WhiteHorse Finance, Inc. (WHF) Q2 2022 Earnings Call Transcript

Good afternoon, my name is Katie, and I'll be your conference operator today. At this time, I would like to welcome everyone to the WhiteHorse Finance Second Quarter 2022 Earnings Conference Call. Our host for today's call are Stuart Aronson, Chief Executive Officer; and Joyson Thomas, Chief Financial Officer. Today's call is being recorded and will be made available for replay beginning at 4:00 PM Eastern Time. The replay dial-in number is 402-220-6059, no passcode is required. At this time, all participants have been placed in a listen-only mode and the floor will be opened for questions following the presentation. It is now my pleasure to turn the floor over to Jacob Moeller of Rose &Company. Please go ahead.

Thank you, operator, and thank you everyone for joining us today to discuss WhiteHorse Finance's second quarter 2022 earnings results. Before we begin, I would like to remind everyone that certain statements, which are not based on historical facts made during this call, including any statements relating to financial guidance, may be deemed forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. Because these forward-looking statements involve known and unknown risks and uncertainties, these are important factors that could cause actual results to differ materially from those expressed or implied by these forward-looking statements. WhiteHorse Finance assumes no obligation or responsibility to update any forward-looking statements. Today's speakers may refer to material from the WhiteHorse Finance second quarter 2022 earnings presentation, which is posted on our website this morning. With that, allow me to introduce WhiteHorse Finance's CEO, Stuart Aronson. Stuart, you may begin.

Thank you, and good afternoon everyone. Thank you for joining us today. As you are aware, we issued our press release this morning prior to market open. I hope you've had a chance to review our results for the period ending June 30, 2022, which can also be found on our website. On today's call, I'll begin by addressing our second quarter results and the current market conditions, then Joyson Thomas, our Chief Financial Officer, will discuss our performance in greater detail. After which, we'll open the floor for questions. I am pleased to report solid second quarter performance for 2022. Q2 GAAP net investment income was $7.9 million or $0.339 per share. Core NII was approximately $7.8 million or $0.334 per share. After adjusting for a $100,000 capital gains incentive fee reversal. Our NAV per share at the end of Q2 was $14.95, representing a decrease of $0.04 from Q1 2022. Importantly, it remains very close to our initial underwriting price of $15 per share. This decrease was a result of some credit deterioration in a few accounts, along with markdowns reflecting higher pricing in the lower mid-market. Turning to our portfolio activity for the quarter. Gross capital deployments in Q2 totaled $48.1 million, of this amount, $28.9 million was funded into four new originations and the remaining $19.2 million was funded in the add-ons of existing portfolio investments. As we suggested would happen during our last earnings call, delayed repayments have begun to occur. During Q2, total repayments and sales were $66.1 million, primarily driven by five full realizations with repayments outpacing origination activity and additional transfers of investments into the STRS JV, net effective leverage decreased to 1.18 times at the end of Q2 compared to 1.3 times at the end of Q1. At this leverage level, we are below our target of 1.25 times to 1.35 times leverage. Regarding the five realizations, we are in $6.7 million including fees and interest, which generated an aggregate IRR of 11.4% on the $59.7 million of aggregate capital invested into these deals. This attractive return for senior secured loans demonstrates the power of our sourcing model and highlights our ability to negotiate tight covenants and strong call protections. These repayments provide the BDC with nearly $50 million of investment capacity. Looking forward, a number of borrowers have alerted us that they plan to make repayments in the third or fourth quarter, which will give us additional investment capacity. Given the change in marketplace pricing, which I will discuss later, we believe that in many cases the repayment on historical investments will allow WhiteHorse to redeploy capital into higher yielding investments. Of our four new originations in Q2, three were sponsor deals and one was a non-sponsored deal with an average leverage of 4.7 times. I note that all of these deals were first lien loans and had an expected average all-in rate of 8.1% with an effective yield of 9.7%, which was higher than the portfolio average of Q1. At the end of Q2, 96.5% of our debt portfolio was first lien loans and 100% were senior secured. As I shared on the last call, so long as our portfolio remains heavily concentrated in first lien loans, which have lower risk profiles but also lower returns than second lien loans, we expect to continue to run the BDC at up to 1.35 times leverage. In order to help the BDC consistently earn its $0.355 quarterly dividend, which we have consistently paid since coming public. With that in mind, I'll now step back to bring our entire investment portfolio into focus. After the effects of the STRS JV asset transfers, as well as $3.5 million in net mark-to-market decreases, $1.9 million in realized gains and $1.6 million of accretion, the fair value of our investment portfolio was $766.5 million at the end of the second quarter, down from $800 million at the end of Q1. The weighted average effective yield on our income producing debt investments was 9.9% as of the end of the second quarter, which reflects a 70 basis point increase from Q1 level of 9.2%. This increase resulted primarily from rising LIBOR and SOFR rates. We continue to utilize our joint venture with STRS Ohio successfully. The JV generated investment income to the BDC of approximately $3 million in Q2 compared to only $2.6 million in Q1. The increase in JV income in Q2 was due in part to WhiteHorse’s increased economic ownership of 66.25% compared with 60% in Q1. During the second quarter, we transferred one new deal and one add-on investment to the STRS JV totaling $17.8 million. The fair market value of the JV's portfolio was $318.8 million as of June 30 and at the end of Q2, the JV's portfolio had an average unlevered yield of 8.7% above Q1's yield of 7.9% and a portfolio size of $312.8 million. The increase in the unlevered yield is primarily due to rising base rates of LIBOR and SOFR. The JV's portfolio is currently comprised solely of first lien senior secured loans. The JV has produced an average annual return on equity in the low-teens to the BDC, we believe WhiteHorse’s equity investment in the JV provides attractive returns for shareholders and is particularly relevant given the current market backdrop. Given the JV's return on equity, we continue to consider funding additional equity commitments to the JV as we seek to increase our exposure to a highly accretive earnings stream. We are pleased to report that we have no investments on non-accrual status, and our investment portfolio remained stable during the broad market volatility in Q2. We did have both markups and markdowns in the portfolio based on improving or decreasing performance, but on average, the portfolio was stable. Our well-diversified portfolio is weathering an economy experiencing several negative factors, including rising interest rates, rising raw material prices, rising labor costs, and rising transportation costs. Fortunately, to date, our portfolio companies have done a very good job of passing along these price increases. A couple of borrowers are having their margins squeezed and we are certainly seeing a slowdown in consumer retail demand, which has led to modest increases in leverage in several portfolio companies. Additionally, our portfolio is overwhelmingly represented by non-cyclical or light cyclical borrowers, and we hold no direct exposure to oil and gas, auto or restaurants and very little exposure to the construction sector. Since we generally serve the lower mid-market, we've been able to build a portfolio with an average leverage at the portfolio company level of only about 4.5 times, by keeping our portfolio company leverage low our portfolio companies are better able to cover their debt service in this rising interest rate environment. Thus far, rising interest rates have only had a modest impact on the debt service coverage for our portfolio companies. While the portfolio is holding up well, we are keeping a careful eye on demand characteristics, especially in the consumer sector. We have not seen many recessionary signs yet in our portfolio, but I should note that portfolio numbers are delayed by a lag in reporting typically 45 to 60 days after quarter end. The modest leverage levels to which we underwrite our loan investments from both an EBITDA as well as an operating cash flow perspective is a key differentiator versus lenders with higher levered portfolio companies that may experience greater difficulty servicing debt as interest rates increase. We expect the majority of our portfolio companies to be able to service our debt in this rising interest rate environment, and we believe our investment portfolio is well positioned to benefit from such rising interest rates, given that almost 100% of our debt portfolio is comprised of floating rate investments. Given where three-month LIBOR and SOFR contracts reset to around the end of June, we expect some organic earnings accretion starting in Q3. We'll also see the full impact of our increased ownership in the JV beginning in Q3. The market and by this, I mean the market for stocks, bonds, cryptocurrencies and most other assets has corrected sharply with an emerging consensus view that the economy is in recession. Across the mid to lower mid end of the market, in addition to rising prices loans are being written to more conservative credit terms with tighter documentation and covenants. Total leverage on transactions is a quarter turn to a half a turn lower than it was three to six months ago. That said, we have witnessed that several lenders have not yet adjusted to the new market pricing, which frankly is a bit unexpected. There has also been a correction in the broadly syndicated market creating opportunities for direct lenders, including BDCs, to acquire syndicated bank debt at lower prices and much higher yields than a few months ago. We believe this environment is very attractive for making investments in larger non-cyclical or marginally cyclical businesses. Our pipeline reached another record level which enables us to be highly selective about which credits we pursue. While we expect our pipeline activity levels to remain high, we generally have a cautious approach and continue to underwrite to conservative downside scenarios. We have been selectively taking advantage of market conditions and are positioned to benefit from both rising base rates and rising spreads. Thus far in Q3, the company has closed three add-on acquisitions and currently has visibility for five additional mandated deals and add-on transactions. Although there can be no assurance that any of these deals will close. As I mentioned earlier, the timing of repayments has been fortuitous for the BDC as we have capacity to rotate into higher yielding assets that combined with portfolio growth and the increase in our ownership in the JV should ultimately lead to higher income and greater coverage of our dividend. At the conclusion of this quarter, we are cautiously optimistic for the second half of the year. While we remain concerned about cyclical industries and various economic headwinds, we believe we have built a very strong portfolio with a strong team and solid sourcing and a responsible underwriting process. Further, we expect our additional capital capacity and unique three-tiered deal sourcing capability to act as a strong tailwind for our financial performance moving ahead. With that, I'll turn the call over to Joyson for additional performance details and a review of our portfolio composition.

Thanks, Stuart. And thank you everyone for joining today's call. During the quarter we reported GAAP net investment income of $7.9 million or $0.339 per share, this compares to $8.5 million or $0.368 per share in the first quarter. Core NII was approximately $7.8 million or $0.334 per share, after adjusting for a $0.1 million capital gains incentive fee reversal. This compares with Q1 core NII of $7.9 million or $0.344 per share and the quarterly distribution of $0.355 per share. Q2 fee income increased slightly quarter-over-quarter to $0.7 million from $0.5 million in Q1. The increase was due to higher prepayment and amendment activities during the current quarter. For the quarter, we reported a net increase in net assets resulting from operations of $7.3 million, a $1.6 million increase from Q1. Our risk ratings during the quarter showed that 84.8% of our portfolio positions carried either a one or two rating, a decrease from 90.1% in the prior quarter. As a reminder, a one rating indicates that a company has seen its risk of loss reduced relative to initial expectations and a two rating indicates that the company is performing according to those initial expectations. Regarding the JV specifically, we continue to grow our investment. As Stuart mentioned earlier, we transferred one new deal and one add-on transaction, which totaled $17.8 million. As of June 30, the JV's portfolio held positions in 32 portfolio companies with an aggregate fair value of $318.8 million compared to 33 portfolio companies at a fair value of $312.8 million in Q1. The investment in the JV continues to be accretive to the BDC's earnings. As we've noted in prior calls, the yield on our investment in the JV may fluctuate period over period as a result of a number of factors, including the timing and amount of additional capital investments, the changes in asset yields in the underlying portfolio, as well as the overall credit performance of the JV's investment portfolio. Turning to our balance sheet, we had cash resources of approximately $18.6 million at the end of Q2, including $9.4 million in restricted cash. As discussed on our last call, we amended the terms of the revolving credit facility earlier in the year to permanently upsize the credit facility to $335 million, which has provided us significant flexibility when accounting for timing differences between anticipated prepayments and originations. We also still have an accordion feature to upsize our credit facility to a total of $375 million should we choose. As of June 30, 2022, the company's asset coverage ratio for borrowed amounts as defined by the 1940 Act was 181%, which was above the minimum asset coverage ratio of 150%. Our Q2 net effective debt to equity ratio, after adjusting for cash on hand was 1.18 times compared to 1.3 times in the prior quarter. Before I conclude and open up the call to questions, I'd like to highlight our distributions. On May 10, 2022 we declared a distribution for the quarter ended June 30, 2020, to $0.355 cents per share to stockholders of record as of June 20. The dividend was paid on July 5, 2022, marking the company's 39th consecutive quarterly distribution. This speaks to both the consistent strength of the platform, as well as our resilient deal sourcing capabilities in being able to create a well-balanced portfolio, generating consistent current income. Finally, this morning we announced that our Board declared a fourth quarter distribution of $0.355 cents per share to be payable on October 4, 2022, to stockholders of record as of September 20, 2022. This will mark the company's 40th consecutive quarterly distribution paid since our IPO in December 2012, with all distributions consistent at the rate of $0.355 per share per quarter. As we said previously, we will continue to evaluate our quarterly distribution, both in the near and medium term, based on the core earnings power of our portfolio, in addition to other relevant factors that may warrant consideration. With that, I'll turn the call over to the operator for questions.

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

Yeah. Good afternoon, Stuart and Joyson. Stuart, I see that the per year internal credit rating system, the fair value of investments performing below expected. The three-category rose from around 9% to 14% of fair value. Are there any specific investments in there that you could highlight and any trends that you're seeing across the portfolio that have accounted for that change?

Good to see you this hour, Mickey. In response to your question, some of our companies are indeed facing supply chain challenges and rising labor costs. Additionally, we are noticing a slowdown in demand as retailers are taking longer to restock inventory due to high inventory levels, along with a general decline in consumer demand. It appears we may be in a recession, which is reflected in diminished demand. While only a few companies are experiencing heightened leverage, the number of those categorized as threes has increased by 5%. There are certain consumer-facing companies in our portfolio where leverage has risen by a turn or two. At this moment, we are not at risk of any new situations becoming non-accrual, but we are certainly witnessing a decrease in consumer demand and a slowdown in retailers restocking, which is exerting pressure on some companies.

It's not that many companies, which is why the number of threes has only increased by 5%. However, there are some consumer-facing companies in our portfolio where leverage has increased by a turn or two. While there is nothing at risk of being on non-accrual at the moment, we are noticing a slowdown in consumer demand and a reduction in retailers restocking inventory, which is putting pressure on some companies.

Mickey, I want to emphasize that regarding the overall risk ratings, we've observed that many portfolio companies rated one or two have dropped to three. Specifically, four companies fell from two to three: TV, American Crafts, Arcserve Storage Craft, and Outward Hound. Additionally, as Stuart mentioned, there hasn’t been much movement for companies dropping to four, with only one very small position, Crown Brands.

We are collaborating with the company's owner to potentially inject new equity, which, if it occurs, would enhance the asset's position for a better valuation.

Yeah, I was going to ask about Crown. That's a non-sponsored deal then, Stuart?

No, that is a sponsored deal because the sponsor injected equity previously several times, but the company does need more equity.

Yeah, it looks like it from the mark on the second. Just a couple of more questions, Stuart. The gain on the RCF shares, I didn't see them listed in the SOI for March or are they held as receivable of some sort on the balance sheet or was it sort of just unexpected income that you booked below the line.

Mickey, it's going to be the latter. If you recall, the RCS shares were received in conjunction with the restructuring of the actual investment that we had in RCS, which had converted into equity in AeroTech. This was proceeds received from the residual bankruptcy ex-date of the Holdco. It was unexpected in nature. Our understanding is that, this distribution would be the only distribution we would receive. We don't expect to have any further amounts in the future.

So there is no remaining receivable or anything like that on the balance sheet?

Correct. We don't have anything recorded.

Okay. And lastly, Stuart, we have an estimate for a while. Can you just remind me where in the life cycle the private funds at HIG that own WhiteHorse shares are, how many years left before they have to deal with that issue?

It's a great question and I have not measured the passage of time. So I don't have an answer ready. Joyson, if you happen to know that would be great. And if not, we can try to get that data to you after the call on a follow-up, Mickey.

Just is it still multiple years away?

Yes, it's still several years away.

Okay. That's it for me this afternoon. I appreciate your time as always. Thank you.

Thank you.

Thank you. Our next question will come from Melissa Wedel with JP Morgan. Your line is now open.

Good afternoon, and thank you for allowing me to ask my questions today. I wanted to revisit your comments regarding the incoming repayments. If I understood you correctly, it seems there are some repayments anticipated, although they may have been delayed or are just starting to occur. Coupled with your remarks about aiming for higher portfolio leverage, should we anticipate an increase in repayment activity in the latter half of the year, while also expecting net deployment due to the strength of the pipeline?

Yes. The pipeline is quite robust. We have seen repayments, which created about $50 million of investing capacity. We are expecting repayments in Q3 and Q4 and have a pipeline of deals that could refill our coffers. In the vast majority of cases, our expectation is that pricing will be higher, both on JV deals and balance sheet deals for the BDC than it was really for all of 2021 and the early part of 2022. We are seeing pricing up anywhere from 50 basis points to 200 basis points with the higher increases associated with the broadly syndicated market and/or with credits that have more cyclicality. We continue to take a very cautious view on companies that have cyclicality and we'll do those only at modest leverage multiples with owners that are putting up big equity checks. So we believe we will support those companies. If we do have a prolonged economic downturn. But broadly, I would tell you what we are seeing in the portfolio is better than we've seen in many years. During 2020 there was a brief period, as I reported where pricing and structure was very attractive, but during that part of 2020 really March to September, the markets were largely frozen and not a lot of deals got done, we did as many as we could, but there were that many done. Right now seeing lower leverage, stronger deal terms, stronger covenants and better pricing, it makes me feel like we're seeing an environment that is more aligned to like 2016 than any time since then. So we think it's a very attractive time to invest and we're pleased that we have some capacity in the BDC to invest. And our intention is that all the deals that go on the BDC balance sheet will go on with pricing of SOFR 700 or above. And most of those loans will continue to be first-lien loans, although we will consider some second liens given that market is trading very weakly right now and there may be some opportunities to add some higher yielding assets.

That's really helpful. I appreciate all that context. It raised another question in my mind, and given some of the struggles that you're starting to see, some portfolio companies have at least on the cost side and maybe a little bit on the top line as well, is this an environment where you would think of skewing more towards sponsor deals and away from non-sponsored just to have the potential backed-up equity capital and owner to step in and inject more capital as needed? And if so, what's the implication on yield of new investments? Appreciate it.

Our general perception, Melissa, is that in a hot market environment where sponsor-backed deals get premium leverage, our non-sponsored deals are actually less risky because they are levered on average a turn or turn and a half lower and you get higher pricing and tighter docs and tighter covenants. In this market environment where sponsored deals have become less risky because leverage multiples have come down and loan-to-values have come down, I would say that I see sponsored deals as being equally attractive to non-sponsored deals. And as a result, more of our deals that were in the pipeline right now and actively working on are sponsored transactions. But I can tell you that for anything that we would deem to be stretch senior debt or unitranche debt, we are seeing minimum pricing of $6.50 and debt that was senior debt that would have been pricing at $4.75 to $5.25 before, we are now getting minimum pricing of $600. So again, the market is much more attractive in terms of asset quality and these are typically non-cyclical borrowers. Cyclical borrowers trade at an even higher price or at higher yield. We see the market as extremely attractive right now, even as we're being cautious about an economic downturn for the balance of 2022 and into 2023.

Got it. Thank you.

Thank you. Our next question will come from Robert Dodd with Raymond James. Your line is now open.

Hi guys. Thanks. So all kind of touching on to that pricing question again. I mean, you've been very clear about the expansion in spreads, but there was a, I believe, a comment you made during your prepared remarks that several lenders have not adapted to the new market. I mean, is that an indication there were still a number of lenders out there that are kind of underpricing where you think the bulk of the market has moved today. Can you give us any more color on that? I mean, bottom line, I mean the concern there would be, is that like-for-like, are they picking off the higher quality A plus steel or just underpricing where you think the market is? And is that potentially raising the prospect of spread snapping back lower again?

Mickey, I apologize for the mix-up. Good to hear from you today. What has really surprised us is that the situation has not aligned with our expectations. These lenders are not selectively choosing the best credits and underpricing them to secure favorable deals. For example, there was a deal involving a company with $14 million of EBITDA that serviced the venture financial sector. This company does face some cyclicality risk, and we assessed its leverage and pricing as responsible. However, another lender offered a significantly lower price on a deal that we believe was fully leveraged and carried some cyclicality risk. Another deal we declined involved a company with two major customers known for being tough on suppliers, which we saw as a significant credit flaw. We adjusted our leverage downwards and sought a higher price, but one of these lenders, who seems to be out of sync with the market, offered higher leverage and a lower price despite the risk. We believe only three to five out of the 100 lenders we might compete with have not adapted, but it’s clear they haven’t. I find it surprising, and I heard from a large investment firm that other businesses they deal with have also identified these lenders who seem unaffected by market changes. They are not focusing on better credits but instead are taking on what we believe is excessive credit risk. We are willing to forfeit deals where lenders pursue more aggressive leverage and lower pricing. We have a substantial pipeline, and we can comfortably afford to lose several deals while maintaining a well-selected portfolio of credits for the BDC.

I appreciate the insights provided. I would prefer to invest cautiously. As you mentioned, there is a delay in receiving financials from the portfolio companies, ranging from 45 to 60 days, and in some cases, it could be up to 90 days. Given the information you provided about margin pressure, I am curious if you have noticed any changes in the frequency or intensity of margin pressure in the most recent data compared to older data that has a longer delay.

The advantage of being in the mid-market, particularly the lower mid-market, is that we don't have to wait for 90 days after the quarter ends without knowing what's happening with our credits. We maintain regular communication with company owners and management teams, especially those under pressure, and we often seek updates either monthly or even weekly. Currently, we observe that most companies have managed to implement price increases, but there is a slowdown in consumer demand affecting some of the companies that were downgraded to a three in rating. However, we are also noticing a decrease in inflationary pressures. For instance, we had a company that previously employed people at $13 an hour before COVID, and they had to raise wages to $18 an hour to achieve full employment now; they have maintained that wage level for the past three to six months without increases. Additionally, container costs from Asia have dropped significantly, nearly 50%. This suggests that some of the inflationary pressures may have already subsided, and consistent with the reports from this morning, we could witness a continued slowdown in inflation. Nonetheless, we are still experiencing some increases in raw material prices, although customers are now pushing through price increases less frequently than they were three to six months ago.

I really appreciate the color. Thank you.

No problem. Thank you, Robert.

Thank you. It seems we have no further questions at this time. I would now like to turn the program back to our presenters for any additional or closing remarks.

I'd like to say thank you to everyone for taking the time today. We're in an attractive but market condition that requires caution, but we are seeing a good transaction, solid pricing and we do hope to fully deploy the BDC capital and keep it generally between the 1.25 times to 1.35 times leverage that we've outlined unless we take on a lot more second lien loans, which at the moment we're not actively doing. So positive trend line and we'll continue to share with you as much information as we can. And for any of the analysts or shareholders that want to communicate with us intra-quarter, we're happy to answer questions. And for next quarter's call please let us know anything you want us to include in the prepared remarks, and we'll try to do that. So thank you very much.

Thank you. Ladies and gentlemen, this concludes today's event. You may now disconnect.