Runway Growth Finance Corp. Q3 FY2022 Earnings Call

Thank you, operator. Good evening, everyone, and welcome to Runway Growth Finance Conference Call for the third quarter ended September 30, 2022. Joining us on the call today from Runway Growth Finance are David Spreng, Chairman, Chief Executive Officer, Chief Investment Officer, and Founder; and Tom Raterman, Chief Financial Officer and Chief Operating Officer. Runway Growth Finance's third quarter 2022 financial results were released just after today's market close and can be accessed from Runway Growth Finance's Investor Relations website. We have arranged for our playback of the call at Runway Growth Finance's web page. During this call, I want to remind you that we may make forward-looking statements based on current expectations. The statements on this call that are not purely historical are forward-looking statements. These forward-looking statements are not a guarantee of future performance and are subject to uncertainties and other factors that could cause actual results to differ materially from those expressed in the forward-looking statements, including and without limitation, the uncertainty surrounding the COVID-19 pandemic, changing economic conditions, and other factors we identified from time to time in our filings with the SEC. Although we believe that the assumptions on which these forward-looking statements are based are reasonable, any of those assumptions can prove to be inaccurate, and as a result, the forward-looking statements based on those assumptions can be incorrect. You should not place undue reliance on these forward-looking statements. The forward-looking statements contained on this call are made as of the date hereof, and Runway Growth Finance assumes no obligation to update the forward-looking statements or subsequent events. To obtain copies of SEC-related filings, please visit our website. With that, I will turn the call over to David.

Thank you, Mary, and thank you all for joining us this evening to discuss our third quarter results. I'd like to start by providing an overview of the quarter, operational highlights, and a brief market update. Runway Growth generated record third quarter originations and net investment income results fueled by disciplined execution against our strategic initiatives. Our success underscores our credit-driven investment process, which provides the downside protection of debt with the potential for upside of equity. Runway Growth's weather-proof platform has been built to navigate all operating environments. This call marks a little over a year since Runway Growth went public. As we prepared for life as a public company, we believe we had significant opportunity for portfolio growth, ROE expansion, and to build what we believe to be the most stable portfolio among our venture lending peers. We knew that we would do this by deploying leverage to accelerate prudent portfolio growth while partnering with the highest quality late-stage companies in the venture market. Over the last year, Runway Growth has delivered gross fundings of $585 million, resulting in 55% net portfolio growth; expanded ROE 130 basis points to 10.1%, nearly quadrupled our leverage ratio to 0.6 times; strengthened our balance sheet with diversified capital sources; recorded zero realized credit losses; and increased our dividend per share for four consecutive quarters from $0.25 to $0.36 per share. This has been a historic year for our company, and we believe there is ample room to run for the balance of 2022 and into 2023. Runway Growth represents a compelling opportunity for investors that are looking for stable returns generated from partnering with some of the highest quality growth companies in the market. Now let's dive deeper into the third quarter. We are pleased with our ability to originate and structure high-quality senior secured debt investments and deliver significant portfolio growth. As we predicted at the start of the year, the cost differential between debt and equity capital continues to increase, and that remains a tailwind for our platform. Our investment team has built the strongest pipeline we've seen, which demonstrates the growing demand for our financing solutions amidst the current market environment. Many of the companies in our pipeline are seeking nondilutive capital to take the next step in their development without giving up significant equity. Companies that are seeking rescue financing are quickly weeded out. We're lending to companies that can raise equity but choose not to in order to preserve ownership positions and expand their businesses. We delivered our strongest third quarter of portfolio growth historically, completing nine investments in new and existing portfolio companies. This represents $216 million in new commitments, including $161 million in funded loans. In addition, we closed two transactions totaling $64 million in funding subsequent to quarter end. We increased our core leverage ratio from 0.4 to 0.6 times in the third quarter. Additionally, we strengthened our liquidity position by upsizing our KeyBank credit facility, on which Tom will provide additional details momentarily. We delivered total investment income of $27 million and net investment income of $15 million in the quarter. This is up 47% and 35%, respectively, from the prior year period. Net assets were $574 million at the end of the third quarter, up 14% from $504 million in the prior year period. These results, and particularly the growth, demonstrate the demand for our creative financing solutions. We are pleased with the consistent strength of our credit quality. This is a direct result of our disciplined underwriting and monitoring processes. Our work with portfolio companies continues throughout the life of our loans. We believe Runway Growth monitoring process ensures that we are accurately marketing these investments and mitigating risk while achieving consistent stable yield. We view our risk mitigation process as a competitive edge and a key method to preserving credit quality. We can see that through our loan-to-value comps. For an apples-to-apples comparison, we calculated the loan to value for loans that were in the portfolio at the end of Q2 and Q3. In comparing this consistent grouping of loans, our dollar-weighted loan-to-value ratio held consistent at 21% to 22% in the third quarter. As we've said, it may be more accurate to call this metric loan to our value; this is because whenever we conduct due diligence, our credit team takes an extremely conservative approach to valuation. We're not solely basing a portfolio companies' enterprise value on the last round of fundraising. Runway Growth has always used proprietary processes to insulate our underwriting rigor from frothy evaluations. Looking ahead, we believe the rising interest rate environment and industry tailwinds will contribute to Runway Growth's momentum. According to PitchBook Data, U.S. Late-stage venture activities slowed during Q3, which was further constricted by a lack of start-up liquidity. Year-to-date, late-stage company deals were down from 2021 but still well above 2020 levels. The median deal value, however, continued to decline. In other words, late-stage companies are continuing to raise equity capital, but it's for smaller increments than in the previous two years. We believe late-stage companies are deciding to execute smaller deals because they're scaling back growth, focusing on profitability, and being offered more onerous terms at lower valuations. In the third quarter, U.S. venture capital deal value was $195 billion year-to-date, surpassing the total value for the full year 2020, which was $169 billion. Similarly, venture debt deal value exceeded $22 billion and continues to grow as late-stage companies embrace debt as a means to reach additional milestones and avoid dilutive equity financing. This trend points to venture debt's untapped potential and bodes well for Runway Growth's nondilutive capital, which we believe is only becoming more attractive. We are positioned to take advantage of declining VC equity valuation as venture debt is increasingly being utilized to support the needs of entrepreneurs. More companies are looking at debt as an alternative or complement to new equity, positioning Runway for future growth. Given the momentum we have in the market, we look forward to closing out our first full calendar year as a public company. I will now turn it over to Tom.

Thanks, David, and good evening, everyone. Runway Growth completed nine investments in new and existing portfolio companies in the third quarter representing $216 million in new commitments, which included $161 million in funded loans. Runway's weighted average portfolio rating increased to 2.2 from 2.1 in the second quarter. As a reminder, our risk rating system is based on a scale of one to five, where one represents the most favorable credit rating. At quarter end, we continue to have only one portfolio company rated five and on non-accrual status. We attribute this to the partnerships we form with portfolio companies. We conduct extensive due diligence and risk analysis that meaningfully informs our underwriting and subsequent monitoring programs. This order of operation optimizes deal terms for us along with our borrowers. If one of our companies goes on non-accrual status, we evaluate ways we can work with management to bring it back to a performing loan while best protecting our interests as the lender. Our mission is to support passionate entrepreneurs that lead best-in-class late-stage companies by positioning them for success from term sheet to final payment. At the end of the third quarter, our total investment portfolio, excluding U.S. treasury bills, had a fair value of approximately $910.2 million, compared to $807.7 million at the end of the second quarter and $586.4 million for the comparable prior year period. This represents a sequential increase of approximately 13% and a year-over-year increase of 55%. As of September 30, 2022, Runway Growth had net assets of $573.7 million, decreasing slightly from $579.4 million at the end of the second quarter. NAV per share was $14.12 at the end of the third quarter compared to $14.14 at the end of the second quarter. We're pleased with our stable NAV, which we feel reflects industry-leading levels of scrutiny. Every material position in our portfolio is reviewed on a quarterly basis by a third party, ensuring confidence in our marks. From a credit spread perspective, we continue to see an encouraging environment attributable to our focus on late- and growth-stage companies with proven business models. Credit spreads are stable, and other terms are becoming slightly more favorable to lenders. With respect to interest rates, we want to remind everyone that our loan portfolio is comprised of 100% floating rate assets. Near-term, we believe the current rising rate environment will have a positive impact on portfolio yield and net investment income. In the third quarter, we received $55 million in principal repayments, a decrease from $80.6 million in the second quarter of 2022. We expect prepayment activity to slow since equity is so expensive, and refinancing markets remain challenged. That said, we have attractive late-stage companies that could become opportunistic acquisition targets in any environment, making it difficult to predict future prepayments. In the third quarter, we generated total investment income of $27.3 million and net investment income of $14.5 million compared to $18.6 million and $10.7 million in the third quarter of 2021, driven by an increase in the size of our portfolio. Our debt portfolio generated a dollar-weighted average annualized yield of 14.4% for the third quarter as compared to 15.3% for the third quarter of 2021. Moving to our expenses. For the third quarter, total operating expenses were $12.8 million, increasing from $7.9 million for the third quarter of 2021, driven by an increase in management fees, incentive fees, interest expense, as well as expenses related to being a public company. Our performance-based incentive fee was $3.6 million for the third quarter compared to $2.7 million for the third quarter of 2021. Our base management fee was $3.1 million, up from $2.3 million in the third quarter of 2021 due to the increase in the average size of our portfolio. Runway had a net realized gain of $0.4 million for the third quarter, which compares to a net realized gain of $0.7 million for the third quarter of 2021. We recorded net unrealized depreciation of $3.2 million in the third quarter, largely due to the decline in fair value of our loan to Pivot3 and public equity holdings in FiscalNote. Weighted average interest expense was 5.5% at the end of the third quarter, increasing from 4.1% during the second quarter of 2022. End-of-period leverage was 60% and asset coverage was 266% compared to 40% and 349%, respectively, at the end of the second quarter of 2022. All investments in the third quarter were funded with leverage as part of our strategy to generate non-dilutive portfolio growth. Turning to our liquidity. At September 30, 2022, our total available liquidity was $255.8 million, including unrestricted cash and cash equivalents, and borrowing capacity of $250 million under our credit facility, all subject to existing terms and conditions. This compares to $123.8 million and $117 million, respectively, on June 30, 2022. During the third quarter, we strengthened our liquidity position by upsizing our KeyBank credit facility to $425 million from $280 million to fund portfolio growth with cost-effective debt capital. In addition, we issued $100.5 million in unsecured notes during the quarter. Runway Growth continues to be judicious in deploying capital at favorable terms while maintaining market-leading credit quality. Our credit quality is a reflection of our rigor across the entire lifecycle of a loan, including sourcing, negotiating, underwriting, and monitoring. An example of this is our pipeline development. We are very targeted with respect to the industries we're in and where we want to go. We are more concerned with long-term returns than being early adopters in the space, which is why we have no current exposure to the Web 3.0 and crypto spaces at this time. We will continue to prioritize credit quality at every stage. With the lowest balance sheet leverage among the BDC industry, we believe Runway is strategically positioned for the current macroeconomic backdrop. We have dry powder and credit disciplines to use it judiciously. We remain on track to achieve our core leverage target for the portfolio, which is between 0.8 and 1.1 times by the first quarter of 2023. As leverage builds, we believe it will unlock the full potential of our earnings power. We have the ability to grow our portfolio and, in turn, earnings without raising equity. Before taking into account prepayments, we have the ability to grow our portfolio by approximately $286 million without exceeding our core leverage targets or returning to the equity markets. We also believe our strong portfolio quality would allow us to exceed our upper leverage target for periods of time, providing us great flexibility in timing any return to the equity market. Earlier this year, our Board of Directors approved a stock repurchase program to acquire up to $25 million of Runway Growth's common stock. The program expires on February 23, 2023. Runway Growth used the program during the quarter, and senior management was active in purchasing shares. Finally, on October 27, 2022, our board declared a dividend distribution for the fourth quarter of 2022 of $0.36 per share, a 9% increase from our third quarter dividend of $0.33 per share and our fourth consecutive quarterly dividend increase. I'm encouraged by the momentum in deal flow as late-stage venture-backed companies turn to Runway Growth, as the preferred lender for minimally dilutive capital. As we originate high-quality loans, we expect our intentional deployment of leverage to enhance ROE and long-term shareholder value. This concludes our prepared remarks. We'll now open the line for questions.

Thank you. Our first question will come from Mickey Schleien from Ladenburg. Your line is open.

Yeah, good evening. David, a couple of questions. You talked about the fact that your investment thesis in the sector remains intact in terms of the attractiveness of the type of funding you provide. I just want to further understand how is the volatility in the market? And in particular, the rising interest rate environment, whether we're looking at LIBOR or SOFR sort of impacting the organic demand for your capital as opposed to refinancings, which we understand it will be suppressed under this environment.

Great question. The main advantage is that debt remains less expensive than equity. While debt is becoming slightly more costly due to rising interest rates, equity has become significantly more expensive, with valuations at around half of what they used to be and accompanied by restrictive terms. As a result, venture-backed companies, especially the strong ones capable of raising equity, are choosing not to and are instead viewing debt as a more viable and cost-effective option, particularly in terms of dilution. Although interest costs are higher, they do not represent a significant portion of these companies' overall expenses. The average loan-to-value ratio is below 20%, and interest isn't a major consideration for them. From their perspective, the key factor is how they will use the funding and the expected return on investment. If they can double their revenue without losing more equity and subsequently double their business value, this far outweighs the cost of interest. We haven't encountered much resistance or requests for fixed rates. We are fortunate to have no fixed-rate loans, and we do not engage in that practice. The market feedback indicates that while rising rates are not favorable, debt remains cheaper than equity, and we continue to see a strong return on investment.

So, David, with those comments you just gave us in mind, how would you characterize the size of your pipeline today versus a year ago? And perhaps even more importantly, the quality of the pipeline.

I'm glad you mentioned that. The quantity has never been larger, and while quality is subjective, I believe it has also reached new heights. The top tier companies are approaching us now. One of the reasons for this is the high costs associated with equity. Additionally, some of the major players who used to provide late-stage pre-exit funding, like hedge funds and even SoftBank, have withdrawn from the market. These funds were previously our competitors because raising equity capital at $2 billion wasn't very dilutive and created positive press, boosting employee morale. However, that's not the case anymore, leading to less competition in equity. Consequently, the caliber of companies we are seeing is at an all-time high.

I appreciate that. My final question, I'm not sure how to look at the performance of your portfolio companies relative to the typical BDC. In this economic environment, I mean, we're generally seeing BDC portfolios producing revenue growth more or less in line with inflation, but margins coming down. Is that also true in your venture space? Or are these companies at such high growth trajectories that they haven't been affected yet by the slowdown in the economy and the sort of cost input increases that we've seen?

Well, it's difficult to generalize. We have a very diversified portfolio across three broad segments: tech, life sciences, and consumer. On the whole, the portfolio is still very much in growth mode. I think you're seeing some companies having changed their forecast for 2022. But by and large, for the most part, I mean, out of roughly 30 companies, call it, four or five have reduced their plans. So most companies are still achieving the revenue plans that they put together at the end of last year, early this year. And I'd say we're seeing that impact more in the consumer than we are in the tech and life sciences verticals.

And David, I'm sorry to keep asking questions. But based on what you just commented, have you started to see 2023 projections for these companies? And are they being more conservative relative to where they were before?

So we, of course, have a 2023 plan for every company, but we haven't really started to see the official, let's call it, Board-approved plan yet. So I can't really give you feedback. Just in talking to companies, I would say they're taking a cautionary view. Of course, they still want to grow and they're still going to continue to invest in growth, but they're being a little bit more thoughtful on it, and there's probably a plan B. I'd say especially as it relates to hiring, because it's one of the biggest expenses for almost all of our companies, that is being paced, I would say. Like we'll hire, but only when we really need it and maybe a little bit slower than we might have otherwise. So bottom line, my answer to your question is, no, we have not started to see 2023 official plans yet.

Okay. That's it for me this evening. I appreciate your time. Thank you very much.

Thank you.

Thank you. Our next question will come from the line of Casey Alexander from Compass Point. Your line is open.

Hi, good evening. And thank you for delaying your call till 6 o'clock. I know it's pain but with everybody else diving in at 5 o'clock it's actually less stressful at 6 o'clock. So I appreciate that.

Well we appreciate you too.

You actually had reasonably almost robust sales and repayments of investments compared to much of what we've seen across the venture debt universe, especially relative to your size. Could you give us some color as to where they came from, what some of the circumstances are? Because your ability to recycle is as important as your ability to originate, and seeing paybacks in this environment is actually quite encouraging.

Sure. Let me make a general observation, and then Tom can share more details. Prepayments are challenging to forecast or anticipate. We are aware of any M&A transactions that are in progress, and we certainly know if a company is planning to go public. We did have one company that successfully went public through a SPAC. While we receive some advance notice, planning remains difficult. This is an unavoidable aspect of our business. I anticipate that we will observe a decrease in M&A activity, fewer IPOs, and likely a decline in SPACs as well. Therefore, I expect the volatility to diminish somewhat over the next year. However, I foresee an increase in private-to-private mergers, where two venture companies join forces. This can be beneficial for us since it typically allows us the choice to remain involved or to exit through refinancing. Tom, would you like to provide additional insights on specifics?

I would just say that we participated in two refinances, one of which was a broader syndication for the SPAC company that allowed us to reduce our exposure slightly. This decision was made to diversify our funding sources while still remaining involved in the loan. In terms of predictability, there are some attractive late-stage companies continuously evaluating opportunities that might come our way. We expect some level of recycling, likely more from mergers and acquisitions and less from refinances. Some loans are now converting from the interest-only period and will begin amortizing. While it's difficult to predict accurately, we do foresee opportunities for recycling. It may not be as strong as in 2021, but it should still be reasonably significant.

Okay. Secondly, and this is just kind of an oddity that I noticed. In the second quarter, your PIK income jumped up about $2.5 million over the first quarter. And then in this quarter, it dropped right back, actually to a level even lower than where it was in the second quarter. And I'm just curious how that cadence occurred in terms of PIK income? And was it just a one quarter pass that you gave a company? Or how that came about?

That was the collection of the income that had been PIKed, referring to the interest on Mojix. As you may recall, Mojix was a long-time category five and non-accrual loan. We had a long-term strategy to collaborate with that company and guide it through to sale. It was sold in the second quarter, which allowed us to recognize all the previously deferred PIK income. Therefore, it was a second quarter anomaly.

All right. Great. Thank you. That explains it. All right, thank you for taking my questions.

Yeah, of course. And we should clarify. As a normal course of business, our loans are cash paid. So that was that workout situation where we just got it all after five years. So all right, we can go to the next call, please.

Thank you. Our next question will come from the line of Bryce Rowe from B. Riley. Your line is open.

Thanks very much. Good evening, thanks for taking my question. I wanted to, Tom, ask you. It looks like you're almost a bit more asset sensitive here at the end of September than you were at the end of June. I think if you look in the presentation from last quarter to this quarter, that 200 basis point move in LIBOR will have a positive impact of $0.34 on NII versus $0.30 last quarter. I mean not a huge jump, but just curious what's driving the increased asset sensitivity.

Our portfolio continues to have a floating rate, but in the third quarter, we introduced $100 million in fixed rate notes. As interest rates rise, we aren't completely aligned with SOFR rates as we would be if we were financed through the revolving credit facility. However, we will benefit from these two new fixed rate tranches in our capital structure.

Okay. That's helpful. Thanks. And then, David, I think in your prepared remarks, you mentioned spreads being stable here, which is a good sign, but other terms might be shifting to in the favor of lenders. So I just wanted to see if you could possibly expand on that comment.

Yeah, of course. So spreads are pretty stable, which is good. The terms that we see improving are in covenants and in warrant coverage, where we're just able to get marginally better warrant position. And importantly, and the thing we care the most about, is just able to get either more covenants or tighter covenants, which we view as beneficial to both the lender and the borrower. And we've been pretty successful at communicating that to potential borrowers and convincing them that a properly structured covenant package makes sense for both parties.

Great. That's helpful. Thanks. And then maybe one more for me, Tom. You highlighted the increased commitment level for the revolver, just curious if you're adding lenders to that? Or is that existing lenders upping their commitments?

No. We are adding lenders and there's strength in numbers on the facility. We were at $425 million at the end of Q3. And we're always looking to diversify that lender base, and we'll continue to do that with all of our, frankly, sources of debt.

Great, thanks so much. That's it for me.

Thank you.

Thanks, Bryce.

Thank you. Our next question will come from Melissa Wedel from JPMorgan. Your line is open.

Good evening. Thanks for taking my question. The first is actually more of a clarification. I want to make sure I heard you right in your prepared comments. I think you said subsequent to quarter end, there were 2 transactions that were closed for $56 million of funding. Is that right?

I think it's $64 million of funding.

$64 million, I think, yeah.

Thank you for the clarification. As we consider a busy third quarter, should we be aware of the timing of the fundings and their addition to the portfolio? I've noticed that sometimes contributions can be more concentrated in the latter part of the quarter, which may not fully reflect in the P&L. Is there anything we need to keep in mind regarding this?

As we always say, deals tend to close at the end of the quarter, and that was really true for the third quarter as well, and it was I think just a great testament to our origination team and the pipeline. Now that we're out of the box in the fourth quarter with two deals closing in the first month. But typically, and I would expect this will remain the case for the balance of the fourth quarter, that deals end up closing at the end of the quarter.

Yeah. Understood. And if I could sneak in one last question. You mentioned your exposures in terms of industries in tech and life sciences and consumer. And thinking specific to consumer, given sort of the macro uncertainties out there, concerns about the weakening of the consumer into '23, is there anything that you're looking at differently with your consumer-related companies or prospective consumer investments?

We expect to navigate through an economic downturn, and our business model must be resilient in this environment. We will focus on ensuring we have enough capital to withstand challenges and will avoid taking excessive financing risks. One advantage of being the final source of funding before companies become profitable is that we can conduct thorough scenario analyses to determine the necessary resources for achieving that profitability. Historically, we have been careful not to engage in ventures driven by trends or consumer fads. Our ongoing strategy is to concentrate on recession-resistant opportunities, capital-efficient business practices, and exceptional management.

Thank you.

Thank you. I'm actually not seeing any further questions in the queue. I'd like to turn the call back over to David for any closing remarks.

Thank you, operator. At Runway Growth, we're focused on building a high-quality portfolio that will generate stable and attractive long-term shareholder value. We have the team in place to execute on our strategy and deliver for years to come. Thank you all for joining us today and for your support. We hope everyone stays safe and healthy, and we look forward to updating you on fourth quarter and full year results in March.

And this concludes today's conference call. Thank you for participating. You may now disconnect. Everyone, have a great day.