Over the years, our advisor's experienced team has successfully managed portfolios through various economic cycles. I am proud of our entire team's efforts which resulted in this excellent quarter for us and our shareholders. I will now turn the call over to Jerry and Dan to give you more details and color on our performance. Jerry?

Jerry Michaud, President

Thanks, Rob and good morning to everyone. The third quarter is typically the lightest quarter for us in terms of originations, which makes our origination performance in the third quarter all the more impressive. Our portfolio topped $450 million for the first time ever at the end of Q3. With the robust demand for venture debt, we funded a record 15 transactions totaling $99 million during the quarter. Our onboarding yield of 11.5% during the quarter reflected our advisor's predictive pricing strategy and continued discipline in pricing transactions that we believe will produce strong NII. We experienced four loan prepayments during the quarter, totaling $50 million, and the prepayment fees and accelerated income from the prepayments contributed to our debt portfolio yield for the quarter of 16.2%, again, among the top in the BDC industry. In addition, we received proceeds of $1.5 million from the exercise or termination of warrants as well as proceeds of $1.1 million from success fees related to two debt investments, a further testament to our method of structuring investments to generate additional yield. As of September 30, we held warrant and equity positions in 74 portfolio companies with a fair value of $21 million. Since the beginning of 2020, the company has received approximately $13 million in proceeds from warrant and equity investments. 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 third quarter, we closed $91 million in new loan commitments and approvals and ended the quarter with a committed and approved backlog of $101 million compared to $144 million at the end of the second quarter. Our advisor also ended the quarter with an additional $48 million in newly awarded transactions. While there is no guarantee we will fund all of the transactions in the committed or awarded backlogs, the total supports a positive funding outlook. In addition, our advisor ended the quarter with a pipeline of new opportunities totaling $734 million. Subsequent to the end of Q3, we funded a $2.5 million venture debt loan and received $35 million in loan prepayments, including the prepayment in full of our debt investment in Topia, which was rated two at the end of Q2. These early prepayments in the fourth quarter will obviously benefit NII in Q4 but will also provide a challenge to our efforts to grow our portfolio during the quarter. Nonetheless, as of today, our committed backlog has grown to $146 million and our advisor's awarded backlog has increased to $50 million. In addition, our advisor's pipeline of new opportunities today is approximately $697 million, providing us with a solid base of opportunities to further grow our venture debt portfolio over the coming quarters. The significant growth in our portfolio has been achieved while maintaining its robust credit quality, as the fair value of 97% of the company's debt portfolio consisted of three and four rated loans as of September 30, an increase from the prior quarter's end. As further indication of the credit quality of our portfolio, one of our portfolio companies, CVRx, went public during the third quarter, two of our portfolio companies, Bardy Diagnostics and OutboundEngine, completed M&A transactions and three of our portfolio companies have entered into SPAC transactions. During the quarter, one smaller investment migrated down to the one rated bucket, while a larger two rated credit was upgraded to a three rating. As always, we and our advisor are aggressively managing the remaining one and two rated credits in order to achieve the best possible outcome. Turning now to the venture capital environment. It almost, across the board, hit new full record highs in only nine months. According to PitchBook, approximately $83 billion was invested in VC-backed companies in the third quarter, an increase over last quarter's total. From the beginning of the year through the third quarter, approximately $239 billion of venture capital has been invested, putting it on pace to double last year's record of $166 billion. In terms of VC fundraising, $22 billion was raised in the third quarter and $96 billion has been raised through September 30, already breaking last year's full year record and virtually assuring that VC fundraising will clear the $100 billion milestone before the end of the year. Larger VC funds continue to drive the bulk of increased fundraising. Regarding VC-backed exit activity, the IPO and SPAC window stayed open in the third quarter with venture-backed IPOs and SPACs helping to drive a total exit value in the quarter of over $187 billion. For the year through September 30, exit value has shadowed the $500 billion mark, although recent underperformance by some SPAC combinations is raising questions as to whether the SPACs are a viable long-term alternative to IPOs. There are a wealth of options for venture-backed companies to generate additional liquidity which provides us with both an opportunity and competition for technology and life science investments. With our advisor's strong and active lending platform, we believe we are well positioned to compete and win in this environment. Turning now to our lending markets; they continue to offer many quality investment opportunities to restock our committed backlog and our advisor's pipeline. During the quarter, we made $63 million in debt investments to eight new portfolio companies consisting of three new life science investments, one new sustainability investment and four new technology investments, providing further diversification to our portfolio. We also funded $36 million to seven of our existing portfolio companies. Supply chain challenges, COVID risks and inflation concerns, all have the potential to disrupt our markets and impact our portfolio companies. Accordingly, we are taking the potential impact of each of these issues into account as we underwrite new investments, including transparent discussions with our prospective portfolio companies and their investors. That said, demand for venture debt remains abundant in the life science, technology and sustainability markets. Our advisor remains disciplined in its marketing and underwriting and we expect to onboard new quality investments over time which will continue to grow our portfolio with ample capacity, a deep pipeline and a predictive pricing strategy. We remain well positioned entering Q4 to deliver additional long-term shareholder value. With that, I will now turn the call over to Dan.

Dan Trolio, CFO

Thanks, Jerry and good morning everyone. As Rob and Jerry mentioned, we had another excellent performance in Q3 as we significantly grew our portfolio and generated strong NII while maintaining a strong overall balance sheet. As of September 30, we had $88 million in available liquidity, consisting of $43 million in cash and $45 million in funds available to be drawn under our existing credit facilities. As of September 30, there was $38 million outstanding under our $125 million KeyBank credit facility and $66 million outstanding on our $100 million New York Life credit facility, leaving us with ample capacity to grow the portfolio. Additionally, through our ATM program, we successfully and accretively sold 395,000 shares opportunistically raising nearly $7 million. Our debt-to-equity ratio stood at 1.1:1 as of September 30 which is lower than our target leverage of 1.2:1. Based on our cash position and our borrowing capacity on our revolving credit facilities, our potential new investment capacity at September 30 was $165 million. As you go towards our target leverage, we would expect that our NII will also increase. For the third quarter, the company earned total investment income of $16.4 million, an increase of 33% compared to the prior year period. Interest income on investments increased primarily as a result of a higher average earning debt investment portfolio for the quarter and fee income also increased due to higher prepayment and success fees received from two of our debt investments. Our debt investment portfolio on a net cost basis stood at $431 million as of September 30, an 11% increase from June 30, 2021. For the third quarter of '21, we achieved onboarding yields of 11.5% compared to 12.2% achieved in the second quarter. Our loan portfolio yield was 16.2% for the third quarter, up 110 basis points from 15.1% for last year's third quarter. Turning to our expenses. For the third quarter, total expenses were $8.3 million compared to $6.5 million in the third quarter of 2020. Our performance-based incentive fee was $2 million, an increase from $1.5 million for last year's third quarter based on higher NII generated in the third quarter of '21. Our interest expense increased to $3.1 million from $2.6 million in last year's third quarter due to an increase in average borrowings. Our base management fee was $2 million, up from $1.6 million in last year's third quarter due to an increase in the average size of our portfolio. Net investment income for the third quarter was $0.40 per share compared to $0.31 per share in the second quarter of '21 and $0.34 per share for the third quarter of 2020. The company's undistributed spillover income as of September 30 was $0.44 per share. To summarize our portfolio activities for the third quarter, new originations totaled $99 million which were partially offset by $3 million in scheduled principal payments and $50 million in principal prepayments. We ended the quarter with a total investment portfolio of $452 million. The portfolio consisted of debt investments in 43 companies with an aggregate fair value of $430 million and a portfolio of warrant, equity and other investments in 76 companies with an aggregate fair value of $21 million. Based on our outlook for NII, our Board declared monthly distributions of $0.10 per share for January, February and March 2022. And based upon our liquidity forecast and our spillover income levels, our Board also declared a special distribution of $0.05 per share payable in December. We have now declared monthly distributions of $0.10 per share for 63 consecutive months. We remain committed to providing our shareholders with distributions that are covered by our net investment income over time. Our NAV as of September 30 was $11.63 per share compared to $11.20 as of June 30, 2021 and $11.17 as of September 30, 2020. The $0.43 increase in NAV on a quarterly basis was primarily due to certain portfolio companies closing investment rounds at higher valuations which drove higher valuation of warrants, our net investment income exceeding paid distributions and accretion from the sale of our shares through our ATM program. As we've consistently noted, 99% of our outstanding principal amount of our debt investments bear interest at floating rates with coupons structured to increase as interest rates rise with interest rate floors. As of September 30, 100% of our portfolio is at their specific floors. This concludes our opening remarks. We'll be happy to take questions you may have at this time.

Operator, Operator

Our first question is from Sarkis Sherbetchyan with B.Riley. Please proceed.

Sarkis Sherbetchyan, Analyst

Hi, good morning and thank you for taking my question here. I just wanted to start off by clearly highlighting the strong origination activity in the third quarter. Maybe any comments on going into the fourth quarter, if you expect that level to continue just kind of given your committed backlog? I know in the release and the recent developments, it seems like the prepayments are kind of outpacing maybe what was disclosed from an origination standpoint. But just want to get your thoughts around that?

Rob Pomeroy, CEO

Yes, that's a great question. We are definitely seeing an increased level of prepayment activity. Our portfolio companies have various financing options available to them as they move forward, which we've discussed, including the IPO market, SPACs, debt options, and significant venture capital investments. The speed at which companies are securing funding, utilizing their liquidity to advance their products, launch them, and fund exits is much higher than in the past. This presents us with an opportunity since venture debt plays an important role in supporting the financing strategies that technology and life science companies require today. While we anticipate higher prepayments and have already seen that this year, especially moving into the fourth quarter with a couple of instances already, we also notice significant growth in the venture debt market, which we estimate to be between $20 billion and $25 billion. Given this market size, there are ample opportunities to replace those prepaying transactions with new deals. Historically, our portfolio has leaned towards newer deals, allowing us to regularly replace transactions. We believe this trend will continue, and we expect to grow our portfolio while experiencing higher prepayments than in the past. So far this year, that has been the case. Lastly, our advisor has significantly expanded our platform in terms of the number of originators in the field and their experience and market knowledge, positioning us at the forefront of origination capability.

Sarkis Sherbetchyan, Analyst

And just kind of thinking through some of the recent releases, I think in September, you had a release where you and Trinity Capital provided a $40 million venture loan to a certain company; I believe that was for Nexii. If you kind of step back and think about potential partnership opportunities or underwriting transactions with potential partners, is this part of the strategy kind of going forward? Would you dip into this more often? Just want to get your thoughts around that?

Rob Pomeroy, CEO

Yes, that's a great point. That transaction you mentioned was accurate. We have collaborated with several lenders that we see as both competitive and cooperative in the market. While there isn't a specific strategy tied to this, our overall market knowledge—regarding the types of companies we target and the competition and potential partners—guides us in selecting the best transactions for our customers, as we believe that approach will ultimately lead to success. We will always engage in discussions and consider participating in certain transactions to help manage our concentration risks in our public company portfolio. There's no shift in our strategy here; this is something we've consistently done in the past, and we expect it to continue at some level.

Sarkis Sherbetchyan, Analyst

Great. One final one for me and I'll hop back into queue. As you're looking at the pipeline of opportunities to underwrite debt, clearly you have a pretty good history with some of the existing companies that you've underwritten. But as you look at the new companies, any concerns popping up in your mind regarding business models or kind of valuations? Or do you think that there's plenty of opportunities kind of given the flush liquidity environment?

Jerry Michaud, President

The current flush liquidity environment can certainly influence enthusiasm for the market. However, we are grounded in the types of transactions we consider, particularly regarding loan to value, adhering to the fundamental principles of underwriting venture debt transactions. We excel in this aspect compared to others in the market and will continue to do so. As mentioned earlier, we are mindful of various macroeconomic challenges like supply chain issues, COVID, and hiring, which we encounter regularly in the market. Our portfolio managers maintain ongoing communication with our portfolio companies to assess if these challenges are affecting them directly. We aim to stay proactive, and when underwriting new deals, these factors are taken into account in our evaluation process.

Sarkis Sherbetchyan, Analyst

Great, thanks. That's all for me.

Operator, Operator

Our next question is from Ryan Lynch with KBW. Please proceed.

Ryan Lynch, Analyst

Good morning, and thank you for taking my questions. My first question is about the record levels of venture capital being raised, which we've observed for some time. I'm curious about how the competitive landscape looks in that context, especially since one of your major competitors in this space could be equity capital from BDCs, as opposed to the debt route. Additionally, how have these competitive dynamics affected the level of prepayments you are experiencing? While prepayments are advantageous because you're receiving money back and seeing strong returns on those loans, they might also pose a challenge for portfolio growth. It appears that prepayments were quite high in the third quarter and are starting off strongly in the fourth quarter as well.

Rob Pomeroy, CEO

Yes, that's a good question. It's a complex situation. There's been a significant influx of venture capital into our marketplace, which has grown tenfold since we started. This increase has also caused a tenfold rise in demand for venture debt. We currently estimate our market for venture debt to be around $20 billion to $25 billion, making it much larger than we've seen historically. While there is more competition from new venture debt lenders, the market size is expanded, and we are seeing plenty of demand. In terms of venture capital, we've observed that companies today tend to complement their venture funding with additional debt. This approach helps to extend their financial runway and reduce the overall cost of capital, allowing entrepreneurs to retain a bit more equity in their companies. Generally, venture capitalists prefer that their investments go towards growth rather than debt repayment. Most of the repayments we see, particularly as seen in the fourth quarter, come from mergers and acquisitions or companies going public, leading to potential payouts for us. Another source of repayment is the refinancing of loans at lower costs as some of our four-rated credits reach a stage where they become more attractive to banks. The influx of venture capital has also accelerated the pace at which companies utilize their resources. They're leveraging funds more rapidly, creating and marketing their products faster, which necessitates greater liquidity. We believe there is currently a robust opportunity for venture debt in the market, which is significantly larger compared to historical figures.

Ryan Lynch, Analyst

Got you. That's helpful backdrop and commentary on that. As we look at the fourth quarter, $35 million of prepayments have already been received. In your release, you mentioned end of term payments and prepayment fees. Could you provide the total for those, so we have a sense of what you have already received from an income perspective that was accelerated in the fourth quarter?

Dan Trolio, CFO

Yes. So every prepayment is in similar to each quarter is very different. But on average, you can estimate as far as prepayment fees, about 2% to 2.5% end of term payments and other accelerated fees kind of in the 4%, 5.5%. And from there, you can kind of back into the impact of the income for the quarter.

Ryan Lynch, Analyst

Okay, that's helpful. And then just a final one. Are your guys realized and unrealized gains that you guys recognized this quarter, can you just describe kind of what was the main driver behind those? Was it one or two companies? Or was it a wide variety of companies being written out?

Dan Trolio, CFO

Yes, it was both. For realized gains, we had two to three companies that had events where we realized warrant gains. And then on the unrealized side, there's a handful of companies that have raised substantial capital at higher valuations that drove our fair value mark for each one of the warrants that we hold.

Ryan Lynch, Analyst

Okay, understood. I appreciate the time today and really nice quarter, guys.

Dan Trolio, CFO

Thank you.

Rob Pomeroy, CEO

Thanks, Ryan.

Operator, Operator

There are no more questions at this time. I would like to turn the call back over to Robert Pomeroy, Chairman and CEO, for closing comments.

Rob Pomeroy, CEO

Thank you all for joining us this morning. We appreciate your continued interest and support in Horizon. We hope you and your families continue to remain safe and healthy and we look forward to speaking with you again soon. This will end our call.

Operator, Operator

Thank you. This concludes today's conference. You may disconnect your lines at this time and thank you for your participation.