Earnings Call Transcript - HRZN Q2 2023

Operator, Operator

Greetings, and welcome to the Horizon Technology Finance Corporation Second Quarter 2023 Earnings Call. As a reminder, this conference is being recorded. It is now my pleasure to introduce your host, Megan Bacon, Director of Investor Relations and Marketing. Thank you. Ms. Bacon, you may begin.

Megan Bacon, Director, Investor Relations and Marketing

Thank you, and welcome to Horizon Technology Finance Corporation's Second Quarter 2023 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 Q2 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 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.

Robert 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. Jerry will then discuss our business development efforts, our portfolio events and our markets, and Dan will detail our operating performance and financial condition. We will then take some questions. We had a solid second quarter at Horizon despite the quarter beginning with the fallout from the banking crisis and the ongoing economic and credit concerns. To that end, our adviser, Horizon Technology Finance Management, closely focused on the credit quality of our portfolio companies, while we also selectively originated new loans and increased our balance sheet's investment capacity. We are navigating through a challenging period and the macroeconomic environment remains uncertain. Though we've built a resilient and expert team of professionals that positions us well to succeed long term in both maximizing the value of our current portfolio of investments as well as adding attractive new investments to our portfolio. Turning to our specific results for the quarter, we generated net investment income of $0.54 per share well in excess of our declared distribution level, due largely to higher interest rates on our floating rate debt investment portfolio as well as lower incentive fees earned by HTFM. Dan will further discuss the impact of incentive fees on NII in his remarks. Based on our outlook and our undistributed spillover income of $1.02 per share as of June 30, we declared monthly distributions of $0.11 per share through the end of 2023. We once again achieved a portfolio yield of over 16% on our debt investments for the quarter at or near the top of the BDC industry. We raised $44 million of equity from a follow-on offering and from our at-the-market program, both at a premium to NAV. The equity raises enabled us to increase our investment capacity and to reduce our net-debt-to-equity ratio below our target of 1.2:1. We also increased our investment capacity by successfully expanding both our KeyBank and our New York Life facilities by a combined $75 million. Our proactive efforts have positioned us well to fund our current backlog and future originations as the environment improves. Our portfolio at quarter end stood at $715 million. We finished the quarter with a committed and approved backlog of $159 million providing us with a solid base of opportunities to thoughtfully grow our portfolio. As a reminder, most of our funding commitments are subject to our portfolio companies meeting certain key milestones. Finally, we ended the quarter with a net asset value of $11.07 per share. Due to the difficult capital raising environment for companies over the last few quarters, resulting in some companies being unable to access new capital to maintain operations. We wrote off 3 debt investments as well as marked down the fair value of other debt investments contributing to the $0.27 per share reduction in NAV for the quarter. However, with our close working relationships, expertise and consistent support of our portfolio companies, we believe our overall credit profile improved during the quarter. We will continue to closely manage our portfolio and will remain selective in originating new investments in the near term as we look for the economic and investing environment to stabilize. We continue to believe our portfolio and backlog is positioned to generate strong NII in the second half of the year. I'm also pleased to report the completion of the acquisition of our adviser, HTFM, by Monroe Capital on June 30. Our adviser maintains its entire team and will generally operate as it has with the added benefits of the Monroe umbrella. With Monroe's fundraising abilities and platform, HTFM will have the capability to compete and win larger investment opportunities, which will provide Horizon with a larger and more diverse portfolio of investments. In summary, while the environment remains unpredictable, our experience and expert team is doing all of the right things to steer us through the cycle. We will continue to execute our investment strategy, maintain a sharp focus on credit quality and seek to carefully grow the portfolio with 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?

Gerald Michaud, President

Thanks, Rob, and good morning to everyone. Given the ongoing macroeconomic banking and VC headwinds in Q2, our portfolio size remained flat from the prior quarter at $715 million as of June 30. In the second quarter, we funded 11 debt investments totaling $50 million, including a $10 million debt investment to a new tech portfolio company focused on security imaging and a $10 million debt investment to a new health care information portfolio company, providing AI-enabled technology for dementia care. We expect to remain selective in originating debt investments in the near term given the environment. However, the top of our pipeline is beginning to reflect greater demand by companies that have raised fresh equity and are demonstrating growth. We believe we are well situated to compete for these opportunities, having raised $44 million of equity through a follow-on offering in our ATM in the quarter, as well as expanding our borrowing capacity under our credit facilities in the quarter. Our onboarding yield of 13.6% during the quarter remained near our historic highs, reflecting the higher rate environment in our markets as well as our discipline in structuring and pricing transactions, which we expect to produce strong net investment income. We experienced two loan prepayments, one refinanced loan and one partial paydown during the quarter totaling $30 million. We expect prepayments to remain muted in the third quarter of 2023, compared to our historic levels given the weak IPO and M&A markets. Our debt portfolio yield of 16.3% for the second straight quarter is a first testament to the value of our floating interest rate structures in a rising interest rate environment. We again generated one of the highest debt portfolio yields in the BDC industry. As of June 30, we held warrant and equity positions in 97 portfolio companies with a fair value of $31 million. During the quarter, we received $1.5 million of warrant and equity-related proceeds. As we have consistently noted, and as evidenced by these proceeds, structuring investments with warrants and equity rights is a key component of a venture debt strategy and a potential generator of shareholder value. In the second quarter, we closed $74 million in new loan commitments and approvals maintaining our selective approach to new opportunities and ended the quarter with a committed and approved backlog of $159 million compared to $187 million at the end of the first quarter. We believe our committed backlog, with most of our funding commitments subject to our portfolio companies meeting certain key milestones, provides a solid base to prudently grow our portfolio as we selectively add quality investments in new portfolio companies in the second half of 2023. Along with our prescreen and underwriting process, which ensures we remain selective on new originations, we are working closely and creatively with all of our current portfolio companies to ensure they are able to navigate through the current market challenges, including the ability to raise additional capital. For example, during the quarter, we diligently worked with our portfolio company Evelo Biosciences, a public biotech, and its larger investors to ensure the company has the necessary financial resources to complete its Phase 2a trial for its lead product through our collaborative efforts. In July, the company's lead investor successfully completed a $25 million private placement in public equity. In concept with the pipe, Horizon received a $5 million paydown on its outstanding $45 million loan, and Horizon converted $5 million of its loan to equity at the same price paid by the pipe investors. Not only did Horizon prudently reduce its exposure, but it now has the potential for significant upside gains. We believe this unique series of transactions is evidence of our ability to create innovative solutions in times of stress, which provide immediate credit relief for borrowers and the opportunity for additional value to our shareholders while preserving income-generating assets. As of June 30, 90% of our debt portfolio consisted of 3- and 4-rated debt investments, a step-up from 86% as of March 31. The number of 2-rated debt investments declined to 4% in the quarter. We had 1-rated debt investment at the end of Q2, down from 3 in the last quarter. Our 1-rated credit represents 1.4% of our total debt portfolio. Turning now to the venture capital environment. According to PitchBook, approximately $40 billion was invested in VC-backed companies in the second quarter of 2023, a return toward pre-pandemic VC activity levels. While exciting investment opportunities continue to present themselves, we expect the investment environment to remain depressed for at least the near term. The decrease in available equity capital for companies while creating challenges also creates opportunities as companies and investors seek alternative capital, particularly debt capital, to fill their capital needs. We believe venture lenders, especially public BDCs, remain best positioned to fill this need, especially with the void created by the collapse and pullback of the venture banks. In terms of VC fundraising, $21 billion was raised in the second quarter as the market remains on pace to record a 6-year low. However, VC dry powder remains high due to sidelined investor capital which should enable VCs to provide a level of ongoing support for potential portfolio companies until improved exit markets emerge. We see better exit activity at a decade low due to the current economic environment and the closed IPO window. Total exit value for the quarter was just $5.5 billion, mostly driven by acquisitions. While the IPO backlog continues to build, given the uncertain environment, we expect VC-backed exit activity to remain mostly acquisition-driven in the near term. In terms of market conditions for new venture loan investments, we are seeing a return to the market of greater growth opportunity transactions that are well supported by their investors. Over the first two quarters of 2023, many opportunities were with companies focused on balance sheet improvement and cost reduction. Given the continued challenging environment, Horizon, through at least the third and fourth quarters of 2023, expects to maintain a pragmatic and cautious approach to new investment opportunities while preserving and improving the value and quality of its portfolio. As the economic and investing environment stabilizes, we believe we have many opportunities to reaccelerate the growth of our portfolio through new high-quality venture debt loans. A key baseline for future prudent portfolio growth is our committed, approved and awarded backlog, which as of today stands at $243 million, and our advisers pipeline of new opportunities, which as of today stands at over $1 billion. To sum up, we remain focused on credit quality and providing our portfolio companies with support and alternative solutions when necessary to ensure optimal outcomes for our portfolio. As the environment stabilizes, we expect an increase in attractive quality companies looking for venture debt solutions, which will enable us to thoughtfully grow our portfolio, our committed backlog, and our advisers pipeline. In the meantime, based on the size of our portfolio and our current portfolio yield, we believe we remain well positioned to generate solid NII for our shareholders and additional long-term shareholder value. With that, I will now turn the call over to Dan.

Daniel Trolio, CFO

Thanks, Jerry, and good morning, everyone. During the second quarter, the yield generated from our debt investments once again produced NII that more than covered our distributions. In addition, we were very active in the quarter and further strengthened our balance sheet, providing us with a significant amount of additional capacity with which we can prudently make new investments. During the quarter, we successfully completed a follow-on offering, raising $39 million in net proceeds. We also utilized our ATM program successfully and accretively raised an additional $5 million of capital. In addition to our equity raises, we expanded our KeyBank revolving credit facility by $25 million to $150 million and increased its accordion feature by $150 million to $300 million. We also expanded our New York Life credit facility by $50 million to $250 million. We continue to believe our proactive and focused balance sheet management keeps us well positioned to thoughtfully grow the loan portfolio and create additional shareholder value in the current environment and beyond. As of June 30, we had $107 million in available liquidity, consisting of $50 million in cash and $57 million in funds available to be drawn under our existing credit facilities. We currently have no outstanding balance under our $150 million KeyBank credit facility and $177 million outstanding on our $250 million New York Life credit facility, leaving us with ample capacity to grow the portfolio. Our debt-to-equity ratio stood at 1.19:1 as of June 30, and netting out cash on our balance sheet, our leverage was 1.05:1, which is below our target leverage of 1.2:1. Based on our cash position and our borrowing capacity on our credit facilities, our potential new investment capacity at June 30 was $274 million. In the second quarter, we earned total investment income of $28 million, an increase of 51% compared to the prior year period. Interest income on investments increased primarily as a result of the higher average size of our debt investment portfolio for the quarter and increases in the variable interest rates on our debt investments. Our debt investment portfolio on a net cost basis stood at $700 million as of June 30, a slight decrease from March 31, 2023. For the second quarter of '23, we achieved onboarding yields of 13.6% compared to 14.3% achieved in the first quarter. Our loan portfolio yield was 16.3% for the second quarter compared to 14.2% for last year's second quarter. Total expenses for the quarter were $11.9 million, compared to $9.9 million in the second quarter of '22. Our interest expense increased to $7.2 million from $4.2 million in last year's second quarter due to an increase in average borrowings and higher interest rates on our borrowings. Our base management fee was $3.2 million, up from $2.5 million in last year's second quarter due to an increase in average size of our portfolio. Our performance-based incentive fee was $0.1 million, down from $2.1 million for last year's second quarter. The lower performance-based incentive fee was related to an incentive fee cap and deferral for the second quarter of 2023. Net investment income for the second quarter of 23 was $0.54 per share compared to $0.46 per share in the first quarter of '23 and $0.35 per share for the second quarter of '22. The company's undistributed spillover income as of June 30 was $1.02 per share. We anticipate that our larger portfolio, the increase in our portfolio's interest rates along with our predictive pricing strategy, will enable us to continue generating NII that covers our distribution. As we have said previously, we really experienced prepayments throughout the remainder of the year. However, in today's environment, we still expect repayments to be below our historical levels. To summarize our portfolio activities for the second quarter, new originations totaled $50 million, which were offset by $6 million in scheduled principal payments and $30 million in principal prepayments, refinancing, and partial paydowns. We ended the quarter with a total investment portfolio of $715 million. Given the macro environment, we expect to remain selective in the near term with respect to originations. At June 30, the portfolio consisted of debt investments in 54 companies with an aggregate fair value of $683 million and a portfolio of warrant, equity and other investments in 99 companies with an aggregate fair value of $32 million. Based upon our outlook for 2023, our Board declared monthly distributions of $0.11 per share for October, November, and December '23. We remain committed to providing our shareholders with distributions that are covered by our net investment income over time. Our NAV as of June 30 was $11.7 per share compared to $11.34 as of March 31, '23 and $11.69 as of June 30, '22. The $0.27 reduction in NAV on a quarterly basis was primarily due to our paid distributions and adjustments to fair value, partially offset by net investment income. As we've consistently noted, 100% of the outstanding principal balance of our debt investments bear interest at floating rates with coupons that are structured to increase as interest rates rise with interest rate floors. As of today, 95% of our debt portfolio will benefit from additional increases in the prime rate. This concludes our opening remarks. We'll be happy to take questions you may have at this time.

Operator, Operator

The first question comes from Bryce Rowe with Riley Securities.

Bryce Rowe, Analyst

Wanted to ask about the portfolio's internal ratings and then also about some of the realized activity in the second quarter and subsequent to the second quarter. So first, on the internal ratings. You highlighted in the prepared remarks that 1- and 2-rated credits fell in absolute numbers. And then the 4-rated credits actually went up. Can you talk a little bit about kind of the dynamic that's driving at least the improvement to the 4-rated credits and then I'm assuming the 1s and 2s kind of came down primarily as you cleared out some of the, I guess, the underperformers here in the quarter.

Gerald Michaud, President

This is Jerry. Despite the chaos caused by the banks, some companies in our portfolio have performed exceptionally well and continued their growth. They managed to raise capital even in a challenging market. While we don't often discuss our 4-rated credits, there were several that did particularly well during this period, and it's nice to acknowledge them as we conduct our evaluations at the end of each quarter. On the flip side, it was extremely challenging to raise capital early in the second quarter due to the turmoil surrounding the banks. Companies were uncertain about where to deposit their funds and how to manage orphan loans from banks. This created opportunities for companies looking to refinance their debts from banks. However, the market indicated that this was not the right time for such actions, prompting VCs, investors, and company boards to seek alternative financing options. It was chaotic at the start of the second quarter, but we've observed some stabilization. Companies are becoming clearer about where to obtain the necessary funding to remain viable. Some that were underperforming struggled to raise capital in this environment. The market remains dynamic. A positive trend I see is that the opportunities entering our pipeline are becoming more rational, with investments coming in fresh capital and significant expansions in their runways, especially in the health care and biotechnology sectors. AI is also a significant topic, and some companies are ahead of the curve, well-funded, and thriving. Although we recognize that we're not entirely out of danger given the instability in the IPO and M&A markets, we feel more optimistic about our portfolio today compared to the beginning of the second quarter, as reflected in the valuations and changes in our credit ratings.

Bryce Rowe, Analyst

That's helpful, Jerry. Let's see. And then in terms of some of the realizations in the second quarter, you talked about realizing losses on writing off 3 investments look like interior defined and secure transfusion left the portfolio, I assume that was the kind of the major source of the realized losses. Just curious what the third write-off was? And then kind of a related question in terms of the July activity, should we think about, some realized losses coming through with the better place transaction that you noted in the press release.

Daniel Trolio, CFO

Yes. Regarding the investment schedule, you pointed out the two interior defined transactions that we realized this quarter. These were rated credits on nonaccrual, and their fair value was marked as we recognized this quarter. The impact on NAV from this was minimal. The third deal was private, and we don't disclose names, but it was related to what Jerry mentioned about not being able to raise additional capital, and that transaction ultimately did not go through. As for July, we do not provide future guidance, but we are currently evaluating each of our companies and do not have any updates on Better Place or any expectations for our portfolio in the third quarter.

Operator, Operator

Next question comes from the line of Christopher Nolan with Ladenburg Thalmann.

Christopher Nolan, Analyst

Following the acquisition of the manager by Monroe Capital. Well, first of all, are you going to start co-investing in Monroe with their family of funds?

Robert Pomeroy, Chairman and CEO

So currently, the plan really is to operate as we have been, Christopher, this is Rob. And so our activities are focused primarily on the public company, Horizon HRZN. I think over time, we will be looking for opportunities to both raise additional separately managed accounts that will be dedicated to the Horizon platform under Monroe, as well as seeking opportunities where there might be an opportunity to co-invest. But initially, we will be focused on the same target customers and transactions that we are today.

Christopher Nolan, Analyst

And then I guess as a follow-up on that same vein on leverage. Following the Monroe acquisition, is the plan to take up your debt-to-equity target?

Daniel Trolio, CFO

No. As Rob mentioned, we're running the public company as normal. So the target leverage will stay around the 1.2, 1.3x.

Christopher Nolan, Analyst

Okay. And then final question. For the market in general, are you seeing any banks effectively being able to step into the void created by the seizure of Silicon Valley Bank?

Gerald Michaud, President

I think it's too early to tell. So the short answer would be no, not particularly. However, there are banks that have made some moves, such as the one that acquired SEB and others hiring venture banking professionals available in the market. There is some anticipation that they plan to take action, but we haven't seen any bank clearly emerge and declare, 'This is going to be the next Silicon Valley Bank.' I don't believe there will be a next Silicon Valley Bank. The actions banks take will likely be much more measured due to the nature of banking and regulation, considering that SVB may have overreached in several areas. As of now, we don't have clarity on this market at all.

Operator, Operator

Next question comes from Ryan Lynch with KBW.

Ryan Lynch, Analyst

Just a question on IMV that obviously had a write-down this quarter. I know that's in the process of the bankruptcy process in Canada. Can you just talk about does that mark reflect what you guys expect to receive out of that bankruptcy process? Or what does that markdown sort of reflect?

Daniel Trolio, CFO

Yes. I mean, just like any time when we're valuing all of our assets at the end of the quarter, we're making our best estimate of what fair value is based on in a situation like this, different probabilities of different outcomes. And based on the information we have up through the day we file, we go through that and come up with our calculation. So at this point in time, yes, that's our best fair value of what we expect the investment to realize.

Ryan Lynch, Analyst

Okay. And then can you just remind us, obviously, you guys made some changes in the capital that got paid back, got some equity in Evelo. Can you just remind us what are the next big test results that we're waiting for? And what's your expectation? Or what are you hopeful to see out of that?

Gerald Michaud, President

Okay. So you're talking about Evelo. That's a publicly traded biotechnology company. We amended our loan in Q2. In concert with a $25 million pipe transaction that the company did, they repaid $5 million of our $45 million loan. We also converted $5 million to equity at the exact same terms and price that the pipe investors invested in. So the company has capital now for a period of time. They're in the process of running a clinical trial, 2A trial for a psoriasis drug, 2993 is the technical name. And they expect, based on public information, they expect to have results of that in October.

Ryan Lynch, Analyst

Is there any lockup or time restriction on your equity position? Given the current stock price, there's a significant gain, and I anticipate that the gain could increase if things go well, although it could also decrease if things don't go as planned. I'm curious if there are any time restrictions on that equity position and whether you plan to hold it long-term.

Gerald Michaud, President

The stock is currently restricted, but the company plans to register those stocks. This process is expected to occur in the next quarter, and as always, we will evaluate any asset based on the opportunities that arise. We'll see what happens.

Ryan Lynch, Analyst

Got you. Yes. That's helpful. That's quite a substantial gain on that you guys currently have on paper right now. Just the last question. I mean I know you gave some commentary on the market. Obviously, the overall venture market is down. It's been down pretty meaningfully throughout 2023. I'm just curious, I'd love to give your sentiment. You guys are obviously operating in that marketplace every day. I know trends haven't changed much. I mean capital raising is down, investments down, exits are down in 2023. But have you seen any sort of meaningful or incremental shift in VC sentiment, either positive or negative since the last time we talked 3 months ago?

Gerald Michaud, President

One notable change we've observed is that venture capitalists are now focusing intently on their portfolio companies, assessing their needs and expectations for funding until exit markets improve. We're witnessing more creative and rational financing options being considered, which are actually feasible. An example is the Evelo transaction that raised $25 million. Additionally, there are interesting merger and acquisition opportunities along with other forms of bridge financing. The situation is less chaotic compared to 90 days ago, as VCs have a clearer understanding of how to support their portfolio. However, some companies still face difficulties in securing capital due to poor exit markets and declining valuations from 2021 that will likely need adjustment to attract investors. While not all trends are positive, there is a rational approach emerging with potential solutions that may require the venture debt market’s participation. We believe that when the markets recover, publicly traded biotech companies, which have seen irrational valuations, will present opportunities. For instance, Evelo at one point had a significantly low valuation despite substantial cash reserves. Still, there is considerable risk until markets reopen, and it appears we may face a few more challenging quarters driven largely by macroeconomic factors. Until we see improvements in the broader economy, IPO and M&A markets will continue to struggle. Overall, it is expected to be a tough market in the near term.

Operator, Operator

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

Robert Pomeroy, Chairman and CEO

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

Operator, Operator

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